Question

2. Suppose the economy of Diagon Alley contains 50,000 gold Galleons. a. If people hold all money as coin and currency, what is the quantity of money in Diagon Alley. b. If people deposit all of their gold coins in Gringotts Bank which maintains 100% reserves on deposits, what is the quantity of money? c. If people deposit all of their gold coins in Gringotts Bank which maintains only 10% reserves on deposits, what is the quantity of money? d. If people hold equal amounts of coins and demand deposits, and the reserve requirement is 10%, what is the quantity of money? e. Suppose the Ministry of Magic requires banks to hold reserves of at least 5% of deposits. If the Ministry conducts an open market transaction and purchases 1,000 Galleons worth of securities from Mr. Ollivander, a resident of Diagon Alley, what is the largest possible increase in the money supply that is possible? Explain. What is the smallest possible increase in the money supply that is possible? Explain. 1. Is a Galleon commodity money or fiat money? (Careful here, this question is harder than it looks!) 2. Assume that a Galleon is commodity money. If a wizard mastered the art of "alchemy," which is the medieval science of transforming base metals such as lead into gold, what would you imagine would happen to price levels in Diagon Alley? Why? h. Suppose the economy of Diagon Alley also uses silver coins called Sickles so that 17 Sickles equals one Galleon. What is the problem maintaining a bi-metallic standard for commodity money?

Answer 1

Solution

a.Quantity of money :

M1 = 50,0000 gold Galleons

M1 = Currency in the form of cash and coins + in demand deposits

since all the money is in the form of coin and currency.It is the most liquid form of money.

b. Quantity of Money M0 = 50,000 gold Galleons

M0 is the currency in circulation + banks' deposits with the federal bank + other deposits with the federal bank

Here,it is given that the entire currency and cash of public is deposited with the bank and that the bank maintains a 100 % on these deposits.

c. then only 90% of the money is considered which falls under M1 = 45,000 Galleons

d.Then M 1 = (0.90 * 50,000) i.e., 45,000 Galleons

e.When the Ministry conducts an open market transaction and purchases the Galleons then the money supply in the economy reduces.Open market transactions is a technique used as a part of Monetary policy of Federal / Central Bank.

f.Galleon is a commodity money because it is made with Gold.Commodity money involves the actual usage of the good in place of money. Ex:Gold ,silver coins,tea etc.,)

Fiat money means paper money.It does not have any value by itself.It is just used as a medium of exchange.

g.Since base metals are being converted into gold,the supply of gold will increase.So the value associated with gold reduces.Since Galleons are gold coins,the value of galleons falls which means there would be price rise.

h.The problem is that since each country tries to establish it's different rate of exchange between the two commodity currencies,the rates between these underlying metals (i.e., here,silver and gold) differ vastly from one country to the other.