Consider an economy in which people wish to hold bank checking deposits worth a
ID: 1227337 • Letter: C
Question
Consider an economy in which people wish to hold bank checking deposits worth a total of 5 million goods and currency worth 2 million goods in every period. In addition there is a stock of unintermediated capital worth 10 million goods. Fiat money is the only asset used as currency. Deposits at banks are subject to a reserve requirement of 20 percent. After meeting the reserve requirement, banks invest the remainder of all deposits into capital. The monetary base is $1 millon. Hint: The key to this exercise is understanding the difference between inside and outside money.
e. Find the revenue (in goods) from seignorage if the monetary base triples every period.
f. Suppose people want to keep more of their money balances in the form of cash, although their total demand for money does not change. What will happen to each of your answers to part a to e?
Explanation / Answer
Total money stock = M1 = C + DD + OD,
where, C = Currency
DD = Demand or Checking deposits of the people with the bank
OD = Other deposits
Thus, M1 = 2 + 5 + 0 = $7 million
Since, Required reserve ratio = 20% or 20/100 = 0.20
Thus, money multiplier (mm) = 1 / required reserve ratio = 1/ 0.20 = 5
Seignorage revenue is used by the government as finance to cover parts of the government expenditure without collecting taxes from the public. This revenue adds value to the money supply. This changes monetary base.
The monetary base is $1 million. If the monetary base triples every period, the Seignorage revenue (in goods) will be 3 * money multiplier = 3 * 5 = $15 million
Money multiplier implies to the maximum extent to which the supply of money is affected due to change in deposits in bank. If the monetary base triples every period, the demand for goods rises according to money multiplier. Since, money multiplier (mm) = 5. Thus, demand for goods increments 5 times. It will become = 2 * 5 = $ 10 million. Demand for goods increments by $10 million.