Question about the money multiplier – Welker’s Wikinomics Page

The following question was submitted by “blobber008″ to the discussion forum at our class wiki:

When I need to find the maximum increase in the total money supply, where the money deposited is $100 and the reserve requirement is 10 percent, do I multiply the total money deposited by the money multiplier, or do I multiply the excess reserves by the multiplier to find the increase, or does it depend on the situation? I thought that I would multiply the initial deposit by the multiplier, thus getting an increase of $1000. My answer key, though, said that increase is $900. When I asked my teacher, she said that you subtract out the original $100 from the $1000 to get the increase in money supply.

The reason I’m confused is that another question asking for an increase resulting from the Fed buying securities from the public doesn’t subtract out the original value. Do you do something different when dealing with money in a bank/checking account and the purchase of securities? Or, do I really subtract out the initial deposit? If so, can you explain why?

This is a good question and one that often comes up among students and even teachers via the AP Economics teacher email group.

The basic difference between an individual depositing $100 and the Fed buying $100 worth of bonds from a commercial bank is that when the individual deposits money, it was already part of the money supply. This is is why the amount of new money created is only $900 when an individual deposits $100 in the bank. We multiply the $100 by the money multiplier (1/required reserve ratio), and then subtract the original deposit, since it was already held by the public, thus part of the money supply.

In the case of the Fed’s purchase of bonds, on the other hand, the $100 of new reserves at the bank are themselves new money, since money held by the fed is not part of the money supply. In this case, we multiply the change in deposits by the multiplier, and the new money created includes the initial change in deposits, which came from the Fed.

Thanks for your submission, hope that helped!

Related posts:

1. From the Help Desk – more on loanable funds and the money market
2. How big is the government spending multiplier in America? Well, it depends on which economist you ask…
3. The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal

Carmen submitted the following through the “Econ Help Desk“

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

Related posts:

1. Loanable Funds vs. Money Market: what’s the difference?
2. From the Help Desk – crowding out, money market and new money creation
3. 2007 AP FRQ #2 – Tax credits and the loanable funds market

*Click on the graphs to see full-size versions

The following message was submitted through the AP/IB Econ Help Desk:

Jason,

An AP Macro Question: Comes from the recently published AP Practice Exam

An increase in which of the following is most likely to promote economic growth?

A. Consumption Spending
B. Investment Tax Credits
C The natural rate of unemployment
D The trade deficit
E Real Interest Rates.

The answer is B, and I understand the economic principles of why that would promote economic growth, but what I can’t answer for my students is why A, Consumption Spending wouldn’t work. I know that consumption spending makes up part of the demand in aggregate demand, but I can’t help but think that an increase in it, would promote economic growth.

Thanks, “Econ Teacher”

For what it’s worth, here is my reply:

Hello “Econ Teacher”,

That’s a good question. I would explain to my students that in the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run, an increase in AD alone will lead to some growth, but would be accompanied by inflation, since AS does not shift out when consumption increases. However, an investment tax credit will result in REAL long-run economic growth (by real I mean nominal GDP will increase while the price level remains stable), since it encourages investment. Investment is a determinant of AD, just like consumption, so AD will shift out, but it is also a determinant of AS, since firms are investing in capital. Increase the quantity or the quality of capital, and labor becomes more productive. Greater productivity shifts out AS, leading to growth AND stable prices.

Economic growth is defined, in terms of the AD/AS model, as an outward shift of both AD and AS. Increases in consumption will increase AD, but this will lead to inflation, and in the long run, workers will demand higher wages, increasing the costs of production and shifting AS leftward, returning the economy to the full employment level of output at an even higher price level, i.e. no economic growth occurs (see graph to the right). Investment, however, encouraged through a tax credit, will have positive demand and supply side effects, resulting in real economic growth and stable prices (see graph below)

Hope that helps!

Jason Welker

Related posts:

1. Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
2. Walking the fine line between good growth and bad growth in China
3. Models of Economic Growth and Development