Monetary System and Monetary Policy Flashcards
What are the economic functions of money?
Medium of exchange, unit of account, store of value
Barter system
Contingent on a double coincidence of wants
Fiat money
Cash or coins
Functions of the central bank
Banker for the government
Banker for the commercial banks
Regulator of the money supply
Protector of financial markets
What are banks liabilities and assets?
Liabilities are deposits
Assets are loans
What is the fractional reserve system?
Only a fraction of deposits is held as reserves.
What are reserves?
Cash holdings from money that was deposited in case of withdrawals
What is money supply?
Deposits
Eqn: change in deposits
Change in reserves x 1/reserve ratio
What is the deposit multiplier?
1 / reserve ratio
Eqn: Money multiplier and what is it exactly?
Calculates how much money has left the banking system.
Change in the quantity of money/ change in the monetary base
What is the monetary base?
Total amount of deposits
Relationship between future value and present value:
PV= FV/ (1+i)^n
FV= PV (1+i)^n
i=interest rate
n=number of years
What is the nominal interest rate compared to real and when on a graph what is it referring to? Why is MS vertical?
Nominal interest rate is the interest rate not adjusted to inflation, whereas real interest rate is. In this case, it is referring to the cost of holding money. MS is vertical because the bank controls it.
Why is MS vertical? Why is the money demand curve downward sloping?
MS is vertical because the bank controls it. It is sloped downwards because the opportunity cost of holding money increases the higher the nominal interest rate.
Motives for the demand for cash?
precautionary, transactions and speculative.
How does the Money demanded curve shift?
The curve will shift to a change in the price level or real GDP.
What is the liquidity preference theory of interest?
The demand for money indicates a preference for more liquid assets.
How can the bank of Canada influence money demanded?
Bank of Canada can lower interest rates which increases the money supply thereby increasing the nominal interest rates.
increase nominal interest rates by increasing the money supply; shifting the MS curve to the right or it can decrease interest rates by decreasing the money supply; shifting the MS curve to the left.
What are the steps of Monetary transmission mechanism?
Step 1:
Changes in equilibrium interest rate by the Bank of Canada.
Step 2:
Changes in desired investment and consumption.
Lower interest rates mean the opportunity cost of borrowing goes down and also consumption increases.
Step 3:
Changes in aggregate demand.
Aggregate expenditure curve shifts right because of lower interest rates that increase investment expenditure. This means higher equilibrium income.
What are the four tools of monetary policy?
Open Market Operations (OMO), bank rates (discount rates), government deposit shifting and required reserve ratio.
What are Open Market Operations?
Involves the buying and selling of government securities- treasury bills and government bonds.
Summarize the expansionary and contractionary monetary policy of Open Market Operations, Bank Rates, Government Deposit Shifting and Required Reserve Ratio
Open Market Operations:
Expansionary: buy bonds
Contractionary: sell bonds
Bank Rates:
Expansionary: lower rates
Contractionary: raise rates
Government deposit Shifting:
Expansionary: deposit funds
Contractionary: withdraw funds
Required Reserve Ratio:
Expansionary: lower ratio
Contractionary: raise ratio
What are banks rates?
The interest rate that central banks charge commercial banks to the reserves lent to them. (known as the discount rate).
What is the effect of monetary policy?
Real GDP will return to its full employment level on its own through the process of nominal wages, it only speeds up the process. It prevents extended periods of high employment in recessions, maintains price stability and low level of inflation in booms.
What is Government Deposit Shifting?
Transfer of government funds from a government account in the Bank of Canada to its account in a commercial bank.
Expansionary monetary policy
Increase the size of the economy’s money supply during a recession by lowering interest rates, lowering the reserve ratio, or buying bonds to accelerate the economy coming back to potential GDP and prevent an extended period of high unemployment.
Contractionary monetary policy
Reduce the size of the economy’s money supply during a boom by increasing interest rates, raising the reserve ratio, or selling bonds to accelerate the economy coming back to potential GDP sooner and stabilize wages and prices and prevent sustained inflation.
Effectiveness of monetary policy:
Responsiveness of money demand to interest rates investment to interest rates. Monetary policy is more effective when money demanded is less responsive to interest rates and when investment expenditure is less responsive to interest rates.
What does the steepness of the MD curve say about the effectiveness (elasticity) of monetary policy and what about investment demand curve?
The steeper the money demanded curve the more effective the monetary policy. The flatter the investment demanded curve the more effective the monetary policy.
What are second round effects?
A right shift in the money, demand curve because people now require more money to facilitate more transactions because more output is being produced. This causes the interest rates to rise, which is the second-round effect as it means the monetary policy is redundant.
