4 Monetary System

Question 1

Functions of money

Answer 1

Medium of exchange
Unit of account
Store of value

Question 2

Commodity money

Answer 2

Satisfies the 3 functions of money and also has an intrinsic value (e.g gold)

Question 3

Fiat money

Answer 3

Satisfies the 3 functions of money but has no intrinsic value. It is used because of government decree

Question 4

What is a potential problem with fiat money

Answer 4

If people lose faith in it then it’ll lose its value

Question 5

Money stock

Answer 5

Sum of all fiat money which is government approved (legal tender)

Question 6

M1

Answer 6

Currency + demand deposits +checkable deposits

Question 7

M2

Answer 7

M1+ savings deposits (short term) + money market mutual funds

Question 8

What does the central bank do?

Answer 8

Oversees the banking system

Regulates the quantity of money in the economy

Question 9

What is the goal of the monetary policy committee?

Answer 9

2% CPI inflation rate

Question 10

What is the MPC?

Answer 10

Monetary Policy Committee, they work at the Bank of England and are independent from the government

Question 11

Federal reserve main goal

Answer 11

To ensure the health of the nation’s banking system

Question 12

What is the ECB’s main goal?

Answer 12

To achieve price stability, inflation below but close to 2% in the medium term

Question 13

Reserves

Answer 13

Deposits that banks have received but have not loaned out

Question 14

Reserve ratio

Answer 14

Fraction of deposits that banks hold as reserves

Question 15

Reserve requirement

Answer 15

The minimum amount of reserves that banks must hold. Exists in US and EU but not UK

Question 16

Excess reserve

Answer 16

Any reserves held above the legal minimum

Question 17

Money multiplier

Answer 17

The amount of money that the banking system generates from each dollar of reserves

Question 18

What is the equation for the money multiplier

Answer 18

MM=1/reserve ratio

Question 19

Tools for monetary control

Answer 19

• open market operations (conventional or unconventional)
• the refinancing rate
• reserve requirements

Question 20

Open market operations

Answer 20

The purchase and sale of government bonds by the central bank

Question 21

What happens when the central bank buys government bonds?

Answer 21

The money supply increases

Question 22

The refinancing rate

Answer 22

The interest rate at which the central bank will lend to commercial banks on a short term basis

Question 23

Other names for refinancing rate

Answer 23

Repo rate

Discount rate

Question 24

Why do central banks prefer not yo change the reserve requirements?

Answer 24

It messes up the plans of commercial banks

Question 25

Why is it hard for the central bank to control the money supply?

Answer 25

They don’t know how much money the public will put into deposits or how club banks will keep in reserve

Question 26

What does inflation do to the value of money?

Answer 26

Inflation causes the value of money to drop (1/P)

Question 27

What is the classical theory of money

Answer 27

It is the overwhelming consensus amongst economists today for the long run explanation of inflation

Question 28

What does the graph of money supply and demand look like in the long run?

Answer 28

Vertical supply curve, downward sloping demand curve with value of money on y axis and quantity of money on x axis

Question 29

Nominal variables

Answer 29

Anything measured in monetary units e.g pounds

Question 30

Real variables

Answer 30

Variables measured in physical units

Question 31

Explain how the classical dichotomy works

Answer 31

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

Question 32

Quantity equation

Answer 32

M x V= P x Y

M= quantity of money
V= velocity of money
P= GDP deflator
Y= GDP

Question 33

The fisher effect

Answer 33

Real interest rate= nominal interest rate- inflation rate

Question 34

What does the fisher effect say?

Answer 34

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

Question 35

What is inflation tax

Answer 35

When the government can raise revenue by inflation increasing prices and therefore decreasing the value of money

Question 36

What is the inflation fallacy

Answer 36

“Inflation robs people of purchasing power from their hard earned money” this only occurs if wages don’t rise with inflation

Question 37

Shoe leather costs

Answer 37

The transaction costs associated with constantly taking small amounts of money from your current account

Question 38

Menu costs

Answer 38

The costs associated with having to continuously change prices

Question 39

Market economies and misallocation

Answer 39

Prices allocate scarce resources. Inflation distorts relative prices so resources aren’t allocated to their best use

Question 40

Arbitrary redistribution of wealth

Answer 40

Surprise inflation redistributed wealth from creditors to debtors

Question 41

Debt deflation

Answer 41

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