Chapter 7 Flashcards
What is money?
Government issued currency in an economy
What are the functions of money?
Medium of exchange
Unit of account
Store of value
What is medium of exchange?
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
What is unit of account?
Basic unit for measuring economic value
Simplifies comparison of prices, wages and incomes
What is store of value?
Used to hold wealth but earns little interest
What is used instead of money in a prisoner-of-war camp?
Cigarettes
What is money aggregating?
Distinguishing what is money from what isn’t money is sometimes difficult
What is M1?
Currency held by the public
Transaction accounts on which checks may be drawn
Closest money measure to our theoretical description of money
What is M2?
M1 + large time deposits
What is currency for?
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
How does the central bank of a country increase the money supply?
Print new money to buy financial assets from the public - open market purchase
Buy newly issued government bonds ie. treasury
How does the central bank of a country reduce the money supply?
Sell financial assets to the public to remove money from circulation - open market sale
What are open-market operations?
Open market purchases and open market sales
How do people allocate their wealth among various assets?
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
What is risk?
Degree of uncertainty in an asset’s return
Don’t like risk, prefer assets with low return
What is liquidity?
How quickly an asset can be traded for cash
What is time to maturity?
Amount of time until a financial security matures, and the investor is repaid the principal
What are types of assets and their characteristics?
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
What are the asset demands?
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
What is the demand for money?
Money demand depends on expected return risk and liquidity
Most liquid asset
Low return
What are the key macroeconomic variable that affect money demand?
Price level
Real income
Interest rate
What is the nominal money demand function?
M = P x L(Y,i)
What is the real money demand function?
m = l(y,r)
What are factors affecting money demand?
Liquidity of
Payment technologies
Wealth
Risk
- increase risk in economy may increase money demand
What is the income elasticity of money demand?
+ = greater income increases money demand
< 1 = greater income increases money demand less than proportionately
What is the interest elasticity of money?
Small and negative = higher interest rates on non-monetary assets reduce money demand slightly
