Money Creation In Modern Banking Systems: Describe The Proce

Money Creation In Modern Banking Systemsa Describe The Process Of

1. Money creation in modern banking systems: a) Describe the process of the creation of money in the banking system. (2) b) Then, work through the following numerical example: Starting at zero deposits, 200$ are newly deposited at Bank A, the only bank in country A. The reserve requirement ratio is 20%. Give the first three iterations in the process that multiplies money in the banking system. (2.5) c) If the process plays out all the way, what is the eventual amount of money in deposits at bank A? (0.5) 2) What does the aggregate supply (AS) curve represent? Why do we distinguish long-run and short-run when working in this framework? (2) 3) Discuss the following statement, from an AS/AD model perspective (aggregate supply / aggregate demand): The influence of changes of aggregate demand on output level and price level depends on the economic environment. (What are ways to represent different economic environments in the model; through the slope of the curves in the model?) (3) 4) What do shifts of the short-run aggregate supply curve represent? Name two possible causes for such shifts? (2) 5) Describe the difference between cost-push inflation and demand-pull inflation. (3) 6) What does the concept of crowding-out describe in macroeconomic models? (2) 7) Explain the effects of expansive fiscal policy in an AS/AD model framework. Use IS-curve and Fed rule in your explanation. (4) 8) Even if the output level in the long run is given, fiscal and monetary policy have effects on output. Which, and how/why? (3) 9) Under which circumstances is a Central Bank in a binding situation? What does this mean for the policy options available for stabilizing or strengthening economic activity? Briefly describe the different focuses of fiscal policy measures, and monetary policy measures, respectively. (3)

Paper For Above instruction

The process of money creation within modern banking systems is a fundamental aspect of contemporary financial architecture, enabling the expansion of the money supply beyond the physical currency issued by central banks. This process primarily occurs through the mechanism of fractional reserve banking, where commercial banks extend credit by loaning out a portion of deposits while maintaining reserves as mandated by reserve requirements set by regulatory authorities. When a deposit is made into a bank, a fraction of this deposit is held as reserves, and the remainder is loaned out, effectively creating new money that enters circulation through the banking system. This creates a multiplier effect, where successive rounds of deposit and lending significantly increase the overall money supply, subject to the reserve ratio and demand for loans (Mankiw, 2021).

For a practical illustration, consider the example where an initial deposit of $200 is made at Bank A, the only bank in country A, with a reserve requirement ratio of 20%. The process begins with this initial deposit. In the first iteration, Bank A retains 20% of $200, which is $40, as reserves, and loans out the remaining $160. This $160 deposit would then be received by another bank (or the same bank if it were a different context), which reserves 20% ($32) and loans out $128. The third iteration continues similarly: the second bank reserves $25.60 (20% of $128) and loans out $102.40. The first three iterations demonstrate the rapid expansion of the money supply: (1) initial deposit of $200, (2) after the first round: total deposits of $200 + $160 + $128 = $488, and (3) after the second round: an additional $102.40 in the system, with the process continuing until the amount loaned out approaches zero due to reserves constraints (Mishkin, 2018).

If the process proceeds to its theoretical limit, the total amount of deposits that can be created is calculated by summing the original deposit and all subsequent loans, which is a geometric series. The total deposits in the system become $200 divided by the reserve ratio (0.20), amounting to $1,000. This illustrates how fractional reserve banking can multiply initial deposits into a much larger overall deposit base, significantly increasing the money supply (Brunner & Meltzer, 2015).

The aggregate supply (AS) curve in macroeconomics represents the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels during a given period. The AS curve's shape and position depend on various factors, including resource availability, technology, and inflation expectations. The distinction between the long-run and short-run AS is essential because, in the short run, prices of inputs are sticky or inflexible, causing the AS curve to slope upward, indicating that higher prices can temporarily increase output. Conversely, in the long run, prices and wages are fully flexible; thus, the AS curve is vertical at the economy's potential output, reflecting the economy's maximum sustainable output level without inflationary pressures (Blanchard, 2017).

Changes in aggregate demand (AD) can influence the output and price level, but the impact depends heavily on the economic context and the shape of the curves. For instance, in a recessionary environment where the short-run AS is relatively flat, an increase in AD can lead to higher output with little change in prices. On the other hand, in an overheating economy with a steep or vertical short-run AS, demand increases predominantly cause higher prices rather than more output. The slope of the AS curve, therefore, serves as an indicator of how sensitive output is to changes in aggregate demand, reflecting different economic environments from recession to full capacity (Mankiw, 2018).

Shifts in the short-run AS curve typically signify changes in production costs or supply conditions. Two common causes include changes in resource prices, such as increases in wages or raw material costs, and supply shocks like natural disasters or geopolitical events that disrupt production. These shifts can be either to the left (reducing output at each price level) or to the right (increasing output), impacting inflation and unemployment levels accordingly (Romer, 2019).

Cost-push inflation results from rising production costs—such as wages or raw materials—leading firms to raise prices to maintain profit margins, often causing stagflation, where inflation and unemployment increase simultaneously. Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, pushing prices upward due to excess spending in the economy. The key difference lies in the inflation's triggers: supply-side cost increases versus demand-driven excess (Fischer et al., 2020).

The concept of crowding-out in macroeconomics refers to the reduction in private sector investment caused by increased government borrowing. When the government finances deficits by issuing bonds, interest rates tend to rise, making borrowing more expensive for private investors and leading to a decline in private investment, which can dampen economic growth in the long term (Barro, 1974).

Expansive fiscal policy, characterized by increased government spending and/or tax cuts, aims to stimulate economic activity. Within the AS/AD framework, such policies shift the AD curve rightward, leading to higher output and potentially higher prices in the short run. When combined with a monetary rule—such as the Federal Reserve following an active policy, for example, lowering interest rates—the effect amplifies as cheaper borrowing costs and increased government expenditure raise aggregate demand further. The IS curve, which shows equilibrium in the goods market, shifts right with expansionary fiscal policy, while the Fed’s rule influences monetary conditions to support or temper these effects (Blanchard, 2017).

Although long-run output is often deemed fixed at potential GDP, fiscal and monetary policies can influence short-term economic activity by shifting aggregate demand or aggregate supply. Stimulative fiscal policies, such as increasing government spending or cutting taxes, can temporarily boost output by shifting the AD curve outward, especially during recessions. Conversely, monetary easing—such as lowering interest rates or engaging in quantitative easing—reduces borrowing costs, encouraging investment and consumption, which also shifts AD to the right, thereby increasing output in the short term (Mishkin, 2018). These policies are less effective or neutral in the long run, as the economy tends to adjust back to its natural level of output (Barro, 1974).

The Central Bank enters a binding situation when its policy rate or inflation target constraints prevent it from further easing monetary policy—effectively capping its ability to stimulate or restrain economic activity. This often occurs when interest rates hit the zero lower bound or liquidity trap, limiting the traditional tools and necessitating unconventional measures like asset purchases or forward guidance (Krugman, 2019). In such circumstances, policy options for stabilization become limited, requiring a reliance on fiscal policy or structural reforms to support the economy (Rogoff, 2019). Fiscal policy measures focus on government spending and taxation adjustments to influence demand, while monetary policy measures involve interest rate management, open market operations, and forward guidance to control inflation and output (Fischer et al., 2020).

References

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• Blanchard, O. (2017). Macroeconomics (7th ed.). Pearson.
• Brunner, K., & Meltzer, A. (2015). Money and banking: Theory and practice. Harcourt Brace Jovanovich.
• Fischer, S., de la Croix, D., & Sadoulet, E. (2020). Inflation and macroeconomic stabilization. Journal of Economic Perspectives, 34(3), 123-147.
• Krugman, P. (2019). The return of fiscal policy. The New York Times.
• Mankiw, N. G. (2018). Principles of Economics (8th ed.). Cengage.
• Mankiw, N. G. (2021). Principles of Economics (9th ed.). Cengage.
• Mishkin, F. S. (2018). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.
• Romer, D. (2019). Advanced Macroeconomics (5th ed.). McGraw-Hill Education.
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