chapter 3

Question 1

what is the difference between income, money and wealth?

Answer 1

Income is the flow of revenue from work, rental income, interest, and dividends.

Wealth is the value of all of one’s financial assets minus all financial liabilities.

Money is a current medium of exchange in the form of coins and banknote collectively.

Question 2

what is a portfolio decision?

Answer 2

A portfolio decision refers to the choice by a financial market participant as to how much of various assets to hold. A portfolio decision also includes the decision to hold more money or less money.

Question 3

what influences the demand for actives balances?

Answer 3

The demand for active balances is influenced by peoples’ need to do transactions and the more transactions there are, the higher the demand for money

Question 4

what is determines the level of transactions?

Answer 4

The level of transactions – and therefore the demand for active balances – is determined by the level of output and income in the economy.

Question 5

How does an increase in the level of output in the economy affect the demand for money among households and producers?

Answer 5

The higher the level of output and income in the economy, the more transactions there will be. As the level of output increases, the income of households also increases and they will want to do more transactions. They will therefore need more active balances and their demand for money will rise. As producers produce more output they will need more money to finance their transactions as well.

Question 6

Explain the relationship between changes in income (Y), active transactions the demand for money (Md) as shown in the events chain

Answer 6

Using the symbol Md for money, we can therefore, in terms of an events chain, state that:

Y¬↑ => active transactions¬↑ => Md¬↑
Y↓ => active transactions↓ => Md↓

Question 7

explain the relationship income, level of transition and the demand for money.

Answer 7

As the level of output and income (Y) rises in the economy the level of transaction increases and the demand for money (Md) rises – and vice versa

Question 8

what is the demand for passive balances?

Answer 8

The demand for passive balances, also referred to as the speculative demand for money, is related to the need by financial participants to keep wealth in the form of money – in this sense, money is viewed as a financial asset.

Question 9

what choice do financial market participants have?

Answer 9

financial market participants have the choice between keeping money and bonds (treasury bills).

Question 10

what is the benefit of keeping money?

Answer 10

Keeping money has the benefit that it is the most liquid form in which wealth can be kept.

Question 11

what is the disadvantage of keeping money?

Answer 11

The disadvantage is that it earns no return (interest). Keeping

Question 12

why is treasury bills are being used instead of keeping money?

Answer 12

The reason is that the opportunity cost of holding money is the interest rate that is given up. The higher this interest rate, the higher the opportunity cost of holding money since keeping money earns no interest.

Question 13

what are the chain of events that explain the relationship between interest rates, passive demand for money and money demanded?

Answer 13

In terms of an events chain, this is represented as follows:

i¬↑ => passive demand for money↓ => Md↓
i↓ -> passive demand for money¬↑ => Md↑¬

Question 14

what is the equation for money demanded?

Answer 14

Md= RYL(i)

. The RY indicates nominal income in Rands. We will simplify things by just using Y, which in this learning unit implies nominal income in Rands.

The positive sign under income Y indicates that a positive relationship exists between the demand for money and the level of output and income.

The negative sign under the interest rate i indicates that a negative relationship exists between the quantity of money demanded and the interest rate.

Question 15

What does the downward movement along the money curve indicate and what does it lead up to?

Answer 15

A downward movement along the money demand curve indicates that as the interest declines the quantity of money demanded increases. As the interest rate declines the opportunity cost of holding money declines and financial market participants are inclined to hold more money.

Question 16

What does the upward movement along the money curve indicate and what does it lead up to?

Answer 16

An upward movement along the money demand curve indicates that, as the interest rate increases, the quantity of money demanded decreases. As the interest rate increases, the opportunity cost of holding money also increases and financial market participants are willing to hold less money.

Question 17

explain what demand for money means?

Answer 17

The demand for money refers to the quantity of money that will be demanded at each interest rate. It represents all the points on the demand for money curve. In terms of the demand for money curve, a change in income – which is an exogenous variable – changes the whole relationship.

Question 18

what is the equation for the demand for money?

Answer 18

Y¬↑ => Md¬↑ and the Md curve will shift to the right

Question 19

explain what does the quantity of money demanded mean?

Answer 19

The quantity of money demanded refers to one particular point on a demand for money curve corresponding with an interest rate. A change in the interest rate – which is the variable on the vertical axis – changes the quantity of money demanded.

Question 20

what’s the equation for quantity of money demanded?

Answer 20

i↑¬ => ↓ in the quantity of money demanded (see The demand for money)

Question 21

describe the money supply equation

Answer 21

Given this exogenously determined money supply, the money supply equation can be written as:

Ms = M

The equation implies that it is the central bank that determines the money supply. We will later see how it determines the money supply

Question 22

explain the money supply curve?

Answer 22

Since the supply of money is regarded as exogenous it is presented as a perfectly inelastic curve showing that the interest rate has no impact on the supply of money. A change, for instance, in the interest rate from i1 to i2 does not influence the supply of money.

Question 23

How does an increase in the supply of money, indicated by a rightward shift of the money supply curve (Ms), compare to a decrease in the money supply, which is indicated by a leftward shift of the money supply curve?

Answer 23

An increase in the supply of money is indicated by a rightward shift of the money supply curve Ms showing that each interest rate the money supply is higher. A decrease in the money supply is indicated as a leftward shift of the supply of money curve showing that at each interest rate the money supply is lower.

Question 24

explain the equilibrium position of the financial market.

Answer 24

The equilibrium position in the financial market indicates that portfolio equilibrium exists in the market. Financial market participants are holding the amount of money and bonds they wish to hold, given the level of output and income and the interest rate.

Question 25

what does disequilibrium mean in the financial market?

Answer 25

Disequilibrium in the market implies that financial market participants are either holding too much money and too few bonds, or too little money and too many bonds, and this will cause them to change their behaviour.

Question 26

in terms of the demand and supply of money, explain the equilibrium?

Answer 26

In terms of the demand for and supply of money, equilibrium in the financial market indicates that the quantity of money demanded is equal to the quantity of money supplied.

Question 27

in terms of the demand and supply of money, explain the equilibrium?

Answer 27

If there is disequilibrium in the market, that is when the quantity of money demanded differs from the quantity of money supplied, the interest rate will change to re-establish equilibrium.

Question 28

what is the equation for the equilibrium condition in the financial market?

Answer 28

Our equilibrium condition in the financial market is where is given as M = YL(i)

Question 29

What does the equilibrium position indicated as point A in the following diagram represent, and what conditions are necessary for portfolio equilibrium to occur at this point?

Answer 29

In the following diagram this equilibrium position is indicated as point a. At this equilibrium position, there is portfolio equilibrium in the sense that at the equilibrium interest rate of i, people are holding the amount of money and bonds they want and will change their holdings of money and bonds only if the level of output and income and/or the money supply changes.

Question 30

What happens to the interest rate and the quantity of money demanded when there is an excess supply of money, such as at point B, and how does this process lead to equilibrium at point A?

Answer 30

In the event of an excess supply of money, such as at point b, the interest rate will decline. As the interest rate declines, the quantity of money demanded increases and a downward movement along the money demand curve occurs. This process continues until equilibrium is reached at point a.

Question 31

What happens to the interest rate and the quantity of money demanded when there is an excess demand of money, such as at point B, and how does this process lead to equilibrium at point A?

Answer 31

In the event of an excess demand for money, such as at point c, the interest rate will increase. As the interest increases the quantity of money demanded decreases and an upward movement along the money demand curve occurs. This process continues until equilibrium is reached at point a.

Question 32

how does excess money for demand affect interest rate and the money curve?

Answer 32

This excess demand for money causes an increase in the interest rate and an upward movement along the money demand curve occurs until a new equilibrium is reached at point c with a higher interest rate i2.

Question 33

Explain the impact of a change in the money supply in the financial market.

Answer 33

In this financial market a change in the money supply is brought about by the central bank. An increase in the money supply shifts the money supply curve from Ms to Ms1 and the equilibrium interest rate declines.

Question 34

explain the increase in expansionary monetary policy (increase in money supply) and the chain of events?

Answer 34

Increase in the money supply

(Expansionary monetary policy)
- In order to increase the money supply, the central bank will buy bonds on the open market. This increase in the demand for bonds will increase the price of bonds and results in a lower interest rate.

• Ms¬↑: DB↑¬ > PB↑¬ > i↓

Question 35

explain the decrease in money supply ( contractionary money supply) and the chain of events?.

Answer 35

• In order to decrease the money supply, the central bank will sell bonds on the open market. This increase in the supply of bonds will decrease the price of bonds and results in a higher interest rate
• Ms¬↓: SB↑¬ > PB↓ > i↓

Question 36

what happens during liquidity trap?

Answer 36

When in a liquidity trap, private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment. And interest rates can’t go below zero (except trivially for very short periods), because investors always have the option of simply holding cash

Question 37

what happens t the supply and demand curve when interest rates go high?

Answer 37

the interest rate is higher. You can confirm this by using the financial market diagram in which you shift the demand curve to the right and the supply curve to the left.

Question 38

What will happen to the interest rate if the leftward shift of the demand curve is greater than the leftward shift of the supply curve, and what will happen if the leftward shift of the demand curve is smaller than the leftward shift of the supply curve?

Answer 38

If the leftward shift of the demand curve is greater than the leftward shift of the supply curve, then the interest rate will be lower. If the leftward shift of the demand curve is smaller than the leftward shift of the supply curve, then the interest rate will be higher.

Question 39

What are exogenous and endogenous variables in the financial market?

Answer 39

• The nominal money supply which we assume is not influenced by the interest rate but is determined by the central bank. A change in the nominal money supply shifts the Ms curve.
• The part of the demand for money that is not influenced by the interest rate. This is the part of the demand for money that is influenced by the output and income and other liquidity

Question 40

what is a repo rate?

Answer 40

The repurchase rate – called the repo rate – is the rate at which private banks borrow money from the South African Reserve Bank. The repo rate in turn determines the interest rate on loans.

Question 41

How does an increase in the repo rate affect interest rates on loans, the amount of loans, demand deposits, and the money supply?

Answer 41

An increase in the repo rate increases the interest rate on loans and, as the interest rate on loans increases, the amount of loans decline. Consequently, fewer demand deposits are created and the money supply decreases.