Commercial bank customers in an economy decide to shift a substantial portion of their fun… — JAMB UTME

Commercial bank customers in an economy decide to shift a substantial portion of their funds from checking accounts (demand deposits) into long-term fixed deposit accounts. What is the immediate effect of this transaction on narrow money supply ( $M_1$ ) and broad money supply ( $M_2$ )?

$M_1$ decreases while $M_2$ remains constantAnswer
B
Both $M_1$ and $M_2$ decrease simultaneously
C
$M_1$ remains constant while $M_2$ increases
D
Both $M_1$ and $M_2$ increase simultaneously

Answer

Narrow money supply (

M_1

) decreases while broad money supply (

M_2

) remains unchanged.

Narrow money (

M_1

) consists of currency outside banks and demand deposits. When depositors transfer funds from checking accounts to fixed time deposit accounts, demand deposits fall, causing

M_1

to decrease. However, broad money (

M_2

) is defined as

M_1

plus quasi-money (savings and time deposits). Because the drop in

M_1

is exactly matched by an equal increase in quasi-money, the total value of

M_2

remains constant.

Step-by-Step Solution

Define narrow money (

M_1

) components

M_1 = \text{Currency in Circulation} + \text{Demand Deposits}

Identify which monetary aggregate is affected by withdrawing funds from checking accounts.

Define broad money (

M_2

) components

M_2 = M_1 + \text{Quasi-Money (Savings and Time Deposits)}

Understand how time deposits fit into broader monetary measures.

Analyze the net effect of the deposit transfer

Demand deposits fall, so

M_1

falls. Time deposits rise by the identical amount, so quasi-money increases. The net change in

M_2

(- \Delta M_1) + (+ \Delta \text{Time Deposits}) = 0

Evaluate the immediate impact on both aggregates.

Key Concept

Monetary Aggregates (

M_1

M_2

) and Money Supply Structure

Question

Answer

Step-by-Step Solution

Key Concept

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