ECON 202 Drexel University Assignment 4 Professor María Pía

ECON 202 Drexel University Assignment 4 Professor: María Pía Oliv

The assignment involves multiple choice questions, short answer questions, and analytical problems centered around banking reserves, money creation, and monetary systems. Students are asked to analyze reserve requirement impacts on deposit multiplication, examine the functions and values of money in different monetary systems, and interpret the effects of changes in income and money demand on interest rates and money supply. The tasks also include balance sheet analysis and exploring reasons for differences between theoretical and actual money supply increases.

Paper For Above instruction

The core of this assignment revolves around understanding the banking system’s capacity to create money through deposit expansion and the limitations imposed by reserve requirements and other factors such as excess reserves and cash hoarding. It delves into the mechanics of deposit multiplication, the distinct functions and values of money in different monetary regimes, and the dynamics of money demand relative to income and interest rates, with a focus on the equilibrium adjustments that occur in a simplified monetary model.

Introduction

Monetary economics examines how deposit creation operates within banking systems and how various monetary systems confer value to different forms of money. Understanding the maximum potential for deposit expansion and the influence of reserve ratios is crucial for policymakers and economists in managing monetary stability and inflation. Furthermore, exploring the functions of money and the principles influencing its value across different systems provides insights into the underlying mechanisms of the economy's monetary framework.

Bank Deposit Multiplier and Reserve Requirements

One of the fundamental concepts in banking is the deposit multiplier, which hinges on the reserve requirement ratio. The reserve ratio determines approximately how much of each deposit banks are mandated to hold as reserves, with the remainder available for lending. For instance, a 25% reserve requirement implies that banks can lend out 75% of their deposits, leading to a maximum deposit creation multiplier of 1 / 0.25 = 4. The total potential increase in deposits is then calculated by multiplying the initial deposit by this factor. However, this theoretical maximum is rarely realized in practice because of factors like cash hoarding and excess reserves. It is essential to understand the impact of changing reserve requirements; a lower reserve ratio (e.g., 5%) increases the deposit multiplier, allowing more extensive deposit expansion, provided other factors remain constant.

The Influence of Cash Hoarding and Excess Reserves

Cash hoarding, where individuals or banks hold onto cash rather than depositing or lending it, reduces the effective deposit creation process. When cash is held outside the banking system, the amount of money that can be created from an initial deposit diminishes because the money does not participate in the banking multiplier process. Similarly, excess reserves, which banks hold above the required minimum, also limit the potential for deposit expansion. These factors explain why the actual increase in money supply often falls short of the theoretical maximum predicted by the reserve requirement ratio.

Functions and Value of Money in Different Monetary Systems

Money's primary function as a medium of exchange ensures efficient transactions, which reinforces its value. In a commodity monetary system, the value of money is derived from the intrinsic value of the commodity backing it, such as gold or silver, which historically grounded money's value and provided stability. In a commodity-backed monetary system, the value is derived from the commodity that backs the currency, with the government or monetary authority issuing notes redeemable for that commodity, thus providing confidence and trust. In contrast, a fiat monetary system derives its value solely from government decree and systemic trust, with no backing by physical commodities. The fiat system relies heavily on public confidence in the issuing authority, which maintains the stability and value of the currency primarily through monetary policy and legal enforcement.

Money Demand and Equilibrium Interest Rate in Country ABC

In the simplified model for country ABC, money demand depends negatively on the real interest rate and positively on income. The demand curve for money, Md = 10,000 – 4,000 r + Y, slopes downward because higher interest rates incentivize holding less money (since the opportunity cost increases), while lower interest rates make holding money more attractive. Given a money supply fixed at Ms = 5,000, the equilibrium interest rate can be found by setting money demand equal to money supply. When income increases from 3,000 to 5,000, the money demand at the previous interest rate exceeds the supply, leading to excess demand and pressure for the interest rate to rise. To restore equilibrium, the money supply must increase accordingly, and the interest rate will adjust until the new demand curve intersects with the fixed supply, establishing the new equilibrium interest rate.

Conclusion

The theoretical models of deposit creation and money demand provide foundational insights into the functioning of modern economies. Reserve requirements, cash hoarding, and excess reserves significantly influence the actual money supply expansion. Understanding the different value implications of money within various monetary systems underscores the importance of trust, backing, and government policy. Analyzing the dynamic interactions between income, interest rates, and money demand helps in comprehending monetary policy's real-world effects and the economic variables that underpin financial stability.

References

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