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Macro > Money > Flashcards

Money Flashcards

1
Q

What is the inflation rate?

A

The percentage increase in the average level of prices

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2
Q

What is a price?

A

The amount of money required to buy a good

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3
Q

What is money?

A

A stock of assets that can be readily used to make transactions

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4
Q

What are the functions of money?

A

Medium of exchange, store of value, unit of account, and liquidity

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5
Q

What are the two types of money?

A

Commodity money has intrinsic value, fiat money doesn’t

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6
Q

What are the levels of money?

A

M0: monetary base or legal tender is currency + reserves
M1: + demand deposits (current accounts) and checkable deposits
M2: + small time and savings deposits
M3: + large time deposits
M4: + least liquid assets like long term bonds

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7
Q

What is the money supply?

A

The quantity of money available in the economy
money supply M = currency C + demand deposits D

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8
Q

What is monetary policy?

A

How the (usually independent) central bank or government controls and manages the money supply in the economy

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9
Q

Why can’t monetary policy fully control the money supply?

A

Central banks and governments cannot perfectly control individual behaviour and preferences so they can only influence, not entirely determine, demand deposits

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10
Q

What are reserves?

A

Denoted R, the portion of deposits which a bank has not lent out

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11
Q

What is fractional reserve banking?

A

When a bank only needs to hold a fraction of deposits in reserve and can lend out the rest, as opposed to 100%-reserve banking when banks hold all deposits as reserves

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12
Q

What is a bank’s net worth?

A

Net worth = equity = capital = assets - liabilities
Assets are anything valuable owned by the institution and liabilities are anything valuable that the institution owes to others
Equity appears under liabilities on balance sheets so that assets = liabilities + equity (books are balanced)

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13
Q

What is the reserve ratio and how does it relate to the money supply?

A

The reserve ratio is the ratio of reserves to deposits, denoted rr
M = C + D/rr

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14
Q

What effect does fractional reserve banking have on money supply and wealth?

A

It creates money but not real wealth as the amount of money added to borrowers is equal to the amount of new debt the bank has

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15
Q

What is a bank’s capital?

A

The resources a bank’s owners have put into the bank

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16
Q

What is leverage?

A

The use of borrowed funds to supplement existing funds for purposes of investment

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17
Q

What is the leverage ratio?

A

Assets or total liabilities divided by net worth

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18
Q

What is the effect of a bank being highly leveraged?

A

The bank is very vulnerable to changes in the value of assets/liabilities as the net worth can be wiped out by smaller percentage changes in the value of assets

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19
Q

What are the exogenous variables for the money supply?

A

Monetary base B = C + R is controlled by central banks, reserve-deposit ratio rr = R/D depends on regulation and bank policies, currency-deposit ratio cr = C/D depends on household preferences

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20
Q

What is the expanded formula for the money supply?

A

M = C + D = (C+D)B/B = B(cr+1)/(cr+rr)

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21
Q

What is the money multiplier?

A

What the monetary base is multiplied by to get the money supply
m = (cr+1)/(cr+rr)
Since rr < 1, m > 1 so a change to the monetary base leads to a greater change in the money supply

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22
Q

How does the central bank manage the monetary base?

A

Open market operations: national currency is circulated or withdrawn by buying or selling government securities like gilts, foreign currency, or gold
Repo/refinance/discount rate: the interest rate the central bank charges on (usually overnight) loans to commercial banks, lowering this means banks are more likely to borrow so the monetary base increases, this is not the same as the interbank rates
Reserve requirements: changing rr, lowering it would increase the money multiplier and so money supply
Interest on excess reserves: this is the rate on the current accounts commercial banks hold with the central bank, it is usually the same as the repo rate, a lower rate would disincentivise banks from depositing at the CB which would lower the rr and increase money supply

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23
Q

What are the goals of an independent central bank?

A

Price stability, output stability, low unemployment, liquidity, smooth market functioning

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24
Q

What are common targets for central banks?

A

Inflation targets (BoE aims for 2% CPI +- 1%, ECB aims for <2% CPI)
Money growth targets (Bundesbank and ECB but not BoE)
Employment targets
Moderate long term interest rates

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25
Q

How does a central bank typically achieve their interest rate targets?

A

Open market operations (sales and purchases of short-term safe government bonds)
If short term rates are near zero usual open market operations are ineffective due to indifference between bonds and cash

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26
Q

What are some unconventional monetary policy tools?

A

Quantitative Easing: sales and purchases of longer-term riskier government bonds
Credit Easing: sales and purchases of corporate bonds and assets
Quantitative Tightening: unwinding QE programmes (selling the bonds that were purchased)
Forward Guidance: committing to carry out a certain policy in the future

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27
Q

What is seigniorage?

A

Difference between face value and ‘mint’ value of newly created money

28
Q

What does the Quantity Theory of Money do?

A

Models monetary demand, linking the inflation rate to the growth rate of the money supply in the medium/long run

29
Q

What makes the Quantity Theory a classical theory?

A

It assumes flexible prices and clearing markets

30
Q

What is the velocity of money?

A

The rate at which money circulates or the number of times the average bank note changes hands in a given period
velocity V = value of total transactions T / money supply M

31
Q

What is the Quantity Equation and how is it derived?

A

MV = PY
Using GDP as an approximation for the value of total transactions in the formula for velocity gives V = PY/M where P is the price of output (GDP deflator) and Y is real GDP

32
Q

What is the real money balance?

A

M/P is the purchasing power of the money supply

33
Q

What is the basic money demand function?

A

(M/P)d = kY where d is a superscript to denote demand, M is treated as exogenously determined by the central bank, and k is the exogenously given amount of money people wish to hold for each unit of income

34
Q

What is the connection between money demand and the quantity equation?

A

k = 1/V

35
Q

What are the determinants of the variables in the quantity equation?

A

Velocity is assumed to be exogenously fixed (can be written V bar), real GDP Y depends on the economy’s supply of capital and labour and its production function, the price level P = nominal GDP / real GDP is the only endogenous variable in the model

36
Q

What is the growth version of the quantity equation?

A

ΔM/M + ΔV/V = ΔP/P + ΔY/Y the first term is the growth in the money supply and the last term is the growth in real output which depends on factor and productivity growth but the second term is assumed to be 0 and the third is the inflation rate π so π = gM + gY

37
Q

Why is some growth in the money supply usually required for economic growth?

A

It facilitates growth in transactions, but money supply growth beyond what is required leads to inflation

38
Q

What does the Quantity Theory of Money predict?

A

There is a one-to-one relationship between changes in the money growth rate and changes in the inflation rate

39
Q

What are the real and nominal interest rates?

A

Real interest rate r = percentage rate of return on real assets (not directly observable)
Nominal rate i = percentage rate of return on nominal assets

40
Q

What is the relationship between the real and nominal interest rate?

A

r = i - π (an approximation from (1+π)(1+r) = (1+i))

41
Q

What is the Fisher equation?

A

The identity i = r + π

42
Q

What does the classical model say about interest rates?

A

The classical model says that savings S = investment I determine the real interest rate and an increase in the inflation rate causes and equal increase in the nominal interest rate, this one-to-one relationship is called the Fisher effect

43
Q

What is the difference between Classical and Keynesian theories?

A

Classical theories apply to the medium/long run and treat the real interest rate as exogenous, Keynesian theories apply to the short run and treat the nominal interest rate as exogenous

44
Q

What is the transactions motive?

A

The part of the demand for money which captures the tradeoff between getting interest (at the nominal rate i) and ease of transaction
This means that i is another determinant of money demand

45
Q

What effect does the nominal interest rate have on money demand?

A

Since i is the opportunity cost of holding money, an increase in i will decrease money demand

46
Q

What is the expanded money demand function?

A

(M/P)d = L(i, Y) with L being used as money is the most liquid asset and increasing in Y but decreasing in i

47
Q

What is the difference between real and expected inflation and how does this change the money demand function?

A

π is the actual inflation rate and πe is the expected inflation rate so when a decision is made the real interest rate is i - πe (ex ante real interest rate) but the ex post real interest rate that is actually earned is i - π, money demand only depends on the former so (M/P)d = L(r + πe, Y)

48
Q

Where is the equilibrium for the money market?

A

The supply of real money balances M/P = the real money demand L(r + πe, Y)

49
Q

How is the long run equilibrium of the money market determined?

A

M is determined exogenously by the central bank, r adjusts to make savings equal to investment (loanable funds equilibrium), Y = F(K, L), P adjusts to make M/P = L(i, Y)

50
Q

What is the relationship between real and expected inflation?

A

In the long run π should be equal to πe as people shouldn’t consistently over- or under- forecast inflation but in the short/medium run they may differ due to imperfect and changing information, pessimistic and optimistic sentiments, etc.

51
Q

How can comparative statics be carried out on the money market?

A

If r, Y, and M are fixed then an increase in expected inflation increases the nominal interest rate which decreases monetary demand which establishes a new equilibrium at a higher price level
If r, Y, and πe are fixed then as in the Fisher effect and quantity theory, a change in M causes an equal percentage change in P as the increased money supply increases the expected inflation rate so the nominal interest rate is higher (from Fisher equation) which results in a higher price level

52
Q

What is absent from the Quantity Theory?

A

In the theory money supply and demand affect prices which affect the inflation rate which affect the nominal interest rate by the fisher effect but the link back to money supply and demand is not accounted for

53
Q

What are shoe-leather costs?

A

The costs and inconveniences of reducing money balances to avoid the ‘inflation tax’ as higher inflation leads to higher nominal interest rates which leads to lower real money balances

54
Q

What is the long run effect of inflation in class theories?

A

Real income and spending aren’t affected but average money holdings will be lower so trips to the bank will be more frequent

55
Q

Why may the quantity theory not be suitable for the short run?

A

High inflation and high associated shoe leather costs will lead to less demand for money which will increase velocity so the assumption of fixed velocity will not hold in the short run

56
Q

What are menu costs?

A

The cost of a firm changing the prices being displayed, higher inflation will mean these costs will be incurred more often and can cause relative price distortions as firms don’t keep menus up to date with inflation

57
Q

What are some harms of inflation?

A

Unfair tax treatment when some taxes aren’t adjusted for inflation
Long-range financial planning is harder
Wealth is redistributed (from lenders to borrowers)
Increased uncertainty can make people more risk averse which distorts inter-temporal decisions

58
Q

What are some benefits of inflation?

A

Nominal wages rarely fall even when the equilibrium real wage falls so inflation can help achieve the equilibrium real wage which could decrease unemployment and improve the functioning of labour markets

59
Q

What is hyperinflation?

A

π >= 50% month on month, caused by excessive money supply growth, causes money to lose its function as a store of value

60
Q

What is the government budget constraint?

A

government funds G = tax revenue T + borrowing ΔB + change in the money supply (resulting in seigniorage or the inflation tax, used when T and B are hard to change) ΔM

61
Q

What is deflation?

A

A fall in the level of prices

62
Q

What is an issue with deflation?

A

If people expect prices to fall they spend less so businesses lose revenue which leads to a vicious cycle of people not having as much to spend on which can lead to a recession

63
Q

What is disinflation?

A

A falling inflation rate

64
Q

What is the Classical dichotomy?

A

Real and nominal variables are separate in the model so do not influence each other, results in the theoretical neutrality of money (changes in money supply don’t affect real variables) which could apply in the long run but not in the short run

65
Q
A

Macro (9 decks)

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