Chapter 9 | Demanders and Suppliers of Money Flashcards
Demand for Money
People demand money for its liquidity as a medium of exchange, unit of account, and store of value, and are often willing to give up interest on bonds in order to hold their wealth as money
Money
anything acceptable as means of payment; money has three functions
Medium of exchange – acceptability solves barter problem of double coincidence of wants
Unit of account – standard unit for measuring prices
Store of value – time machine for moving purchasing power from present to future; you can earn now and spend later
Bond
financial asset for which borrower promises to repay the original value at a specific future date, and to make fixed regular interest payments
Demand for money is about the choice
to hold your wealth as money or as bonds?
Why hold wealth as money that pays no interest, rather than as bonds that pay interest?
Money provides liquidity – ease with which assets can be converted into the medium of exchange
Money is the most liquid asset – money is the most liquid asset – acceptable by sellers as means of payment
Money pays no interest, but has liquidity
Bonds pay interest, but do not have liquidity
Why hold money as a store of value
For Yes – Market Self-Adjust camp, people hold more wealth as interest paying bonds, since savings safely invested in loanable funds (bonds)
For No – Markets Fail Often camp, people hold more wealth as money because fundamental uncertainty about future makes bond investments risky
Interest Rate
price of holding money; what you give up by not holding bonds
Determined by demand and supply in both money and loanable funds markets
Law of demand for money
as the price of money – the interest rate – rises, the quantity demanded of money decreases
Changes in Demand for Money
Changes in real GDP or average prices cause change in demand for money (shift of demand curve)
Increase in demand for money (rightward shift) from
Increase in real GDP
Rise in prices
Decrease in demand for money (leftward shift) from
Decrease in real GDP
Fall in prices
Supply of Money
In a fractional-reserve banking system, the supply of money – currency plus demand deposits – is created both by the Bank of Canada and by chartered banks making loans
Forms of money
Commodity money – saleable product with alternative uses
Convertible paper money – paper money converted into gold on demand
Fiat money – currency (government-issued bills and coins) with no alternative uses; valuable simply by government decree
Deposit money – demand deposits balances in bank accounts that depositors withdraw on demand by using a debit card or cheque
The Money Supply
Supply of money is currency and deposit money
M1+ = currency in circulation plus demand deposits
M2+ = M1+ plus all other less liquid deposits
Who creates the money supply?
Bank of Canada (Canada’s central bank)
Chartered banks
Bank of Canada’s roles
Issuing currency
Banker to chartered banks – chartered bank deposits at Bank of Canada allow chartered banks to make payments to each other
Lender of last resort
Banker to government – managing government’s accounts, foreign currency reserves, and national debt
Conducting monetary policy
Lender of last resort
making loans to banks to preserve stability of financial system
Chartered banks create money (demand deposits) because of
fractional reserve banking
Banks create loans and money (demand deposits) together
When a bank makes a loan, it creates demand deposit credit in the borrower’s chequing account equal to amount of the loan
Risk of a bank run
fractional reserve banking
banks hold only a fraction of deposits as reserves and loan out the rest
Risk of a bank run
many depositors withdraw at once so bank lacks enough cash reserves to pay everyone
Banks face a trade-off between profits and prudence
More potential profits by holding smaller fraction of reserves, making more loans, making higher-risk loans
Trade-off is giving up safety and risking customers’ deposits and trust
Supply of money determined by Bank of Canada and chartered banks
Quantity of money supplied depends on quantity of loans and demand deposits banking system creates
When interest rate rises, quantity of money supplied increases
Higher interest rates makes loans more profitable so banks loan more creating more demand deposits
Interest Rates, Money, Bonds
Bond prices and interest rates are inversely related and determined together in the money and loanable funds markets.
Interest rate is the price of money in two ways
Opportunity cost of holding money
Cost of borrowing money
Bonds promise to pay back the original value plus a fixed dollar amount of money
Bonds do not promise a fixed percentage of interest
When holding a bond until its time period is up, you receive the promised, fixed dollar amount payments plus the original value
Market price of a bond changes when interest rates change
When interest rates rise, market price of a bond falls
When interest rates fall, market price of a bond rises
Price of Bond Formula
Present Value (Price of Bond) = Amount of Money Available in n Years / (I + Interest Rate)^n
Perpetuity Bonds
Simplest example of inverse relation between bond prices and interest rates
- Pays fixed dollar amount forever, but never repays original investment
When does price of a bond change
Market price of a bond changes when interest rate changes
What is more risky, bonds or money as a store of value
Bonds are riskier and less liquid than money as a store of value, because the market price of the bond changes
What are interest rates determined by?
Interest rate determined by the interaction of demand and supply in the money and loanable funds markets
What happens at equilibrium interest rate?
At equilibrium interest rate, quantity of money demanded equals quantity of money supplied
What happens at below equilibrium interest rate?
Below equilibrium interest rate excess demand for money
- People sell bonds to get more money; increased supply of bonds causes falling bond prices and rising interest rates
What happens at above equilibrium interest rate?
Above equilibrium interest rate, excess supply of money
- People buy bonds to get rid of money; increased demand for bonds causes rising bond prices and falling interest rates
There are many interest rates on financial assets, but all tend to rise or fall together
There are many interest rates on financial assets, but all tend to rise or fall together
Domestic Transmission Mechanism
Money affects interest rates, domestic spending (consumption and business investment), and aggregate demand, which change real GDP, unemployment, and inflation
How does money affect the key macroeconomic outcomes of increasing and real GDP per person (economic growth), unemployment, and inflation?
Money can affect inflation, according to quantity theory of money
But money does not directly affect aggregate supply or economic growth
Money does indirectly affect GDP, economic growth, and unemployment
Domestic monetary transmission mechanism - how money indirectly affects real GDP through interest rates, spending, and aggregate demand
When interest rate falls, interest rate sensitive purchases become cheaper; increased consumer spending (C) and business investment spending (I) increase aggregate demand
Lower interest rates are a positive demand shock, increasing aggregate demand, increasing real GDP, decreasing unemployment, and causing inflation
Higher interest rates are a negative demand shock, decreasing aggregate demand, decreasing in real GDP, increasing unemployment, and causing deflation
How Money Affects Businesses Cycle
Yes – Markets Self Adjust” camp thinks money has no effect on business cycles and helps loanable funds markets adjust. “No – Markets Fail Often” camp thinks money creates new shocks and blocks the transmission mechanism, slowing market adjustments.
Economists disagree on the question
