Module 8

Question 1

What is money

Answer 1

Money: the set of all assets that are regularly used to directly purchase goods and services

Typically serves 3 main functions: store of value, a medium of exchange and unit of account

Question 2

Bartering

Answer 2

Barter: directly offer a good or service that you have (jacket, bike or the cost of your labor) in exchange for a good or service that you want. This method is highly inefficient because you have to take the time to find someone that has what you want and wants what you have

Question 3

Commodity-Backed Money

Answer 3

Is any form of money–usually paper money–that can be legally exchanged for a fixed amount of an underlying commodity, generally gold

Question 4

Fiat money

Answer 4

Fiat money is created by rule, with no commodity to back it. The value behind it comes from the trust people have in the Canadian government to not overproduce money and reduce its value. The value of our money is solely derived from the quantity of money that we have

Question 5

Demand Deposits

Answer 5

Money held in the bank that can then be withdrawn (demanded) at any time

Question 6

Reserve Ratio

Answer 6

A fraction of the amount of cash kept as reserves, divided by the total amount of demand deposits

Question 7

Money multiplier in banks

Answer 7

1/R
R= the reserve ratio
A reserve ratio of 10% would make the MM = 10
1/0.1 = 10

Notice that the smaller the reserve ratio, the larger the money multiplier

Question 8

M1+

Answer 8

M1+: includes currency held by the public, plus chequing account balances at chartered banks, trust and mortgage loan companies, credit unions and caisses populaires (demand deposits, which are not exactly cash but are readily available for most people)

Question 9

M2

Answer 9

M2: includes everything in M1 plus personal savings accounts and non-personal notice deposits where money is locked away for a certain period of time. Since these forms of savings cannot be accessed easily without penalty fees, they are slightly less liquid than other forms of money

If we want to look at spending (liquidity) we use M1+
If we want to look at savings we look at M2.

Question 10

How does the government change money supply with open market operations?

Answer 10

When the central bank wants to increase the money supply, it buys bonds from one of the large banks it trades with. The Bank of Canada pays with this in cash, which then translate into more money in deposits and reserves for commercial banks, which they can use to issue more loans

When the central bank wants to decrease the money supply, it sells bonds accepting as payment the reserves from the buying bank. The central bank then effectively destroys the money it receives, which decreases the amount of monetary base in existence

Question 11

Monetarists

Answer 11

Some economists, known as monetarists, state that over the long run monetary policy is irrelevant because prices will eventually adjust to a high or low supply of money without a change in economic output

Question 12

Liquidity preferecne model

Answer 12

This relationship is the central idea of the liquidity preference model, stating the quantity of cash people hold is a function of the nominal interest rate
The money demanded (quantity of cash held) slopes downward on the graph because the as the interest rate decreases, it becomes less beneficial to hold illiquid bonds

Question 13

neutrality of money

Answer 13

—the idea that, in the long run, changes in the money supply does not affect real outcomes in the economy

Question 14

The Quantity Theory of Money

Answer 14

The quantity theory of money explicitly states that the value of money, and the aggregate price level, are determined by the quantity of money in existence (money supply)

Question 15

Menu costs

Answer 15

refers to the costs of changing prices to keep up with inflation, measured in money, time and opportunity. This is when a restaurant has to print new menus, when a vending machine owner has to reprogram his machine, etc

Question 16

Shoe leather costs

Answer 16

refers to the time, effort and money that must be spent to manage cash in the face of inflation. This depends on the current levels of inflation, so if prices are rising rapidly you will want to put your cash in interest bearing accounts to maintain the value of your money. This cost of going back and forth between the bank to deposit money “wears out your shoe-leather”, and this time and effort could be put to better use

Question 17

Tax distortion

Answer 17

Tax distortion: tax laws measure only nominal income, not what you can buy with it. Consider an income of 50,000$ that pays 10% income tax (the next tax bracket is 60,000$). If inflation were at 20% that year, then their employer raises their income to 60,000$ to adjust for inflation, so now that person pays a 15% tax. Although the salary was adjusted for inflation, the tax bracket was not, which makes that person pay more in tax each year

Question 18

Disinflation

Answer 18

Let’s say the Bank of Canada reduces inflation from 7% to 2%, this is called a successful disinflation. Note that over this period, the inflation rate is still positive, only it reduced by 5% (don’t mix this up with deflation, where inflation rates are negative

Question 19

Hyperinflation

Answer 19

When the inflation levels spiral out of control, we say it is hyperinflation–an extremely long lasting and painful increase in the price level. Such increases make the currency lose most or all of its value

Question 20

Short Run Phillips Curve

Answer 20

The relationship in the Short Run Phillips Curve shows that when inflation is high unemployment is low, and when inflation is low unemployment is high

Question 21

Long run Phillips curve

Answer 21

Includes the long run effect of expectations of inflation in the diagram. Represents the fact that there is no trade-off between inflation and unemployment in the long run
Economists call the minimum level of unemployment the non-accelerating inflation rate of unemployment (NAIRU) also known as the natural rate of unemployment

Question 22

NAIRU above or below

Answer 22

Though we may not know the exact location of the NAIRU, we can fairly quickly determine if we are above or below it:
If unemployment is below the NAIRU, inflation generally accelerates
If we observe involuntary unemployment rising, unemployment is above the NAIRU

Question 23

Q:In the liquidity preference model, changes to the money supply will have a smaller effect on interest rates the

Answer 23

flatter, more elastic is the money demand curve.