Question

Common fallaciesWhy are these statements wrong? (a) By abolishing reserve requirements, the central bank gave up any attempt to control the money supply. (b) When real interest rates are negative, people are being paid to hold cash. (c) Consumers are said to behave irrationally if their spending is up when their disposable income is lower.

Short answer

(a) The central bank still controls money supply via other tools. (b) Negative real interest rates mean money loses value. (c) Consumers can be rational with spending despite lower income.

Step-by-step solution

Understanding Reserve Requirements

Reserve requirements are the minimum amounts that banks are required to keep in reserves, either in their vaults or at a central bank. Abolishing reserve requirements does not mean the central bank gives up control over the money supply entirely. The central bank still influences the money supply through other tools like open market operations, discount rates, and interest on reserves.

Analyzing Negative Real Interest Rates

Real interest rates are calculated as the nominal interest rate minus inflation. If real interest rates are negative, it suggests that inflation outpaces the nominal rate, thus reducing the purchasing power of money held. However, saying people are paid to hold cash is incorrect, as negative real interest rates actually mean cash holdings are losing value over time.

Consumer Behavior and Disposable Income

Consumers might spend more even if their disposable income is lower for several reasons, which doesn't necessarily imply irrational behavior. They might expect future income increases, have access to credit, or prioritize spending in certain economic conditions. Rational behavior considers expectations and access to resources, not just current disposable income.

Key concepts

Reserve Requirements

Banks are required to hold a certain percentage of their deposits as reserves. These reserves can either be kept in their vaults or with a central bank. This is a safety measure and ensures that banks have enough funds to manage withdrawals.

It's important to note that even if reserve requirements are abolished, central banks still have other methods to influence the money supply. Central banks use tools such as:

• Open market operations: Buying or selling government bonds to regulate the amount of money in the economy.
• Discount rates: Setting the interest rate charged to commercial banks for borrowing funds.
• Interest on reserves: Paying interest on the reserves held by banks at the central bank.

So, while reserve requirements are an important tool, they aren't the only way a central bank can control money supply. Understanding this helps clarify any misconceptions about the role and influence of central banks.

Real Interest Rates

To understand real interest rates, one must look beyond the nominal interest rate. The real interest rate is derived by adjusting the nominal rate for inflation.

The formula is:\[\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate}\]If the inflation rate surpasses the nominal rate, the real interest rate becomes negative. This means that the value or purchasing power of money is decreasing over time.

Negative real interest rates do not "pay" people to hold cash. Instead, they lead to a decrease in the value of money saved. The purchasing power of cash reduces as prices rise, highlighting the importance of understanding how inflation erodes liquidity over time.

Consumer Behavior

Consumers make spending decisions based on a variety of factors beyond just their current disposable income. Spending may increase even if disposable income is down due to specific reasons:

• Expectations of a future income increase: Consumers may spend more if they believe their financial situation will improve soon.
• Access to credit: Loans and credit cards provide additional funds for spending despite lower income.
• Prioritizing spending: In certain situations, consumers prioritize spending on essential items or experiences despite having less money.

It is crucial to understand that consumer behavior is often rational, taking into account expectations about the future and access to savings or credit. Decisions are not always directly tied to immediate disposable income levels, and this reflects the complexity of economic behaviors.