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1.
INTRODUCTION
Money
Known value
Easily divisible
High value relative to their weight
Not perishable (store of value)
Not easily counterfeited
FinQuiz Notes 2 0 1 6
Reading 19
Reading 19
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Practice: Exhibit 3,
Volume 2, Reading 19.
Money multiplier = 5
The smaller the reserve requirement, the greater the
money multiplier effect.
Reserve requirement is set by the central bank.
Central banks can increase money supply in the
economy by lowering the reserve requirement.
MV=PY
where,
Practice: Example 2,
Volume 2, Reading 19.
M = Quantity of money
V = Velocity of circulation of money (the average
number of times in a given period that a unit of
currency changes hands).
P = Average price level
Y = Real output
According to the quantity theory of money, over a given
period,
Amount of money used to buy all goods and services in
an economy (i.e. M V) = Value of Output in money
terms (i.e. P Y)
Assuming velocity of money as approximately constant,
Spending (i.e. P Y) is approximately proportional to M
According to QTM, if money is assumed to be neutral,
then if money (M) is increased, it will only lead to
increase in P and Y & V will remain unchanged.
However, if Velocity of circulation of money falls or real
output rises, then prices will remain unchanged if money
is increased.
Hence, according to Monetarists school, Inflation is a
purely monetary phenomenon i.e. inflation can be
decreased by decreasing money supply in the
economy. So, the quantity theory of money states
that the central bank, which controls the money
supply, has ultimate control over the rate of inflation.
However, this concept is criticized on the basis that
quantity of money in circulation is determined by the
level of economic activity rather than vice versa.
2.1.5) The Demand for Money
Demand for money refers to the amount of wealth that
the individuals in an economy prefer to hold in the form
of money rather than as bonds or equities.
Reading 19
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Practice: Example 3,
Volume 2, Reading 19.
Reading 19
Practice: Example 4,
Volume 2, Reading 19.
2.2
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Practice: Example 5,
Volume 2, Reading 19.
Reading 19
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Reading 19
Base rates of
commercial
banks and
interbank rates
rise.
Central bank
increases its
policy rate.
Fall in AD puts
downward
pressure on
inflation.
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Consumption
& investment
spending
AD
Borrowing
decreases
Central bank
increases its
policy rate.
Fall in AD puts
downward
pressure on
inflation.
Household
financial wealth
decreases.
Borrowing to finance
asset purchases
and/or investment
spending
AD due
to fall in C
and I.
Fall in AD puts
downward pressure
on inflation.
Borrowing to
finance asset
purchases .
AD
Fall in AD puts
downward pressure
on inflation.
Practice: Example 8,
Volume 2, Reading 19.
Domestic
currency
appreciates.
AD
Domestic Exports
become
expensive.
Exports fall
Reading 19
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Practice: Example 9,
Volume 2, Reading 19.
Reading 19
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For example,
Neutral rate = 2% + 2.5% = 4.5%
2.4
Reading 19
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FISCAL POLICY
NOTE:
Reading 19
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Reading 19
revenues.
Large fiscal deficits may help to reduce distortions
caused by existing tax structures by introducing tax
changes.
Fiscal deficits may have no net impact because the
private sector may increase savings in expectations
of higher future tax rates. It is known as "Ricardian
equivalence".
In case of unemployment in an economy, debt
rather helps to increase employment.
The arguments in favor of being concerned about
national debt relative to GDP are as follows:
High debt to GDP ratio may lead to higher future tax
rates to earn higher tax revenues to finance the
deficit. Higher marginal tax rates reduce labor effort
and entrepreneurial activity and results in lower
growth in the long-run.
When government deficit is financed through
printing money, inflation increases.
Crowding out effect: When deficits are financed
through borrowing, it leads to crowding out effect
i.e. due to higher government demands, cost of
borrowing (interest rates) and as a result, private
sector investing decreases.
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Reading 19
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NOTE:
3.2
NOTE:
According to supply-side economics, income taxes may
reduce the incentive to work, save and invest.
Reading 19
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NOTE:
The announcement of future rise in income tax can
lead to immediate decline in consumption.
Generally, direct government spending has
relatively greater impact on aggregate spending
and output than income tax cuts or transfer
increases.
3.2.2) Modeling the Impact of Taxes and Government
Spending: The Fiscal Multiplier
The net impact of the government sector on AD is:
G T + B = Budget surplus OR Budget deficit
where,
G = government spending
T = taxes
B = transfer benefits
Disposable income = Income Net taxes = (1 t)
Income
where,
Net taxes = taxes transfer payments
t = net tax rate
For example, if t = 20%, then for $1 increase in national
income,
Net tax revenue will rise by 20 cents.
Household disposable income will rise by 80 cents.
The fiscal multiplier: Government purchases have a
multiplier effect on AD i.e. each dollar spent by the
government can increase AD for goods and services by
more than a dollar. It is used to determine the total
change in output that occurs as a result of exogenous
changes in government spending or taxation.
.
( . )
= 3.57
Reading 19
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Reading 19
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4.3