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Instead of the "invisible hand" of the market creating an money supply/interest rate equilibrium, the Chinese government is doing so by requiring banks to hold more deposits on their balance sheets.
China's announcement will likely affect interest rates quite dramatically in that banks will have more cash on hand to help pad their balance sheets while the money supply stays relatively low. This helps to keep the potential for inflation low, where interest rates begin to rise. As long as there is less money to be lent, or in effect, more money tied up within the banking system that cannot be lent to borrowers, the interest rates will likely remain relatively low (McConnell, Brue, and Flynn, 2008). This helps to combat inflation, or the potential for inflation since other economies like the United States have been printing money to help boost their own economies. These actions by the U.S. will likely result in inflation since the money supply has been increased to levels where interest rates are no longer able to be held at low levels. The Chinese, in making their announcement, are in effect working against the U.S. economic interests. The Chinese are continuing to keep their currency devalued in the face of overseas demands. This helps to boost internal growth, GDP, economic strength, and keep the potential for inflation and higher interest rates low.
Since the money multiplier (mm) is a reciprocal of the bank's reserves (R), the effect of the Chinese announcement will undoubtedly effect the mm directly (McConnell, Brue, and Flynn, 2008). The spending and investment multipliers within the Chinese economy will be affected because when the banks have less money to lend and higher deposit rates, they keep interest rates low and liquidity relatively low as well. This encourages real growth, not the kind of credit-driven growth that the U.S. experienced shortly before the economic meltdown of 2008. Since the money multiplier and interest rates affect other sectors of the economy like the MPS and MPC, just to name two, the results of such an announcement are profound indeed.
The Chinese MPC, or marginal propensity to consume is much less when less money is being lent out due to higher deposit requirements (McConnell, Brue, and Flynn, 2008). This is not something that will affect the Chinese like it would the U.S. economy, which is largely based upon consumption. However, the MPS (marginal propensity to save) will also be affected. In China, where people are more accustomed to save than the average U.S. consumer, a tighter money supply and influenced money multiplier (mm) will help to increase savings (McConnell, Brue, and Flynn, 2008). Though interest rates remain low, the less the country consumes (MPC), typically, the more it saves (MPS). This has the effect of keeping the banks' balance sheets stacked with deposits and the flow of liquidity low, which helps to stave off inflation through credit creation and a higher money supply.
The average propensity to save helps to show just how much consumers are saving. When the money supply is restricted through tight fiscal policy, like the Chinese are undergoing, the APS moves higher (McConnell, Brue, and Flynn, 2008). This is an indicator of a more stagnant economy, at least as far as inflation and velocity of money are concerned. When the money supply is increased and the banks begin to lend more (not the case in China as the banks are required to have higher deposit rates), the average propensity to consume (APC) moves higher (McConnell, Brue, and Flynn, 2008). This APC is a direct reflection of the change in money supply, income, and interest rates than bring about and fuel further consumption. The United States is trying to increase the APC by pumping more money into the system. Unfortunately, this also comes with the potential for economically crippling inflation and higher interest rates. It can be seen once again that the Chinese government are trying to keep a cap on inflation by manipulating the required deposits at its Central Bank. In turn, this influences the money supply and money multipliers, which influences investment and taxation, which influence consumption and savings. The entire picture is rather complex, but in effect, the Chinese are trying to influence the behavior of both the banks (lenders) and the consumers (borrowers) through their announcement.
McConnell, Campbell; Brue, Stanley; and Sean Flynn. (2008). Economics:…[continue]
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