Question

Suppose that the velocity of money is V = 4 and the nominal GDP of the nation is 500. Suppose further that the monetary base is 20 and the legal reserve requirement (reserve-required ratio) is 20%. According to the monetary approach:

A. The BOP is in surplus by 25

B. The BOP is in deficit by 25

C. The BOP is in surplus by 5

D. The BOP is in deficit by 5

E. The BOP is in equilibrium

F. None of the above because the BOP is in deficit

Answer 1

The correct answer is (C) The BOP is in surplus by 5

According to monetary approach:

BOP is in Deficit if Money demand < Money supply and BOP is in surplus if Money demand > Money supply

According to quantity theory Money demand is given by:

MV = PY where V = velocity = 4 and PY = nominal GDP = 500 and M = Money demand

=> M = 500/4 = 125

Money supply(Ms) = (1/rr)(Monetary Base) = (1/0.20)20 = 100.

Here rr = Reserve ratio = 20% = 0.20

=> Ms = 100

As M > Ms => Money demand > Money supply => there is a surplus in BOP

Surplus in BOP = (M - Ms)/Money multiplier

Money multiplier = 1/rr = 1/0.20 = 5

=> Surplus in BOP = (125 - 100)/5 = 5

Hence There is surplus in BOP of 5

Hence, the correct answer is (C) The BOP is in surplus by 5