Question

1. The fractional reserve characteristic of the banking system allows banks to create money and also create wealth from bank deposits. Describe why this statement is or is not true.
2. What direction of change in velocity could explain the price level increasing by a smaller percentage than the money supply? What would this change in velocity imply about the frequency with which money changes hands?

Answer 1

The statement that The fractional reserve characteristic of the banking system allows banks to create money and also create wealth from bank deposits is true. This is because the fractional reserve system means that banks only need to keep a part of the deposits as reserves and can lend out the rest. The lent money then again flows into the banking system where its again lent out after keeping the fractional reserves. This process keeps going on. This way the banking system creates money of amount multiple times higher than the original deposit.

Part 2-

We know that

Negative direction of velocity of money will explain price level increasing at a smaller level than money supply. If price level increase is lower than money supply increase, it means velocity of money is decreasing. This would mean that the frequency at which the money is changing hands is going down.