Question

1. "The money supply of an economy increases when the central bank simultaneously decreases the reserve requirement and sells government bonds in open market." Explain whether this statement is true, false or uncertain.                                                                                                                          (6 marks)

2. What should money growth rate be if real output grows 4% per year, velocity grows 2% per year, and the central bank targets inflation to be 2% per year?                                                              (4 marks)

3. What is the inflation tax? Explain.                                                                                   (6 marks)

4. Explain (with the aid of diagrams) whether the central bank can achieve the stability of interest rate and money supply at the same time when money demand changes.                                                    (9 marks)

Answer 1

a) the money supply of an economy increases when the central bank decreases the reserve requirement. this is a tool of monetary policy of central bank to increase money supply in the economy when its needed. but if central bank sells government bonds in open market the money supply in the economy will reduce rather than increasing so here if central bank simultaneously apply both the method money supply will neither increase nor decrease it will remain constant. so the above statement is false.

b)the money growth rate will be 4% per year if the conditions in the question holds true.

c) inflation tax is not the actual money paid to the government as tax. its the decrease of value of money that occurs when inflation rises. the government sometimes increases the money supply in the economy which ultimately harms the people who hold money in cash because purchasing power of money declines. this is called inflation tax.

d) if demand for money changes it is due to various reasons and it can be neutralise by supply of liquidity but again the supply of liquidity in the market will affect the inflation rate and ultimately the exchange rate. so its not possible for the central bank to achieve the stability of interest rate and money supply at the same time when money demand changes.