Money and Banking End-term Flashcards
What are the 2 phases of the money supply process?
Phase 1: The CB supplies banks with bank reserves and bank notes
Phase 2: banks supply households & firms with bank deposits and use bank reserves to settle interbank payments
What are the bank reserves that the CB gives to banks used for?
To settle interbank payments
What are the banknotes the CB gives to banks used for?
They are to be used by households and firms for person to person cash payments
Money multiplier definition (words)
the ratio of broad money to base money
How is most money in the economy created?
By banks when they provide loans
How does the CB influence the supply of loans and bank deposits banks?
They control the supply of banknotes and bank reserves under monopoly conditions.
Banks ________ lend bank reserves
don’t
Banks ________ lend bank deposits
dont, because it belongs to depositors
Banks _____ lend their own money
do, since it is guaranteed by their own capital
Where do bank reserves remain?
Within the monetary system
The 2 main limits of a bank’s ability to lend
1) the availability of capital (including risk reserves)
2) the reliability of customers
NOT from the availability of liquid reserves from the CB
What are the 2 ways to create bank deposits?
1) Passive deposit creation
2) Active deposit creation
Passive deposit creation
The bank creates deposits in favor of individual depositors against the value received in the shape of either cash or of an order authorizing the transfer of a deposit in some bank (either another bank or itself)
Active deposit creation
The bank may either purchase an asset (adds to its investment) or may create a claim against itself in favor of a borrower (in return for his/her promise of subsequent reimbursement –> ex: loans or advances)
What are the key variables in the money supply process?
C: currency
R: bank reserves (required reserves (RR) + excess reserves (ER)
H: base money = C + R = C + RR + ER
D: bank deposits (current accounts)
M: money supply = C + D
L: bank loans to households and firms
CBL: central bank loans to banks
What are the 3 key rations in the money supply process?
- Required reserve ratio
- Excess reserve ration
- Currency ratio
What is the required reserve ratio equation?
The CB sets the reserve requirement ratio as a part of the implementation of the monetary policy
Equation: r = RR/D , where 0 < r < 1
What is the excess reserve equation?
The bank sets the excess reserve ratio to hedge against liquidity risk, based on the expected return on other bank assets
Equation: e = ER/D , where 0 < e < 1
What is the currency ratio equation?
Equation: c = C/D , where 0 < c < 1
What are the 3 determinants of the currency ratio?
The currency-deposit ratio depends on:
1) the payment habits of households and firms
2) the efficiency of the payment system
3) the confidence in the banking system
What are the 6 assumptions of the money multiplier?
- Closed economy
- Three categories of agents [CB, Banks (MFI), and Households&Firms (HAF)]
- Interbank market is netter out
- Focus on traditional commercial banking (loans, deposits)
- Fixed interest rates on loans and deposits
- Key ratios are constant
- C = c*d
- R = (r+e)D , (r+e) < 1
- constant payment habits and given expectations
Money multiplier equation
Money multiplier = m = 1/r
Basically 1 divided by the required reserve ratio (so r and m are inversely related)
- Loan payments ____ the supply of money
- The power to multiply deposits belongs to the (a) ______, and not to (b) ______
- the money multiplier indicates the (a) __________ that the banking system as a whole can create out of (b) __________
- reduces
- (a) banking system as a whole, (b) individual banks
- (a) maximum amount of money, (b) an original deposit
Fractional reserve banking
The system under which banks that collect deposits are required to hold a portion of those deposits as liquid assets as a reserve and can lend the rest
Banks do not lend _____, they lend _______
- bank deposits, 2. their own money
Key points of the traditional view of the money multiplier
- key ratios and the multiplier and constant over time
- stable multiplier = stable banking and a stable monetary environment
- money supply = exogenous with respect to the economy (vertical position)
- Causality runs from base money (H) to money supply (M)
- deposits create loans
- this view is going out of fashion because of innovation and globalization
Money supply determines the (a) ________, (b) ________, (c) _________, and (d) ________ (in the traditional view)
a. rate of interest
b. price level
c. nominal GDP
d. rate of inflation
Money supply equation
M = [(1+c)/(c+r+e)]*H = mH
Key points of the current view of the money multiplier
- key ratios and the multiplier are unstable over time and therefore CANNOT be used for monetary policy purposes
- CB provides banks with the base money they need and hope to indirectly influence the money supply by setting official interest rates
- the money supply = endogenous with respect to the economy (horizontal position)
- Causality runs from the money supply to base money
- loans create deposits
Money supply is determined by the (a) ________, given (b) ________, (c) _________, and (d) ________ (in the current view)
a. demand for money
b. GDP
c. interest rates
d. inflation
Equation for base money
H = [(c+r+e)/(1+c)]M = (1/m)M = M/m
One key tenet of the quantity theory of money (QTM)
a variation in the money supply (M) causes an equivalent variation in the price level (P) and an opposite variation in the purchasing power of money (1/P)
The more money circulates in the economy, the ______ it is worth in terms of goods and services (aka purchasing power)
less
_________ is a monetary phenomenon
Inflation
What are the key economic principles underlying the QTM?
- Money is primarily a medium of exchange and a means of payment
- Exogeneity
- Long-run neutrality
Define exogeneity
When monetary authorities determinate the quantity of money based on their best judgment and not to passively accommodate money demand
Long-run neutrality
In a competitive economy, changes in the supply of money don’t have permanent effects on relative price and real variables (real GDP and employment), but only on monetary variables (classical dichotomy)
Define the velocity of money
The frequency at which one unit of currency is used to purchase domestically produced goods and services within a given time period
Basically, the number of times one dollar exchanges hands within a given time period
If the velocity of money is _______, then more transactions are happening between individuals in an economy
high
The three components of money supply
M1, M2, MZM (arranged from narrowest to broadest)
Define M1
- narrowest component of money supply
- is the money supply of currency in circulation (coins, bank notes, travelers checks (non bank issued)), demand deposits, and checkable deposits
A decreasing velocity of M1 might indicate…
fewer short-term consumption transactions (everyday consumptions) taking place
Equation of exchange 1 (EE1)
EE1: MV = PT
- M: money supply used for transaction purposes
- V: money velocity
- P: price index
- T: index of economic transactions
Equation of exchange 2 (EE2)
EE2: MV + M’V’ = PT
- M: currency
- M’: bank deposits
- V: cash velocity
- V’: deposit velocity
Equation of exchange 3 (EE3)
EE3: MV = PY
- M: money supply used for transaction purposes (?)
- V: income velocity rather than transaction velocity
- P: GDP deflator
- Y: real income (real GDP)
The value of goods traded using money as a medium of exchange is _________ the value of monetary transactions (Demand = Supply)
equal to
Cabridge Equation (EE4)
EE4: M = kPY
- k: the share of nominal income held in average in the form of money for transaction purposes
- M: money supply
- P: GDP deflator (?)
- Y: real income (real GDP)
What is the equation for money supply = money demand in nominal terms?
M= kPY
What is the equation for money supply = money demand in real terms?
M/P = kY
What is the difference between the Equations of Exchange (EE1, EE2, EE3) and the Cambridge Equation (EE4)
- the EEs focus on money as an object that “moves” in the market with a certain velocity
- EE4 focuses on the demand for money as a temporary stock of purchasing power
Define Say’s Law
The claim that the production of a product creates demand for another product by providing something of value which can be exchanged for that other product.
Basically, production is the source of demand (S creates D)
Velocity depends on _____
institutional factors (payment systems and payment habits)
Income (nominal GDP), Y, depends on (a) _______ and is independent of (b) _______
a. real factors (tech, preferences, endowments)
b. M, V, and P
In the money market graph, a positive shock to the money supply leads to a (a) ______ in prices and a (b) _______ in the quantity of money
a. increase
b. increase
In the goods market graph, a positive shock to the money supply leads to a (a) ______ in prices and a (b) _______ in the real income
a. increase
b. no change
Challenges to the QTM
- Constant velocity?
- Real GDP independent of M? It does in the SR, but experts consider these effects transitional and choose to ignore them
- Exogenous money supply (traditional view thinks exogenous and current view thinks endogenous)
Endogenous money supply (alternative view)
The money supply is determined endogenously by the banking system based on the demands of the economy
The CB will never refuse to provide the banks with the monetary base they need and can only indirectly control the money supply
Endogenous causality
Believe causality from PY to M and from M to H
Exogenous money supply (traditional view)
The money supply is exogenously controlled by the CB, which sets the monetary base and the money supply, given the money multiplier
Exogenous causality
Believe causality runs from H to M and from M to PY with the logic of the quantity theory of money
Friedman’s QTM
- money supply and demand
- theoretical versions of the QTM
- empirical evidence and policy implications
Friedman believes that the money supply can be controlled by _________
monetary authorities
Friedman believes that money demand is a ________________ and therefore predictable, controllable, and stable
stable function of a limited number of variables
Friedman’s mathematical contribution to QTM
M/P = function(rb,re,rate of inflation,w,Y,u)
- rb: nominal rate of return on bonds
- re: nominal rate of return on equity
- w: ratio of human to non-human wealth
- Y: GDP in real terms (real income)
- u: tastes and preferences
What can M/P = function(rb,re,rate of inflation,w,Y,u) be rewritten into given homogeneity assumptions?
- M = Pg(rb,re,rate of inflation,w,Y,u)Y
- MV = (rb,re,rate of inflation,w,Y,u) = PY
How does Friedman explain the QTM?
- as long as the monetary authorities control M and V is a stable function of its determinants, then changes in M will determine equivalent changes in PY
- Initially the effect of the changes in M will only be on Y, because wagse, prices, interest rates and inflation expectations are sticky (Short term non-neutrality)
-Subsequently, as real variables revernt to their LR equivalent values, determined uniquely by the real forces of productivity (investment and tech) and thrift (savings and accumulation), then the effect of the change of M is on the price level
Equilibrium logic
Money demanded in real terms, money supply in nominal terms, then the changes in price level reconcile the difference between the two
Dynamic version of the QTM
m + y = inflation rate + g
- m: growth rate of money
- v: rate of change in money velocity
- g: growth rate of the economy
m can be governed to achieve the desired inflation rate
Rate of inflation equation related to the dynamic QTM
rate of inflation = m + y - g
Inflation is always and everywhere a __________ phenomenon
Monetary
Friedman believes that one of the main reasons for the inflationary growth of the money supply is the governments choice to finance (a) _______ through (b)_______
a. public spending
b. the inflation tax
