Lec 5 - Monetary Policy

Question 1

Money definition

Answer 1

Any commodity or token that is generally acceptable as a means of payment.

Question 2

Means of payment definition

Answer 2

A method of settling a debt.

Question 3

Functions of money

what are the main four?

Answer 3

Settling a debt
Medium of exchange
Unit of account
Store of value

Question 4

Medium of exchange definition

Answer 4

An object that is generally accepted in exchange for goods and services.

Question 5

Unit of account definition

Answer 5

An agreed measure for stating the prices of goods and services.

Question 6

Store of value definition

Answer 6

Something which can be held for a time and later exchanged for goods and services.

Question 7

M4 definition

Answer 7

The official UK measure of money in terms of currency and deposits at banks & building societies.

Question 8

Cheque definition

Answer 8

An instruction to your bank to move some funds from your account to someone else’s account.

Question 9

Debit card definition

Answer 9

Debit cards are not money. Using a debit card is like writing a cheque except the transaction takes place in an instant. A debit card is not a means of payment.

Question 10

Credit card definition

Answer 10

Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money. A credit card is not a means of payment.

Question 11

Monetary financial institution definition

Answer 11

A financial firm that takes deposits from households and firms and makes loans to other households and firms.
Mainly commercial banks and building societies.

Question 12

Differences between building societies and banks

Answer 12

A building society is usually owned by its depositors.
Deposits are usually saving accounts.
Loans are usually for house purchases.
Reserves are kept at commercial banks.

Question 13

Monetary financial institutions services

What are the four main ones?

Answer 13

Creating liquidity
Pooling risk
Lower the cost of borrowing
Lower the cost of monitoring borrowers

Question 14

Regulation of monetary financial institutions

Answer 14

To make the risk of failure small, commercial banks are required to hold levels of reserves and owners’ capital equal to or surpass ratios laid down by regulation.
The required reserve ratio is the minimum percentage of deposits that a bank is required to hold in reserves.
The required capital ratio is the minimum percentage of assets that must be financed by the bank’s owners.
The Bank of England doesn’t vary the required reserve ratio very often.
The Bank of England is the lender of last resort.

Question 15

Creating money
(how do banks create money?)

Answer 15

When a bank receives a deposit, its reserves increase by the amount deposited.

But the bank doesn’t hold all of the deposit as reserves, it loans some of the amount deposited.

These loans end up as deposits.

The banking system as a whole can increase loans and deposits with no change in reserves.

The increase in deposits is an increase in money.

Question 16

Limiting factors to money creation

What three factors limit the amount of money that the banking system can create?

Answer 16

The quantity of loans and deposits that the banking system can create are limited by 3 factors:

The monetary base - sum of Bank of England notes and banks’ deposits at the Bank of England plus coins issued by the Royal Mint
Desired reserves - the ratio of reserves to deposits that banks consider prudent to hold.
Desired currency holding - people have a definite view about the proportion of money they want to hold as currency based on expenditure plans. This way currency drains from the banking system.

Question 17

Money multiplier definition

Answer 17

The ratio of the change in the quantity of money to the change in the monetary base.
The smaller the banks’ desired reserves ratio and the smaller the currency drain ratio, the larger is the money multiplier.

Question 18

Influences on money holding

what are the four main ones?

Answer 18

The quantity of money that people plan to hold depends on four main factors:
The price level: the quantity of nominal money demanded is proportional to the price level
The nominal interest rate: the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. A rise in the nominal interest rate on other assets decreases the quantity of real money that people hold.
Real GDP: increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.
Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.

Question 19

Demand for money curve

Answer 19

The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.
A rise in the interest rate brings a decrease in the quantity of money demanded.
A fall in the interest rate brings an increase in the quantity of money demanded.

Question 20

Shifting the demand for money curve

Answer 20

A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.
An increase in real GDP increases the demand for money and shifts the demand curve rightward.

Question 21

Interest rate formula

Answer 21

Interest rate = (Money payment/Price of bond) x 100

Question 22

Relationship between price of a bond and interest rate

Answer 22

The Price of a Bond and the Interest Rate

Buying bonds makes the price of a bond rise and the interest rate fall.
Why?

A bond pays a fixed amount of money each year, so the higher the price of bond, the lower is the interest rate.

Similarly, selling bonds make the price of a bond fall and the interest rate rise.

Question 23

Short-Run Effect of a Change in the Supply of Money

Answer 23

Initially, the interest rate is 2 per cent a year.
If the Bank increases the quantity of money, people will be holding more money than the quantity demanded.
People buy bonds.
The increased demand for bonds raises the bond price and lowers the interest rate.

Question 24

Demand side effects of Monetary Policy - lowering bank rate

Answer 24

1 Other short-term interest rates and the exchange rate fall.
2 The quantity of money and the supply of loanable funds increase.
3 The long-term interest rate falls.

4 Consumption expenditure, investment and net exports increase.
5 Aggregate demand increases.

6 Real GDP growth and the inflation rate increase.

Question 25

Demand side effects of Monetary Policy - fighting recession

Answer 25

If inflation is low and the output gap is negative, the MPC lowers Bank Rate.

The increase in the monetary base increases the quantity of money supplied.
The interest rate falls.

The increase in the supply of money increases the supply of loanable funds.
The real interest rate falls; investment increases.

The increase in investment increases aggregate expenditure, which increases aggregate demand.
A multiplier effect increases real GDP to potential GDP.

Question 26

Loose Links and Long and Variable Lags

Answer 26

Long-term interest rates that influence spending plans are linked loosely to Bank Rate.

The response of the real long-term interest rate to a change in the nominal interest rate depends on how inflation expectations change.

The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.

The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way.

Question 27

Supply side effects of monetary policy

Answer 27

Supply Side Impacts of monetary policy come through the impact of investment on the aggregate production function

Lower interest rates stimulate investment and lead to improvements in productivity in the economy.

Hence LAS shifts out.

These impacts are thought to be slow to be achieved and dominated in the short/medium term by the demand side impacts.

Question 28

Quantity theory of money

Answer 28

The proposition that changes in the money supply lead, in the long run, only to price changes.

It says that if the money supply rises by X%, then, in the long run, prices will also rise by X%.

Question 29

Impact of monetary policy

Answer 29

Assuming that AS is relatively unaffected by monetary policy, then, in the long run, the only impact of monetary policy is on prices.