Monetary System and Monetary Policy

Question 1

What are the economic functions of money?

Answer 1

Medium of exchange, unit of account, store of value

Question 2

Barter system

Answer 2

Contingent on a double coincidence of wants

Question 3

Fiat money

Answer 3

Cash or coins

Question 4

Functions of the central bank

Answer 4

Banker for the government
Banker for the commercial banks
Regulator of the money supply
Protector of financial markets

Question 5

What are banks liabilities and assets?

Answer 5

Liabilities are deposits
Assets are loans

Question 6

What is the fractional reserve system?

Answer 6

Only a fraction of deposits is held as reserves.

Question 7

What are reserves?

Answer 7

Cash holdings from money that was deposited in case of withdrawals

Question 8

What is money supply?

Answer 8

Deposits

Question 9

Eqn: change in deposits

Answer 9

Change in reserves x 1/reserve ratio

Question 10

What is the deposit multiplier?

Answer 10

1 / reserve ratio

Question 11

Eqn: Money multiplier and what is it exactly?

Answer 11

Calculates how much money has left the banking system.
Change in the quantity of money/ change in the monetary base

Question 11

What is the monetary base?

Answer 11

Total amount of deposits

Question 11

Relationship between future value and present value:

Answer 11

PV= FV/ (1+i)^n
FV= PV (1+i)^n
i=interest rate
n=number of years

Question 11

What is the nominal interest rate compared to real and when on a graph what is it referring to? Why is MS vertical?

Answer 11

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.

Question 11

Why is MS vertical? Why is the money demand curve downward sloping?

Answer 11

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.

Question 11

Motives for the demand for cash?

Answer 11

precautionary, transactions and speculative.

Question 12

How does the Money demanded curve shift?

Answer 12

The curve will shift to a change in the price level or real GDP.

Question 13

What is the liquidity preference theory of interest?

Answer 13

The demand for money indicates a preference for more liquid assets.

Question 14

How can the bank of Canada influence money demanded?

Answer 14

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.

Question 15

What are the steps of Monetary transmission mechanism?

Answer 15

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.

Question 16

What are the four tools of monetary policy?

Answer 16

Open Market Operations (OMO), bank rates (discount rates), government deposit shifting and required reserve ratio.

Question 17

What are Open Market Operations?

Answer 17

Involves the buying and selling of government securities- treasury bills and government bonds.

Question 17

Summarize the expansionary and contractionary monetary policy of Open Market Operations, Bank Rates, Government Deposit Shifting and Required Reserve Ratio

Answer 17

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

Question 18

What are banks rates?

Answer 18

The interest rate that central banks charge commercial banks to the reserves lent to them. (known as the discount rate).

Question 19

What is the effect of monetary policy?

Answer 19

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.

Question 20

What is Government Deposit Shifting?

Answer 20

Transfer of government funds from a government account in the Bank of Canada to its account in a commercial bank.

Question 21

Expansionary monetary policy

Answer 21

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.

Question 22

Contractionary monetary policy

Answer 22

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.

Question 23

Effectiveness of monetary policy:

Answer 23

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.

Question 24

What does the steepness of the MD curve say about the effectiveness (elasticity) of monetary policy and what about investment demand curve?

Answer 24

The steeper the money demanded curve the more effective the monetary policy. The flatter the investment demanded curve the more effective the monetary policy.

Question 24

What are second round effects?

Answer 24

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.