Monetary and Banking Systems: A Comprehensive Analysis

Posted on Nov 29, 2024 in Economy

1. Monetary vs. Banking Systems and the Creation of Money
Banking systems can create money by issuing currency (e.g., central banks) or by multiplying deposits (e.g., commercial banks). Monetary systems, however, are broader, encompassing financial intermediation (e.g., investment banks, development banks).

2. Factors Increasing the Banking Multiplier
The banking multiplier increases with higher public preference for demand deposits over paper money and lower bank reserve ratios. That is, a higher ratio of demand deposits to reserves leads to a larger multiplier.

3. Factors Affecting Monetary Base Expansion/Contraction
Expansion: Increased international reserves, central bank security purchases, lending to government entities, and decreased treasury deposits.
Contraction: Decreased international reserves, central bank security sales, treasury loan repayments, and increased treasury deposits (e.g., due to fiscal surpluses).

4. Factors Affecting Money Demand
Money demand is influenced by:

  • Transaction Motive: Money as a medium of exchange.
  • Precautionary Motive: Holding money for unforeseen expenses.
  • Portfolio Motive (Speculation): Money as a financial asset, an alternative to securities.

5. Impact of Expected Monetary Base Reduction
If a government announces a future reduction in the monetary base, agents may revise their inflation expectations downward, reducing the nominal interest rate and increasing demand for real money balances. This could lead to a temporary deflationary pressure. To avoid this, the government might increase the money supply. The government’s credibility is key to the success of this policy.<img alt= “>

6. Determining the Optimal Number of Conversions (Transactions)
Individuals determine optimal cash balances by minimizing the total cost function. The optimal average cash balance is derived by differentiating the total cost function with respect to the number of transactions (N) and setting it to zero. The resulting equation shows that money demand varies positively with income and inversely with interest rates. This is a microeconomic foundation for money holdings.<img alt= “>

7. How Real Wage (W/P) Affects Hours Worked
The decision of how many hours to work involves maximizing a utility function that considers income (from consumption goods) and leisure. The real wage represents the opportunity cost of leisure—the consumption goods sacrificed for each hour of leisure.

8. Income Equilibrium, Multiplier, and Expenditure
Given a consumption function (C = 100 + 0.8Y), where Y represents income, the equilibrium income (YE) is found by setting Y = C. The multiplier is calculated as 1/(1-MPC), where MPC is the marginal propensity to consume (0.8 in this case).<img alt= “><img alt= “>
Y = C
Y = 100 + 0.8Y
Y – 0.8Y = 100
Y(1 – 0.8) = 100
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Introducing Investment
With autonomous investment (I), aggregate demand (AD) becomes AD = C + I. The new equilibrium income is calculated by solving Y = C + I. <img alt= “>
Aggregate demand is now:
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The equilibrium condition remains the same, but now includes investment. The equilibrium income is given by:
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Numerically, with an investment of $200, and substituting C and I into the equilibrium condition, we get:
Y = 100 + 0.8Y + 200
Solving for Y, we get YE = 1500.

Alternatively, using the savings (S) and investment (I) approach, equilibrium is where S = I. Given a savings function (S = -100 + 0.2Y) and investment (I = 200), we have:
-100 + 0.2Y = 200
Solving for Y, we again get YE = 1500.<img alt= “><img alt= “>

Inventory Cycle
Consider a scenario where initial investment was $140, resulting in an equilibrium income of $1200. If investment increases to $200, firms aim to maintain 10% of aggregate demand as inventory. The adjustment process involves excess demand leading to inventory reduction, followed by production adjustments to meet demand and restore desired inventory levels. This iterative process describes the inventory cycle.