Monetary Policy Flashcards
What are the two types of assets that we can store our wealth in? What are the tradeoffs?
1) Monetary assets: Includes cash and bank deposits
-Monetary assets offer convenience, but they offer little to no return.
2) Interest-bearing, non-monetary assets: bonds, stocks and mutual funds
-Non-monetary assets offer higher returns, but do not offer convenience.
What does the money demand curve show?
-The money demand curve shows the relationship between the quantity of money demanded and the interest rate.
-Since the interest rate represents the opportunity cost of holding money, there is an inverse relationship between the quantity of money demanded and the interest rate. That is precisely why the money demand curve is downwards sloping.
What are the factors that shift the money demand curve?
-Any factor that affects the willingness to hold money other than interest rate will shift the monetary demand curve. Here are some key factors:
1) Aggregate price level: Shifts curve right. When price increases, we need to hold more money to buy the same amount of goods and services.
2) Real GDP: Shifts curve right. When output increases, consumption increases, we need to hold more money to facilitate a larger volume of transactions.
3) Improvement in banking, technology like credit cards: Shifts curve left. This allows people to make purchases without holding money. This reduces cash holding overall.
4) Institutional factors such as the introduction of chequable-savings accounts. Shifts curve right. This lowers the opportunity cost of holding money. Banks offer the unique features of checquing account, with the interest rate of saving account. So for any given level of interest, money demand goes up.
What are the five assumptions of the liquidity preference model fo the interest rate?
1) There is only one interest rate paid for non-monetary financial assets
2) The nominal money demand comes from households and firms
3) The level of (nominal) money supply is chosen by the central bank
4) The BOC can change the money supply via open market operations, changing the bank rate, and government deposit switching.
5) Money market equilibrium occurs when money supply equals money demand.
What does the liquidity preference model of the interest rate suggest?
-The interest rate adjusts to ensure the money market is in equilibrium.
When the Bank of Canada changes the target for the overnight rate, it will affect the economy through which four different channels?
1) Interest rate on other assets and loans
2) Asset prices
3) The exchange rate
4) Market expectations
What is the fomrula for Aggregate Demand?
AD=C(YD)+I(r)+G+NX(exchange rate)
What is quantative easing?
Quantative easing involves the central bank purchasing long-term assets in an attempt to lower the long-term interest rate, thus exerting an expansionary effect on the economy.
We are at full employment (Y(FE)), and money supply increases, what happens after that?
-Increase in money supply increases aggregate demand.
-That shift in aggregate demand means that output is greater than Y(FE) which is full employment.
-That is not sustainable.
-Wages rise as money supply rises, which means per unit profit drops.
-Short run aggregate supply shifts left, so that output is the same as it initially was. But price is reasonably higher.
What does the long-run neutrality of money suggests?
-The long-run neutrality of money suggests that a change in money supply whill not have any effect on the critical variables like real output in the long run.
-Money is neutral in the long run because Y(FE)=A*(K,H,L), and changes in money supply don’t come in to this equation. So money supply won’t impact that in the long run.
What does the quantity equation show? What is it’s formula?
-The quantity equation shows the relationship between nominal GDP and the amount of money exchanges
-MV=PY
-M is money supply
-V is velocity of money
-P is aggregate price level
-Y is real GDP
-The left side of the equation is the total amount of money exchanged in a year
-The right side of the equation is nominal GDP.
What does the theory of liquidity preference state?
When the quantity of money supplied is less than the quantity of money demanded, that implies that the interest rate is too low.
How can the central bank hold money supply of an individual bank fixed?
1) Transfer government deposits from the central bank to the bank
-This increases reserves, which then expands lending, and increases money supply
2) Open market purchases
-Open market purchases involve the central bank buying government securities or bonds from the public or banks. It serves to increase reserves in the banking system.
3) Decrease the bank rate/overnight rate
-This makes it cheaper for banks to borrow not only from the central bank but also to each other. This is because generally speaking, the overnight rate is often 0.25% higher than the rate commercial banks charge.
4) Decrease the required reserve ratio
-This allows the banks to loan out more money for every dollar that they have in reserves.
