C48 MT 09W A.doc

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Department
Economics for Management Studies
Course
MGEC71H3
Professor
Melanie Parkin
Semester
Fall

Description
1ECM C48 MidtermVer1 SOLUTIONSVersion 1 has the word INSTRUCTIONS on the front page of your examie it is NOT underlinedQuestion 110 MarksInside money is defined to be the sum of all financial assets created inside the private financial sector This is the sum of all bank loans bank deposits corporate stock corporate bonds etc Since it represents both assets and liabilities of the private sector creditdebit it does not represent or create net wealth for the private sectorOutside money is the sum of all financial assets created outside of the private financial sector ie by the government or public sector This is all government created currency cash plus government bonds Since these assets are held by the private sector as credits while the liabilities for them are held by the public sector then outside money equals the net wealth of the private sectorQuantity Theory of Money QTM postulates that in longrun and beyond the quantity of nominal money supplied M determines the size and growth rates of other aggregate nominal variables such as gdp the gdp deflator the inflation rate the nominal interest rate etc This theory uses the socalled quantity equation MVPY where M is nominal money supply P is the gdp deflator V is the velocity of money and Y is real gdpThe insideoutside theory of money takes the two observations above ie the two bullet points above together with the assumption that private sector welfare depends solely on the level of net private sector wealth This implies that only outside money affects the level of welfare of the private sectorThese definitions and their related theory are inconsistent with what we know about the Quantity Theory of Money In the longrun and beyond we know that real gdp is determined by real factors ie due to the classical dichotomy or neutrality of money Further the velocity of money is fixed in longrun equilibrium as well so increases in the nominal money supply M simply result in an equal proportionate increase in the nominal price level P Thus the real money supply MP does not change so the central bank does not have the ability to change real wealth in the longrun and beyond Therefore changes in outside money via changes in government issued cash do not result in changes in real private sector wealth in the longrunbeyondQuestion 215 MarksOperational efficiency relates to how well the financial system undertakes the function of transferring funds from lenders to borrowers operational costs If banks are highly competitive the costs associated with this function should be small Operational efficiency is impacted by deregulation market structure concentrationmergers globalization competition technology changesAs explained in the diagram below operational efficiency is measured in terms of the welfare impact on society that is both consumers of bank products households and firms and banks suppliers or financial institutions In fact this efficiency is often quoted in terms of the inefficiency or deadweight welfare loss that results from the way the market for loanable funds operates This is measured at a point in time relative to the ideal perfectly competitive outcome which would have no
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