Download Answers to Questions in Chapter 18

Answers to Questions in Chapter 18
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435  Why may money prices give a poor indication of the value of goods and services?

Money prices may be distorted by monopoly power.

They ignore externalities.

Simply adding up the money incomes of individuals in order to get a measure of
their total incomes ignores questions of the distribution of income.

The value of money is eroded over time by inflation. Thus nominal prices would
have to be converted to real prices (see Box 14.1 of the text) in order to compare
the values of goods at different points in time.
436  (Box 18.2) 1. Would it matter if it was easy to forge a $20 note but cost $30 to do so?
No. It would not be `profitable' for forgers to produce such notes.
436  (Box 18.2) 2. How well do each of the following meet the seven requirements listed
above? Grain, strawberries, strawberry jam, gold, diamonds, Commonwealth Bank
share certificates, a savings account requiring one month's notice of withdrawal, notes
and coin?

Acceptability: most are not currently acceptable as a medium of exchange, with the
possible exception of gold under certain circumstances. Most, however, could be
acceptable, if society chose. Strawberries would be a clear exception! Clearly the
degree of acceptability would depend on the extent to which the item met the other
six requirements.

Durability: gold, diamonds, notes and coin and a savings account have almost
perfect durability; share certificates have moderately high durability; grain and
strawberry jam have moderate durability; strawberries clearly have very low
durability (unless frozen).

Convenience: notes and coin (except for large amounts and the risks of robbery),
share certificates would be very convenient; gold and diamonds would be
moderately convenient for large transactions; again, strawberries would be very
inconvenient.

Divisibility: notes and coin (assuming different denominations) and also a savings
account score highest here (assuming that any amount can be withdrawn or
transferred); share certificates also score highly (especially if they come in different
`denominations'); gold and diamonds are divisible down to moderately low levels;
strawberries are also good in this respect (mind you, it's about the only one!);
strawberry jam would be quite good, if it came in small-sized jars as well as
normal-sized ones; grain is virtually perfectly divisible.

Uniformity: notes and coin and the paper assets are the best in this respect; the
others are only suitable here if there is a means of identifying quality.

Hard for individuals to produce themselves. In the case of the commodities, there
would be no problem here providing that their value as money was no higher than
their market value as a commodity. As far as the other assets are concerned, notes
and coin are good (assuming they are hard to forge); a savings account would also
be good, providing it was not possible for people to get unauthorised access to the
account; the suitability of share certificates would depend on how easy they were to
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Answers to questions in Economics by Sloman and Norris
forge.

Stability of value: notes and coin and a savings account are as good as the currency
in which they is denominated; share certificates are bad, given that share prices
fluctuate with the fortunes of the company; diamonds and gold are good, as their
supply is relatively constant; grain and especially strawberries are bad, given that
their supply fluctuates with the harvest; strawberry jam is not very good either,
given that its cost of production also fluctuates - with the price of strawberries.
437  Which of the above are examples of economies of scale?
Expert advice can be given by larger institutions which can employ specialist
personnel. The same applies to expertise in channelling funds: larger institutions can
acquire a greater expertise by having a number of different departments. In both these
cases, however, the economies of scale may be exhausted relatively quickly. Small
financial institutions could always buy specialist information.
In the case of maturity transformation and risk transformation, however, there may be
more substantial economies of scale to be gained. Larger institutions can spread risks
more widely and can operate with a bigger maturity gap.
440  Will the Reserve Bank’s monetary policy objectives conflict with each other at times?
Yes. It is possible that in a period where inflation tends to be above the Reserve Bank’s
target range, that the bank may have to raise interest rates and thus this will conflict
with objectives (b) and (c).
441  (Box 18.3) 1. If money is not backed by gold, what gives it its value?
The fact that it is generally acceptable and that its supply is controlled by the
authorities.
441  (Box 18.3) 2. If the money that banks have created vastly exceeds the amount of cash in
the economy, does this mean that there is too much money in the economy?
No, providing that the total supply is relatively stable, and only grows in line with the
growth in transactions. A high ratio of bank-deposit money to cash, may merely reflect
the limited use society makes of cash in its transactions.
443  If banks choose to operate a 20% liquidity ratio and receive extra cash deposits of $10
million:
(a) How much credit will ultimately be created?
(b) By how much will total deposits have expanded?
(c) What is the size of the money multiplier?
(a) $40m
(b) $50m
(c) 5 (= 1/0.2)
443  Why might a bank with a given amount of liquid assets be more willing to expand its
mortgage loans for house purchase than to expand its personal loans for the purchase
of consumer goods?
Because granting mortgages is a relatively secure form of investment for the bank.
They have the property as security, which can be sold if the borrower defaults on
payment. (There is the problem, however, that the property may fall in value. For this
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Chapter 18
reason banks will not normally grant 100% mortgages.)
444  Is the following statement true: `The greater the number of types of assets that are
counted as being liquid, the smaller will be the bank multiplier'?
Yes. The more assets it counts as liquid for purposes of deciding how much credit to
grant, the bigger will be its liquidity ratio and therefore the smaller will be the bank
multiplier. On the other hand, any rise in the total amount of broad liquidity is likely to
be much larger than a rise in cash, and thus, although the multiplier is smaller, a larger
figure is being multiplied, with the result that the total amount of credit expansion may
be much the same as by basing it on cash alone.
445  Will students in receipt of a grant or an allowance who are paid once per term have a
high or a low transactions demand for money relative to their income?
High, to the extent that they succeed in living off their grant or allowance. In such
cases, their current account balances may be relatively large compared with their annual
income (given that they are only paid three times a year). If, on the other hand, their
grant or allowance is spent very rapidly, and then they have to seek a loan, their
transactions balances may be low relative to their income!
446  (Box 18.4) Under what circumstances are cheques more efficient than cash and vice
versa? Would you get the same answer from everyone involved in transactions:
individuals, firms and banks?
Cheques are more efficient than cash for large transactions, or when there is a danger of
theft of the cash. Cheques are less efficient than cash for small transactions: these have
a low value relative to the cost of processing a cheque; also cash transactions are
quicker than transactions by cheque.
The above points apply generally, but sometimes, what may be in the interests of one
party to a transaction may not be in the interests of the other(s). For example, a shop
may prefer to receive cash on occasions where it is more convenient for a customer to
write out a cheque (because that saves a visit to the bank or cash machine).
446  Why would it not be sensible to hold precautionary balances if you have a credit card?
Simply because there is no need. If you have a credit card with a limit of say $3000
then this is equivalent to having a precautionary balance of $3000. There is no cost to
holding an unused credit facility, but there is a cost in the form of interest foregone in
holding precautionary cash balances.
447  Why does the level of nominal GDP rather than real GDP determine the demand for
money?
The demand for money to undertake transactions depends upon the value of those
transactions, which is obviously influenced by the price level. It is nominal GDP, not
real GDP that determines the demand for transaction balances. Similarly, the amount of
cash you need to hold for precautionary purposes will again depend upon the level of
prices.
448  Trace through the effect of a rise in the demand for money.

In diagram (a) in Figure 18.5, the L curve will shift to the right. The rate of interest
will rise.

In diagram (b), the rise in r will lead to a fall in investment and other forms of
borrowing.
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Answers to questions in Economics by Sloman and Norris

In diagram (c), the fall in investment (being an injection) will lead to a multiplied
fall in national income.
The fall in national income is lessened, however, by the resulting fall in the transactions
demand for money and hence less of a rise in interest rates than would otherwise have
occurred.
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