Macroeconomics 6: Money, Prices and Inflation

Question 1

Describe & explain what money is

Establish the role of credit cards too

Answer 1

Money is what money does
- medium of exchange
- unit of account
- store of value
These functions of money determine what assets are money.
A narrow definition of money (aka M1), based on money being a medium of exchange, is
currency – this is referred to as Monetary Base
bank deposits which can be used to make transactions (e.g.by using debit cards)
Financial instruments like credit cards are not money but they do increase the ability of money
to make transactions and hence influence the demand for (narrow) money (velocity of money)

Question 2

Describe & explain the operational definitions of money. Include a graph which describes the share of the different definitions of money in the Euro Area

Answer 2

Money is relatively easy to define in a
narrow sense where the medium of
exchange function is crucial
To get a broader view of the monetary
situation not just for today but in the
future, many central banks monitor
multiple money definitions such as
M0 monetary base
M1 money as a means of payment
M2 (M1 plus non-transactions
deposits which can be rapidly
converted into money)
M3 (including highly liquid stores of
value such as Money Market funds.

Description of stacked bar chart:
Y-axis labelled “Billions of Euros” from 1k to 8k. X-axis has 3 categories: “M1”, “M2” and “M3”. M1 has “currency” from 0-600 and “overnight deposits” from 600-3.5k. M2 has the same but also “other deposits” from 3.5k-6k. M3 has the same as M2 but also “other money market instruments” from 6k-7k.

Question 3

Describe a model of the money supply

Answer 3

Using a narrow definition of money M=CH + D where CH is the amount of currency held by household
We assume households hold currency according to CH=cD.
Banks hold an amount of cash CB = κD
The total amount of currency in the system, called the monetary base (B), must either be held by banks as
reserves or households as currency so B=CH + CB = cD +κD = (c+κ)D
Hence D = B
c+κ
M=cD+D = (1+c)D = 1+c
c+κB
The money supply is a function of the monetary base B and two key behavioural
parameters (c and κ).
For constant κ and c, varying B changes M

Question 4

List & describe how money supply can be controlled

Answer 4

Open market operations: Monetary policy maker (Central Bank) buys/sells (typically) government bonds
for monetary base
Lender of Last Resort: lending directly to banks (usually covered by bank assets as collateral), through what
is called the discount window. This carries an interest rate which can be changed
Auction: Central Banks can announce in advance the amount of funds they will lend and then banks bid for
them
Changing interest rates: Reserves may earn interest and the interest rate can be varied so influencing bank
holding of monetary base
Required reserve ratio: This is not used extensively since usually bank are left to choose the reserves they
require (as in our model above)