Chapter 7

Question 1

What is money?

Answer 1

Government issued currency in an economy

Question 2

What are the functions of money?

Answer 2

Medium of exchange
Unit of account
Store of value

Question 3

What is medium of exchange?

Answer 3

Allows people to trade their labor for money then use the money to buy goods and services
Trade with less cost in time and effort
Allows specialization

Question 4

What is unit of account?

Answer 4

Basic unit for measuring economic value
Simplifies comparison of prices, wages and incomes

Question 5

What is store of value?

Answer 5

Used to hold wealth but earns little interest

Question 6

What is used instead of money in a prisoner-of-war camp?

Answer 6

Cigarettes

Question 7

What is money aggregating?

Answer 7

Distinguishing what is money from what isn’t money is sometimes difficult

Question 8

What is M1?

Answer 8

Currency held by the public
Transaction accounts on which checks may be drawn
Closest money measure to our theoretical description of money

Question 9

What is M2?

Answer 9

M1 + large time deposits

Question 10

What is currency for?

Answer 10

Money held in an underground economy but also held abroad
Foreigners hold $ because of inflation in their local currency and political instability
US benefits from foreign holdings of our currency, since we get interest-free loan

Question 11

How does the central bank of a country increase the money supply?

Answer 11

Print new money to buy financial assets from the public - open market purchase
Buy newly issued government bonds ie. treasury

Question 12

How does the central bank of a country reduce the money supply?

Answer 12

Sell financial assets to the public to remove money from circulation - open market sale

Question 13

What are open-market operations?

Answer 13

Open market purchases and open market sales

Question 14

How do people allocate their wealth among various assets?

Answer 14

Rate of return - asset’s increase in value over time
Investors want assets with the highest return
Returns not known in advance - people estimate their expected return

Question 15

What is risk?

Answer 15

Degree of uncertainty in an asset’s return
Don’t like risk, prefer assets with low return

Question 16

What is liquidity?

Answer 16

How quickly an asset can be traded for cash

Question 17

What is time to maturity?

Answer 17

Amount of time until a financial security matures, and the investor is repaid the principal

Question 18

What are types of assets and their characteristics?

Answer 18

Money - low return but low risk and high liquidity

Bonds - higher return but more risk and less liquidity

Stocks - pay dividends; have capital gain/losses, and risker than money

Ownership - risky and not liquid, but very high return

Housing - housing services and potential for capital gains, but is quite illiquid

Question 19

What are the asset demands?

Answer 19

Assets with low risk and high liquidity have low expected returns
Investors consider diversification
Amount a wealth holder wants of an asset is his/her demand for that asset
Sum of asset demands equal total financial wealth

Question 20

What is the demand for money?

Answer 20

Money demand depends on expected return risk and liquidity
Most liquid asset
Low return

Question 21

What are the key macroeconomic variable that affect money demand?

Answer 21

Price level
Real income
Interest rate

Question 22

What is the nominal money demand function?

Answer 22

M = P x L(Y,i)

Question 23

What is the real money demand function?

Answer 23

m = l(y,r)

Question 24

What are factors affecting money demand?

Answer 24

Liquidity of
Payment technologies
Wealth
Risk
- increase risk in economy may increase money demand

Question 25

What is the income elasticity of money demand?

Answer 25

+ = greater income increases money demand
< 1 = greater income increases money demand less than proportionately

Question 26

What is the interest elasticity of money?

Answer 26

Small and negative = higher interest rates on non-monetary assets reduce money demand slightly