Chapter 9 | Demanders and Suppliers of Money

Question 1

Demand for Money

Answer 1

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

Question 2

Money

Answer 2

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

Question 3

Bond

Answer 3

financial asset for which borrower promises to repay the original value at a specific future date, and to make fixed regular interest payments

Question 4

Demand for money is about the choice

Answer 4

to hold your wealth as money or as bonds?

Question 5

Why hold wealth as money that pays no interest, rather than as bonds that pay interest?

Answer 5

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

Question 6

Why hold money as a store of value

Answer 6

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

Question 7

Interest Rate

Answer 7

price of holding money; what you give up by not holding bonds

Determined by demand and supply in both money and loanable funds markets

Question 8

Law of demand for money

Answer 8

as the price of money – the interest rate – rises, the quantity demanded of money decreases

Question 9

Changes in Demand for Money

Answer 9

Changes in real GDP or average prices cause change in demand for money (shift of demand curve)

Question 10

Increase in demand for money (rightward shift) from

Answer 10

Increase in real GDP
Rise in prices

Question 11

Decrease in demand for money (leftward shift) from

Answer 11

Decrease in real GDP
Fall in prices

Question 12

Supply of Money

Answer 12

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

Question 13

Forms of money

Answer 13

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

Question 14

The Money Supply

Answer 14

Supply of money is currency and deposit money

M1+ = currency in circulation plus demand deposits

M2+ = M1+ plus all other less liquid deposits

Question 15

Who creates the money supply?

Answer 15

Bank of Canada (Canada’s central bank)
Chartered banks

Question 16

Bank of Canada’s roles

Answer 16

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

Question 17

Lender of last resort

Answer 17

making loans to banks to preserve stability of financial system

Question 18

Chartered banks create money (demand deposits) because of

Answer 18

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

Question 19

fractional reserve banking

Answer 19

banks hold only a fraction of deposits as reserves and loan out the rest

Question 20

Risk of a bank run

Answer 20

many depositors withdraw at once so bank lacks enough cash reserves to pay everyone

Question 21

Banks face a trade-off between profits and prudence

Answer 21

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

Question 22

Supply of money determined by Bank of Canada and chartered banks

Answer 22

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

Question 23

Interest Rates, Money, Bonds

Answer 23

Bond prices and interest rates are inversely related and determined together in the money and loanable funds markets.

Question 24

Interest rate is the price of money in two ways

Answer 24

Opportunity cost of holding money
Cost of borrowing money

Question 25

Bonds promise to pay back the original value plus a fixed dollar amount of money

Answer 25

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

Question 26

Market price of a bond changes when interest rates change

Answer 26

When interest rates rise, market price of a bond falls
When interest rates fall, market price of a bond rises

Question 27

Price of Bond Formula

Answer 27

Present Value (Price of Bond) = Amount of Money Available in n Years / (I + Interest Rate)^n

Question 28

Perpetuity Bonds

Answer 28

Simplest example of inverse relation between bond prices and interest rates
- Pays fixed dollar amount forever, but never repays original investment

Question 29

When does price of a bond change

Answer 29

Market price of a bond changes when interest rate changes

Question 30

What is more risky, bonds or money as a store of value

Answer 30

Bonds are riskier and less liquid than money as a store of value, because the market price of the bond changes

Question 31

What are interest rates determined by?

Answer 31

Interest rate determined by the interaction of demand and supply in the money and loanable funds markets

Question 32

What happens at equilibrium interest rate?

Answer 32

At equilibrium interest rate, quantity of money demanded equals quantity of money supplied

Question 33

What happens at below equilibrium interest rate?

Answer 33

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

Question 34

What happens at above equilibrium interest rate?

Answer 34

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

Question 35

There are many interest rates on financial assets, but all tend to rise or fall together

Answer 35

There are many interest rates on financial assets, but all tend to rise or fall together

Question 36

Domestic Transmission Mechanism

Answer 36

Money affects interest rates, domestic spending (consumption and business investment), and aggregate demand, which change real GDP, unemployment, and inflation

Question 37

How does money affect the key macroeconomic outcomes of increasing and real GDP per person (economic growth), unemployment, and inflation?

Answer 37

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

Question 38

Domestic monetary transmission mechanism - how money indirectly affects real GDP through interest rates, spending, and aggregate demand

Answer 38

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

Question 39

How Money Affects Businesses Cycle

Answer 39

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