4 Monetary System Flashcards
Functions of money
Medium of exchange
Unit of account
Store of value
Commodity money
Satisfies the 3 functions of money and also has an intrinsic value (e.g gold)
Fiat money
Satisfies the 3 functions of money but has no intrinsic value. It is used because of government decree
What is a potential problem with fiat money
If people lose faith in it then it’ll lose its value
Money stock
Sum of all fiat money which is government approved (legal tender)
M1
Currency + demand deposits +checkable deposits
M2
M1+ savings deposits (short term) + money market mutual funds
What does the central bank do?
Oversees the banking system
Regulates the quantity of money in the economy
What is the goal of the monetary policy committee?
2% CPI inflation rate
What is the MPC?
Monetary Policy Committee, they work at the Bank of England and are independent from the government
Federal reserve main goal
To ensure the health of the nation’s banking system
What is the ECB’s main goal?
To achieve price stability, inflation below but close to 2% in the medium term
Reserves
Deposits that banks have received but have not loaned out
Reserve ratio
Fraction of deposits that banks hold as reserves
Reserve requirement
The minimum amount of reserves that banks must hold. Exists in US and EU but not UK
Excess reserve
Any reserves held above the legal minimum
Money multiplier
The amount of money that the banking system generates from each dollar of reserves
What is the equation for the money multiplier
MM=1/reserve ratio
Tools for monetary control
- open market operations (conventional or unconventional)
- the refinancing rate
- reserve requirements
Open market operations
The purchase and sale of government bonds by the central bank
What happens when the central bank buys government bonds?
The money supply increases
The refinancing rate
The interest rate at which the central bank will lend to commercial banks on a short term basis
Other names for refinancing rate
Repo rate
Discount rate
Why do central banks prefer not yo change the reserve requirements?
It messes up the plans of commercial banks
Why is it hard for the central bank to control the money supply?
They don’t know how much money the public will put into deposits or how club banks will keep in reserve
What does inflation do to the value of money?
Inflation causes the value of money to drop (1/P)
What is the classical theory of money
It is the overwhelming consensus amongst economists today for the long run explanation of inflation
What does the graph of money supply and demand look like in the long run?
Vertical supply curve, downward sloping demand curve with value of money on y axis and quantity of money on x axis
Nominal variables
Anything measured in monetary units e.g pounds
Real variables
Variables measured in physical units
Explain how the classical dichotomy works
There is a separation of nominal and real variables which means a change in one won’t cause a change in the other. E.g a change in money supply doesn’t affect real wages
Quantity equation
M x V= P x Y
M= quantity of money V= velocity of money P= GDP deflator Y= GDP
The fisher effect
Real interest rate= nominal interest rate- inflation rate
What does the fisher effect say?
There is a one for one adjustment of nominal interest rate to inflation rate with changes in the rate of money growth in long run
What is inflation tax
When the government can raise revenue by inflation increasing prices and therefore decreasing the value of money
What is the inflation fallacy
“Inflation robs people of purchasing power from their hard earned money” this only occurs if wages don’t rise with inflation
Shoe leather costs
The transaction costs associated with constantly taking small amounts of money from your current account
Menu costs
The costs associated with having to continuously change prices
Market economies and misallocation
Prices allocate scarce resources. Inflation distorts relative prices so resources aren’t allocated to their best use
Arbitrary redistribution of wealth
Surprise inflation redistributed wealth from creditors to debtors
Debt deflation
When people don’t want to buy goods because they will be cheaper tomorrow. Interest rates are reduced but this means there is little incentive for the banks to lend money
