Question

Suppose that, as a result of recent tax cuts, the amount of activity in the underground economy is significantly reduced. a. What effect would this have on the demand for currency? b. What is the effect in part a on the money multiplier? Explain. c. What is the change in the money supply according your answer in part b assuming the monetary base is held fixed? d. Describe the Fed’s response, via the open market operation, to such a change if the short-term interest rate is targeted.

Answer 1

a. As the activity in the underground economy gets reduced, more and more transactions will take place in the regulated manner and this will increase the demand for currency in the underground economy.

b. The money multiplier in the economy will increase as the level of underground economy declines because more and more money will start circulating in the economy and this increases the level of money multiplier.

c. If the monetary base is held fixed and the value of money multiplier increases, the the level of money supply in the economy will increase.

d. As the level of money supplied in the economy increases, the Fed will have to reduce the money supplied in the economy to maintain short term interest rate and this involves selling of government securities in the open market.