chapter 5 Flashcards
why do people hold money?
to make transactions
what is the quantity of money related to?
the number of dollars exchanged in transactions
what is the quantity equation?
Money (M) X Velocity (V)=Price (P) X Transactions (T)
M x V= P x T
what is price (P)?
price of typical transaction
what is money (M)?
the amount of money available
what is transaction (T)?
number of times in a year that goods and services are exchanged for money
what is velocity (V)?
transaction velocity of money, the rate at which money circulated in the economy
if T=60 loafs / yr
P= $0.50 / loaf
M= $10
solve for V?
M x V=P x T
V=PT/M
(60 x $0.50) / $10
$30/$10
V=3 money changes hands 3 times per year
why is the quantity equation true?
due to assumption
what is the equation for nominal GDP?
P x Y
what is real money balance (M/P)?
measures the quantity of money in terms of purchasing power
what is the equation for the demand of money?
k x Y (GDP)
what does the equation of money demand show?
that GDP is a determinant of the quantity of money real balances that people wish to hold, the quantity of real money balances demanded is proportional to real income
what is “k” in the equation for demand of money?
k is a constant, real dollar holdings people wish to hold as a fraction of real income
when GDP goes up, how does that impact the demand for money balances?
the demand for money balances will go up
when GDP goes down, how does that impact the demand for money balances?
the demand for money balances will go down
when does the demand for real money balances equal in equilibrium?
when the demand for real money balances equal the supply for real money balances
what is the equilibrium in the money market?
kY= M/P
who determines the supply of real money balances?
the bank of Canada
when using the money market model, how is the quantity equation written?
M x V = P x Y
what is the assumption about velocity?
it is constant and fixed
according to the quantity equation, how does an increase in money stock (M) impact the quantity equation?
it causes an increase in P x Y
when the quantity equation has a fixed velocity, what does it become?
the quantity theory of money
under the quantity theory of money, how does a change in money impact GDP?
it will cause an equal increase in nominal GDP as the increase as money
when velocity is fixed, what determines nominal GDP?
money stock (M)
what does money supply determine, under the quantity theory of money?
the nominal value of GDP
what is the percentage change in money stock (M) determined by?
the central bank
what is the percentage change in velocity (V) determined by?
typically it is zero by assumption
what is the percentage change in price (P) determined by?
it is a variable of interest/ inflation
what is percentage change in GDP (Y) determined by?
by growth in inputs , changes in technology and it it taken as given
what is the equation for inflation?
inflation= %change in money stock(M)-%change in GDP(Y)
what is inflation?
when the growth of the nominal money supply outpaces growth in real GDP
how could there be no inflation?
if nominal money supply grew and real GDP grew at the same rate
what is seigniorage?
a tax that erodes the value of money so when governments print money for revenue, it increases the money supply to fast and causes inflation and causes the printed money to lose value
what is nominal interest rate (i)?
the rate the bank pays
what is real interest rate (r)?
the increase or decrease in purchasing power
what is the formula for real interest rate/ fisher equation?
nominal interest rate (i)= real interest rate (r) + inflation
what is an example of real interest rate?
say you save money in a bank account that pays 8% interest, and inflation is 5%, in a year your purchasing power has only risen by 3%
what are the 2 reasons why the fisher equation (nominal interest rate) can increase?
increase in real interest rate
increase in inflation
what is the relationship between inflation and nominal interest rate?
it is a one-to-one relationship between inflation and nominal interest rate, if inflation increases by 1% nominal interest rate will increase by 1%
where is the real interest rate determined?
in the model for loanable funds
what is inflation in the long run determined by?
growth of nominal money supply (M)
what is the sign for expected inflation?
E”pi”
what is the ex ante real interest rate?
the relay interest rate borrower and lender expect when the loan is made, when they don’t know what inflation is they just have an estimate, nominal interest rate - expected inflation rate
what is the ex post real interest rate?
the real interest rate when interest is actually paid, nominal interest rate - inflation rate
what is the quantity theory?
that the demand for real money is proportional to real income, the more real income someone has the more real money they will hold
what are the 2 opportunity costs of holding cash?
if you had assets you would be making a real return
holding cash will lose value due to inflation
what is the opportunity cost holding money?
it is the nominal interest you could make on that cash, since nominal interest rate is made up of real interstate and inflation
how does higher income cause a higher demand for holding cash?
because you buy more
as nominal interest rate rises how does that impact opportunity cost and demand for real money balances?
opportunity cost rises and the demand for money balances falls because people want to save/ invest to get the benefit from higher nominal interest rate
what is the demand for real money balances a function of?
its a function of nominal interest rate and income
(kY)
what does price level depend on?
on nominal money supply (M) and expected inflation
what does expected inflation depend on?
future money stock (M)
what is the inflation fallacy?
that inflation erodes the purchasing power of wages and other earnings
what are wages determined by?
marginal productivity
does inflation impact real wage?
no it is not, higher inflation, higher real wage, lower inflation lower real wage
what are the 5 costs of expected inflation?
shoe leather costs
menu costs
distortion of relative prices
taxes on nominal rather than real earnings- disincentive to save
inconvenience of changing price levels
what are shoe leather costs?
when high inflation distorts real money holdings and people hold more wealth in interest bearing assets or as more stable currencies and less of their own money
what are menu costs?
the costs incurred by businesses to frequently change prices due to high inflation
what is the distortion of relative prices?
when some firms change prices only infrequently due to menu costs, while other prices change more frequently, the infrequent prices change will seem very expensive at first until other prices and inflation catches up
what is an example of the distortion of relative prices?
Netflix changes their price periodically when they first change the price their price relative to other prices in the economy seems like a lot, as prices rise to price of Netflix becomes relatively cheaper
what is an example of how taxes on nominal rather than real savings and inflation serve as a disincentive to save?
buy a stock for 100 last yr, sell it for 105 this yr. nominal capital gain = 5
T=0.2
inflation=0.3
after tax gain= 5 X 0.8= 4
4/100= 4%
4%-3%=1%
after tax real capital gain= 1%
what are some inconvenience of changing price levels?
prices are a benchmark upon which many decisions are made. this inflation causes the benchmark to continually change
what is a benefit of inflation?
since wages are nominally sticky, firms rarely cut nominal wages, inflation allows firms to cut real wages by not increasing nominal wages
are workers more reluctant to take a nominal wage cut over a real wage cut?
yes they would be less likely to take a nominal wage cut instead of a real wage cut
what is the classical dichotomy?
the idea that real and nominal variables are determined separately
what is monetary neutrality?
the idea that money supply does not affect the real economy
what are real variables?
variables that are expressed in terms of physical quantities of goods or at least in real dollars
what is an example of real variables?
real wage, measures units of output or fraction of reference basket that can be purchased per hour of work
what are nominal variables?
variables that are expressed in terms of money
what is an example of nominal variables?
nominal wage- dollars earned per hour, the purchasing power depends on price levels
according to the classical dichotomy, how does price level impact the economy?
price level has no effect on overall level of output, allocation of output between C,I and G, real wages or real rental price of capital
often a good approximation of how the economy operates in the long run
