Model Answer
0 min readIntroduction
The money supply plays a crucial role in influencing macroeconomic variables like national income and price levels. The relationship between changes in the money supply and changes in national income is governed by the money multiplier. This multiplier effect implies that an initial change in the money supply can lead to a larger change in aggregate output. Understanding this mechanism is vital for policymakers aiming to manage economic activity. The question asks us to determine the formula for the money multiplier and subsequently calculate the change in output resulting from a 510 unit change in the money supply.
The Money Multiplier Formula
The money multiplier (k) represents the ratio of the change in the money supply to the change in the monetary base. It determines how much the money supply expands for each unit increase in the monetary base. The formula for the money multiplier is:
k = (1 + Currency Ratio) / (Reserve Ratio + Currency Ratio)
Where:
- Currency Ratio (c): The proportion of money held by the public as currency relative to deposits. It is calculated as Currency/Deposits.
- Reserve Ratio (r): The fraction of deposits that banks are required to hold in reserve. It is determined by the central bank (RBI in India).
A simplified version, often used in introductory textbooks, assumes a zero currency ratio (people hold all money as deposits). In this case, the formula becomes:
k = 1/r
Calculating the Change in Output
The change in output (ΔY) is directly proportional to the change in the money supply (ΔM) and the money multiplier (k). The relationship is expressed as:
ΔY = k * ΔM
However, to apply this formula, we need values for the reserve ratio and the currency ratio. Since these values are not provided in the question, we will make a reasonable assumption. Let's assume:
- Reserve Ratio (r) = 0.1 (10%)
- Currency Ratio (c) = 0.2 (20%)
Using these assumptions, we can calculate the money multiplier:
k = (1 + 0.2) / (0.1 + 0.2) = 1.2 / 0.3 = 4
Now, we can calculate the change in output given a change in the money supply of 510:
ΔY = 4 * 510 = 2040
Therefore, the change in output is 2040 units.
Assumptions and Limitations
It's important to note that the multiplier effect relies on several assumptions:
- Constant Price Level: The analysis assumes that prices remain constant. In reality, an increase in the money supply can lead to inflation, reducing the real impact on output.
- Fixed Expectations: The model assumes that expectations about future inflation and interest rates remain stable.
- Full Employment: The multiplier effect is most potent when the economy is operating below full employment. If the economy is already at full capacity, increased money supply may primarily lead to inflation.
- Banking System Stability: The model assumes a stable banking system. Financial crises can disrupt the money creation process and reduce the effectiveness of the multiplier.
Furthermore, the actual multiplier effect can be influenced by factors like leakages (savings, taxes, imports) which reduce the amount of money circulating in the economy.
Conclusion
In conclusion, the money multiplier, calculated as (1 + Currency Ratio) / (Reserve Ratio + Currency Ratio), plays a pivotal role in determining the impact of changes in the money supply on aggregate output. Based on assumed values for the reserve and currency ratios, a 510 unit increase in the money supply would lead to a 2040 unit increase in output. However, it is crucial to remember that this is a simplified model and the actual impact can be affected by various real-world factors and assumptions. Policymakers must consider these limitations when using monetary policy to influence economic activity.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.