Answer to Question #193862 in Macroeconomics for Reginah Tumbo

Question

Given the amount of money being printed the amount of Base Currency sitting as Reserves on bank balance sheets far exceeds currency in circulation when normally the reserves only slightly exceed currency in circulation in a fractional reserve system. How can one derive the cumulative inflation effect of these excess reserves via k assuming the economy being in equilibrium with the current amount of currency in circulation? These excess reserves are a liquidity trap waiting to happen in the form of massive inflation, if (post Covid supply chain problems Dir to shifting demand or reduced production capacities etc?) amd when they make their way into the economy. The k factor ought to be able to approximate what the cumulative inflation effect might be. How can that be calculated via the Cambridge k?

Answer 1

Aggregate money demand (MD) equals money supply in equilibrium (MS). Depending on the degree at which the economy is running, the difference between the two has consequences for inflation and thus causes monetary policy intervention. MS is calculated as a product of the money multiplier (mm) and reserve money (RM). Money sources (NFA + NCG + PSC + OIN) are added together. Net foreign assets is NFA, net credit to the government is NCG, private sector credit is PSC, and other things net is OIN. The transmission mechanism operates via domestic interest rates, such as the policy rate (r CBR), short-term rates (r int), long-term deposit rate (r D), and lending rate (r L).

Past inflation rates, economic agents' expectations for potential inflation, and the production gap all influence inflation. The production difference coefficient captures market flexibility: the higher the value of this coefficient, the more flexible prices are. By substituting for future inflation expectations adaptively, a formulation in terms of lagged inflation is obtained, but such relationships may not be structurally stable. When estimating the position of the production gap, we developed a direct measure of expected inflation to account for possible uncertainty caused by changes in expectations. Inflation is influenced by previous levels of inflation, as well as economic agents' perceptions of future inflation.