chapter 9 Flashcards
Money
anything acceptable as a means of paying for products and services
3 essential functions of money
medium of exchange, a unit of account, and a store of value
money as a medium of exchange
money solves the barter problem of the double coincidence of wants
you must find a trading partner who not only is selling what you want but is willing to accept what you are selling (double coincidence of wants)
money as a unit of Account
money provides a standard unit for measuring prices
(CAD)
money as a store of value
money allows you to separate supply from demand
Bond
financial asset for which borrower promises to repay the original value at a specific future date and to make fixed regular interest payments
What does a company do when they need cash
they go to the loanable funds markets to borrow money and issue bonds
Bonds represent…
bonds, savings accounts, equities, and all other interest-paying loanable funds
Liquidity
ease with which assets can be converted into the economy’s medium of exchange
What is the reason for wanting to hold money and give up earned interest?
Liquidity
What is the most liquid of all assets
Cash
Money pays no ___, but has ___
interest, liquidity
Bonds pay ___, but do not have ___
interest, liquidity
How people handle money
Yes Markets Self-adjust: Money
- People will hold more of their wealth as interest-paying bonds
- Savings, which reduce aggregate demand, are put into bonds which causes the interest rate to fall, increasing business investment spending
No markets fail often: money
- Interest-earning bond investments are risky, not safe (uncertainty)
- When investors worry about recessions, they hold more of their savings and wealth as money, even though money pays no interest
- Fear about the future causes interest rates to rise, which discourages investment spending by businesses and intensifies the recession
Interest rate
price of holding money: what you give up by not holding loanable funds
What is interest rate determined by
demand and supply in both the money market and the loanable funds market
Law of demand for money
as the price of money (interest rate) rises, the quantity demanded for money decreases → people want to hold less money and hold more of their assets as bonds
What changes the quantity demanded of money
a change in the price of money (interest rate)
Two factors that can change the macroeconomic demand for money
real GDP and the average price level
Real GDP effect on demand for money
- An increase in real GDP increases the demand for money and shifts the money demand curve rightward
- The economy has produced more stuff, people have more income, people buy more products which means they need more money to make those purchases
- A decrease in real GDP decreases the demand for money and shifts the money demand curve leftward
Average Price Level effect on demand for money
- An increase in the average price level increases the demand for money and shifts the money demand curve rightward
- This is inflation, means you need to carry more dollars to purchase the same products and services
- A decrease in the average price level decreases the demand for money and shifts the money demand curve leftward
- Deflation, decreases the demand for money
Four basic forms of money
commodity money, convertible paper money, fiat money, and deposit money
Commodity money
commodity (any product that can be sold) such as fur pelts, beads, cattle or metals used as money
canot deteriorate over time
must be easy to carry, measure and divide into fractions
Convertible Paper Money
People became to store gold with goldsmiths, who issued the depositor a piece of paper called IOU (I owe you)
IOU was accepted as payment in place of actual coins
Fiat Money
Money that has no alternative uses and is valuable simply by governmental decree (a fiat)
fiat money we use is acceptable bc we trust the gov’t that issued it
currency
government-issued bills and coins
Deposit money
most widely accepted means of paying for products and services
Demand deposits
- balances in bank accounts that depositors can withdraw on demand by using a debit card or writing check
- An exchange of money for products and services is only complete when the buyer transfers either currency or demand deposits to the seller
In Canada, money consists of
currency issued by the Bank of canada and deposit money in chartered banks, credit unions, and similar financial institutions
Chartered banks
private banks chartered under the Bank Act of 1992 to receive deposits and make loans
Most important financial institutions for creating the supply of money
M1+
measure of money that consists of currency in circulation plus demand deposits
M2+
measure of money that is a broader measure of the money supply; includes all of M1+ plus all other deposits like savings accounts and guaranteed investment certificates
Central bank
government institution responsible for supervising chartered banks and other financial institutions, and for regulating the supply of money
Bank of Canada plays 5 important roles in the Canadian economy
- issuing currency
- acting as banker to chartered banks
- acting as a lender of last resort
- acting as a banker to government
- conducting monetary policy
Issuing currency
the Bank of Canada is the only legal issuer of bills and coins; it issues instruction to the Royal Mint which is responsible for making the bills and coins
Banker to Chartered Banks
- Chartered private banks take deposits from consumer households and businesses and make loans
- Banks deposit to the Bank of Canada which allow chartered banks to make payments to each other
Lender of Last resort
- central bank’s role of making loans to banks to preserve the stability of the financial system
- When chartered banks are short of funds chartered banks can borrow from the Bank of Canada, which helps maintain stability and liquidity in the financial system
Banker to government
- the Gov’t of Canada has a demand deposit account at the Bank of Canada
- The Bank of Canada manages the government’s accounts, reserves of foreign currency and the national debt
Conducting Monetary Policy
monetary policy consists of changes in the supply of money and interest rates to achieve the macroeconomic outcomes of steady growth, full employment, and stable prices → the Bank of Canada is responsible for this
Fractional-reserve banking
banks hold only a fraction of deposits at reserves
Canadian banks hold less than 1% of the value of all demand deposits as cash because:
- Most bank customers rarely demand cash
- Chartered banks can borrow from each other and from the Bank of Canada to meet their customers’ demands and maintained trust in case they want cash back
Bank run
many depositors withdraw cash all at once
Banks face a trade-off between profits and prudence:
a smaller fraction of reserves and higher-risk loans may make more bank profits, but at the cost of giving up safety and risking customers’ deposits and trust
Collateral
- property pledged as security for repayment of the loan
- Banks own collateral and charge higher interest rates until you pay off a loan
More loans mean
more demand deposits created for borrowers’ accounts and makes it riskier for banks to be able to meet the demand of depositors for withdrawals
More prudence means
holding more reserves, making fewer loans, and earning lower profits
Who
The supply of money is determined by
the Bank of Canada and the chartered banks, through the demand deposits and matching loans they create
What happens to loans when interest rates are higher
loans are more profitable so banks make more loans and create more demand deposits
2 ways the interest rate is the price of money
- The interest rate is the price/opportunity cost of holding money → what you give up by not holding your wealth as bonds that pay interest
- The interest rate is also the price you pay to borrow money
The interest rate is determined by
the interaction of the demand for money and the supply of money in both the money and loanable funds markets
Explain
Bonds prices and interest rates are inversely related
- When interest rates rise, bond price fall
- When interest rates fall, bond prices rise
Why are bonds risky and less liquid than money
- If interest rates change after you buy a bond, the price at which you can sell the bonds changes:
- if the price of the bond falls (interest rates increase) and you want to convert the bond back into money, you receive less money than what you paid for
- When the price of the bond increases, you get more money than what you expected
Money affects aggregate demand through 2 transmission mechanisms
domestic and international
When there is excess demand for money (demand for more liquidity)
people sell bonds to get more money
* The increased supply of bonds causes bond prices to fall and interest rates to rise
When there is excess supply of money,
people buy bonds to get rid of money
* The increased demand for bonds causes bond prices to rise and interest rates to fall
Excess supply of money means
there is more liquidity available than people want
is there a direct connection between changes in the money supply and changes in the aggregate supply of real GDP?
No
* money does not directly increase aggregate supply or directly contribute to economic growth
Monetary transmission mechanism
the way money affects real GDP
Domestic monetary transmission mechanism
how money affects real GDP through interest rates, spending, and aggregate demand
What is the key to the domestic monetary transmission mechanism
the effect of interest rates on consumer spending and business investment spending
what shock
Lower interest rates are a
positive aggregate demand shock:
* They increase aggregate demand, increasing real GDP, decreasing unemployment and causing inflation
what shock
Higher interest rates are a
negative aggregate demand shock:
They decrease aggregate demand, decreasing real GDP, increasing unemployment and causing deflation
* Higher interest rates increase the cost of borrowing, which decreases consumer spending and business investment spending
* Can push the economy into the contraction phase of the business cycle as real GDP decreases
Money
All Economists Agree That
- Money affects prices and inflation (as explained by the quantity theory of money)
- Changes in the demand and supply of money indirectly affect real GDP and other key macroeconomic outcomes through interest rates and aggregate demand – the domestic monetary transmission mechanism
How Much Does Money Matter? Yes – Markets Self-Adjust → “Not Much”
- Money does not affect how often business cycles happen
- Money helps markets adjust: helps loanable funds market
How Much Does Money Matter? No – Markets Fail Often → “A Lot”:
- Money causes business cycles by creating a way not to spend, adding new internal demand shocks
- Money slows market adjustments: blocks domestic monetary transmission mechanism
