Explain the difference between active and idle balances in economics. Include a diagram illustrating the demand for money.

Here are the answers to your questions:

Q6

a) Active balances refer to money held for immediate transactions and precautionary needs. This money is used for daily purchases and unexpected expenses. Idle balances, on the other hand, refer to money held for speculative purposes, typically in anticipation of future investment opportunities or changes in interest rates. This money is not used for immediate transactions.

A diagram illustrating this would typically show the demand for money ($M_d$) as a function of the interest rate ($r$). The total demand for money is the sum of transaction demand ($M_t$), precautionary demand ($M_p$), and speculative demand ($M_s$).

$$M_d = M_t + M_p + M_s$$

Transaction and precautionary demands (active balances) are largely independent of the interest rate, primarily depending on income. Speculative demand (idle balances) is inversely related to the interest rate; as interest rates fall, the opportunity cost of holding money decreases, and people hold more idle balances, expecting interest rates to rise in the future. The diagram would show $M_t + M_p$ as a vertical line (or slightly downward sloping if considering a very minor interest rate sensitivity), and $M_s$ as a downward-sloping curve, with the total $M_d$ curve also downward-sloping.

b) The demand for active balances (transaction and precautionary motives) is expected to fall in an economy when:

• Nominal GDP decreases: A reduction in the overall level of economic activity and income means fewer transactions are being conducted, thus less money is needed for daily spending.
• Improvements in payment technology: Innovations like mobile banking, credit cards, and efficient electronic payment systems reduce the need to hold physical cash or large balances for transactions.
• Reduced uncertainty: If economic conditions become more stable and predictable, individuals and firms may feel less need to hold precautionary balances against unexpected events.

Q8

a)

• Devaluation is a deliberate downward adjustment in the value of a country's currency relative to another currency, group of currencies, or a standard (like gold), by the government or central bank in a fixed exchange rate system. It is a policy decision.
• Depreciation is a fall in the value of a currency relative to another currency due to market forces (changes in supply and demand for the currency) in a flexible (floating) exchange rate system. It is a market-driven phenomenon.

b) The advantages of a floating exchange rate system include:

• Automatic adjustment to balance of payments imbalances: Market forces automatically adjust the exchange rate to correct surpluses or deficits in the balance of payments, reducing the need for government intervention.
• Monetary policy independence: Central banks can pursue domestic monetary policy objectives (e.g., controlling inflation or stimulating growth) without being constrained by the need to maintain a fixed exchange rate.
• Reduced need for foreign reserves: Governments do not need to hold large reserves of foreign currency to defend a fixed exchange rate, freeing up these resources for other uses.
• Insulation from external shocks: Exchange rate fluctuations can absorb external shocks (such as changes in global demand for exports or import prices), preventing them from fully impacting the domestic economy.