The monetary multiplier defines how a primary deposit leads to a greater increase in the total money supply in the economy. The money multiplier value is obtained by calculating the inverse of the reserve ratio (O’Sullivan et al., 2014). This formula assumes that all the money moves into transactional accounts, and the formula is used to measure a certain unit of central bank money and the maximum amount of commercial bank money that can be created from this unit (O’Sullivan et al., 2014). When initial cash is deposited into a bank account, it creates multiple other deposits and loans for banks. For example, suppose the banks’ reserve ratio was 5%, the money multiplier value would be 1/0.05 = 20. Therefore, if the total deposits accounted for £1 million, the bank can lend out £20 million.
Ideally, it is assumed that the banks in the United States offer loans based on the reserves that are considered to be in excess. The money multiplier in the United States is estimated to be between one and three percent (O’Sullivan et al., 2014). This falls short of the required 10 percent value because banks hold excess monetary reserves than required. Consequently, banks lend less than the maximum because of accumulating excess reserve leaving commercial banks with less money than that of the central bank. Additionally, the amount loaned to individuals after holding the liquid reserves is not always deposited into accounts. Some are held as cash, and therefore it becomes unavailable for the banks to lend out, causing smaller money multiplier.
There are certain classifications of money supply based on its liquidity. The Federal Reserve classifies the money supply according to the monetary base, which includes M1 and M2 (Labonte, 2015). M1 is the sum of currency held by the public and transaction deposits at a financial institution, such as commercial banks, savings and loan organizations, and credit unions. M1 constitutes the most basic definition of the money supply (Labonte, 2015). On the other hand, M2 constitutes M1 plus savings deposits and money market mutual fund shares. The deposited cash increases the total amount in transactional accounts while reducing the currency being held by the general public by the same amount. Since the currency circulating in the general public and transactional accounts are included in the supply of money, the total money supply does not change. Hence, depositing cash only changes the location of the money without affecting the money supply.
A counteracting rise and fall to the money supply are evident when an individual writes a check to another. Money supply definition, according to the Federal Reserve, is a group of assets that individuals and businesses can use to make payments, purchases, or keep as short-term investments (O’Sullivan et al., 2014). For example, currency and cash balances held in savings and checking accounts are among the many measures of the money supply in the United States. The bank from which a check has been withdrawn contracts the money supply while the bank in which the check is deposited expands the money supply. Since the mentioned transfer of funds from one checking account to another, the net effect is zero; thus, the money supply does no change.
Keynesians consider wages and prices to be inflexible in the real world of economics. Also, people live in the short run, and what happens in the short-run cannot be inferred from what happens in the long-run since no one will be available to make decisions (Tily, 2016). Nominal wages adjust slowly, which favors the Keynesian economic view, due to their association with the unemployment rate. Wage contracts fix nominal remunerations for the life of the contract which could be a week, a month, or a year. The existence of these contracts means that the contracting parties agree on a certain wage amount at the time of negotiating, without putting into consideration that the economic conditions could change while the agreement still holds.
Employers and employees agree on long-term nominal wage contracts because negotiating a contract is a costly process that involves foregoing the production of goods and services at the expense of negotiating wages. A market-oriented economy has no definite way of implementing a coordinated wage reductions plan, and the rigidity of wages and prices in the short run causes demand to fall short of production, resulting in the economy not achieving full employment. Variations in components of spending, for instance, in government expenditure and investment cause the output to change (Tily, 2016). For example, if there were a fall in demand for labor, trade unions would resist nominal wage cuts; therefore, in the Keynesian economic view, it is easier for labor markets to have disequilibrium (Tily, 2016). Wage cuts are avoided because they may reduce the morale and productivity of the existing workers.
The flexibility of wages and prices favors the classic economic perspective in the long run because the economic output is determined by how the cumulative demand affects prices. The flow of prices of a country’s resources determines wages, and this ensures that resources are fully employed in the economy (Meade, 2013). The defining principle of the classical theory is that the economy adjusts itself. In this theory, the economy holds the capability of achieving maximum output or GDP when the resources in the economy are fully employed (Meade, 2013). Therefore, the classical economic perspective, which holds that aggregated markets automatically achieve equilibrium in the long run without the need for government intervention, is favored.
Graph A represents an increase in the economic output level as the price level decreases when the economy is moving from a recession back to full employment. If the economy is in a recession at point a, wages and prices start to fall (P0 to P1). The Short-run aggregate supply shifts downwards, thereby increasing economic output from y0 to y1 (Goodwin, 2013). The economy then shifts from point a to point b, such that only structural and frictional unemployment remains, and the price level becomes stable.
Graph B represents a decrease in interest rates (r) as the money market remains fixed. In this case, the fall in the price level will decrease the demand for holding money, shifting the money demand curve downwards and moving the economy from point c to point d (Goodwin, 2013). The result in the fall of interest rates from r0 to r1.
Graph C represents a decrease in interest rates as investment increases(Goodwin, 2013). When interest rates fall from r0 to r1, investment spending increase from I0 to I1, moving the economy from point e to point f.
Goodwin, N., Nelson, J., Harris, J., Torras, M., & Roach, B. (2013). Macroeconomics in context. ME Sharpe. Retrieved from https://www.researchgate.net/publication/317605466_Macroeconomics_Second_Edition
Labonte, M. (2015). Monetary policy and the Federal Reserve: Current policy and issues for congress. Congressional Research Service, 18. Retrieved from https://www.everycrsreport.com/files/20150618_RL30354_e20799228e3d2a4b2d7cedf026cad499ef5a20f3.pdf
Meade, J. E. (2013). A Neo-Classical Theory of Economic Growth (Routledge Revivals). Routledge. Retrieved from https://books.google.co.ke/books?hl=en&lr=&id=niPAxzfBrdEC&oi=fnd&pg=PT10&dq=classical+economic+theory&ots=_CSrT6xk0&sig=TAXCvpmoVMlRITygge7L5AFgvU&redir_esc=y#v=onepage&q=classical%20economic%20theory&f=false
O’Sullivan, A., Sheffrin, S. M., & Perez, S. J. (2014). Economics: Principles, applications, and tools. Boston: Pearson Prentice Hall. Retrieved from http://dl.booktolearn.com/ebooks2/science/economy/9780132555234_economics_e80d.pdf
Tily, G. (2016). Keynes’s General Theory, the Rate of Interest, and Keynesian’ Economics. Springer. Retrieved from https://books.google.co.ke/books?hl=en&lr=&id=AtBeCwAAQBAJ&oi=fnd&pg=PP1&dq=Keynesian+Economics+theories&ots=ufomybOMOB&sig=soqGmbwfQlw6pUHlE9E-wbm8RQ4&redir_esc=y#v=onepage&q=Keynesian%20Economics%20theories&f=false