lecture 4 Flashcards
What are the three main functions of money? A:
- Medium of exchange: Used for transactions.
- Unit of account: Provides a standard for pricing.
- Store of value: Preserves purchasing power over time.
: What was the role of the gold standard in money supply, and how did it work?
Under the gold standard, central banks issued banknotes backed by gold reserves. The money supply was directly tied to the amount of gold held by the central bank, meaning money issuance was limited to the size of the central bank’s gold reserves.
How does an increase in nominal income affect the demand for money and interest rates?
An increase in nominal income leads to a higher demand for money, which in turn increases the interest rate as people require more money for transactions, reducing the money available for other investments.
What are open market operations, and how do they influence the money supply?
Open market operations involve the central bank buying or selling bonds.
* Expansionary: Central bank buys bonds, increasing the money supply.
* Contractionary: Central bank sells bonds, reducing the money supply.
What is the liquidity trap, and how does it affect the economy?
A liquidity trap occurs when interest rates are very low (near zero) and further rate cuts don’t encourage additional spending or investment. People hold money instead of bonds, and monetary policy becomes ineffective because it can’t lower interest rates further.
How do central banks manage the demand for money?
Central banks control the money supply through policies like interest rates and open market operations. The demand for money depends on factors like income (higher income = higher demand) and the interest rate (higher rates = lower demand for money).
What are financial intermediaries, and what role do they play in the economy?
Financial intermediaries are institutions, like banks, that channel funds from savers to borrowers. They collect deposits and use those funds to purchase bonds or stocks, facilitating investment and supporting economic activity.
Explain the money multiplier effect and its significance in the banking system.
The money multiplier effect occurs when the central bank creates money (currency and reserves), but banks lend out a significant portion of their deposits, thereby expanding the total money supply. The money supply grows more rapidly than the central bank’s direct issuance because of this lending process.
How is the equilibrium interest rate determined in the context of the supply and demand for money?
The equilibrium interest rate is the point where the money supply (controlled by the central bank) equals the money demand (which depends on factors like income and interest rates). At this point, the amount of money available matches the amount demanded by individuals and businesses.
