Answer to Question #145918 in Macroeconomics for bisha

Question

Consider the following relationship between money supply M2, money multiplier (m) and monetary base (MB): M2 = m  MB During the latest financial tsunami in the US, financial de-leveraging and other changes in economic behaviors have caused a significant reduction of the money multiplier (m) from around 8.5 to around 5. If the Federal Reserve chooses to do nothing, what will be the effect of the reduction in m to the US economy? Which variable the Federal Reserve has chosen to work on, and to what extent this has helped the US economy? Some people were worrying that the US could go into another Great Depression. How does the above discussion help your prediction on such possibility?

Answer 1

M2 = m x MB

M2 - money supply

m - money multiplier

MB - monetary base

Monetary Base = Total currency in circulation + The amount held by banks as reserves

Money Multiplier = 1/LRR

Money Multiplier = Change in total money supply / Change in monetary base

As per the question, during the latest financial tsunami in the US, financial de-leveraging and other changes in economic behaviors have caused a significant reduction of the money multiplier (m) from around 8.5 to around 5. Decreasing "m" may be a cause of increased LRR or increasing monetary base. Normally during the recession the central decrease "LRR" or increasing money supply that increases the money multiplier. The objective of this action is to boost economic growth, minimize unemployment, and lower and stabilized the inflation rate. But when the economy grows, the central bank increase LRR that decreases the money multiplier. When the economy grows, inflation increase so, to control inflation the central bank increase LRR that decrease the money supply and interest rate increase. Increasing interest rates help out in controlling inflation. But decreasing the money supply helps out when the economy is growing rapidly or the economy in a pick phase. If the economy is at an initial level of growth rate then tightening monetary policy and damage AD will negatively affect the economic growth and inflation. During an initial level of economic growth (after the recession) there is a need for growing inflation and rapidly recovering economic growth to boost the economic growth toward a boom phase. But increasing interest rate can negatively affect the AD that will negatively affect GDP growth and inflation that will negatively affect production that will increase inflation and decrease income level. It depends upon the current situation or cycle of the economy. During the initial level of growth or the recovery phase of the economy, there is the need for more investment spending and consumption or increasing consumption that boost the economy but these are getting affected when interest rate increase. But it is difficult to predict the real and actual impact in a short-term period. But if the decreasing "m" is favorable for consumption and investment then it will negatively affect AD that will decrease price level and output level (GDP).