Money and Credit Flashcards
How can inflation be controlled?
Either through the Taylor Rule or through monetary supply expansion
State the three motives for high inflation
- Inflationary Finance
- Reduce unemployment, increase output
- Low interest rates
Corresponds to the Fed goals of:
- Max. employment
- Stable prices
- Moderate interest rates
But Fed can’t decrease unemployment continually with destabilising inflation
Effect of low interest rates on corporations and other individuals?
Lower interest rates decrease borrowing costs, make mortgages more affordable but will harm savers as well as those living on investments.
Name the two monetary policy instruments at the disposable of the central bank
- Expansion of the base via OMO and the Federal funds rate to influence bond yields or loans respectively (both components of B)
State the equation for the total demand for credit
Total demand= Nonmonetary demand for credit + monetary demand for credit, md is assumed to not be affected by changes in the real interest rate
Effect of an increase in money demand on total demand for credit and the real interest rate in a commodity M economy?
Increase in md increases the real interest rate
State the equation for the total supply of credit
Nonmonetary supply of credit + real money balances
How do banks ensure that the real interest rate does not change despite an increase in Md?
Supplies credit and thus shifts the supply of credit to the right (thus decreasing the real interest rate, which initially increases as a result of the shift in the demand for credit curve)
What happens if the total increase in supply of credit exceeds the increase in real money demand, caused by an increase in M?
Decreases the real interest rate, causes the price level to increase until M/P=md once more.
Define the liquidity effect
The depression of real interest rates which causes an increase in the total demand for credit.
Define the short run liquidity effect
The increase in demand for credit caused by the temporary disequilibrium in the asset market.
Can the liquidity effect exist in the long run?
Readjustment of price level means the liquidity effect is not preserved in the LR (since M/P=md is restored). This means that there must be a continual expansion of credit to decrease real interest rates.
Why is the excess supply of money equal to the net nonmonetary demand for credit?
Temporary decrease interest rates increases demand for credit
In the LR, how does a perpetual increase in the money supply correspond to a much higher nominal interest rate?
Sustained expansion of money supply continually increases the price level and causes expected inflation to change. Thus, through the fisher equation r + pi = i, this results in a higher nominal interest rate in the LR.
How can the Fed continually depress real interest rates?
Via perpetual expansion of the money supply to preserve the SR liquidity effect, but at the expense of perpetual inflation
Conditions for the real interest rate to be kept below the equilibrium rate
Continual expansion of M, meaning real money balances must exceed the demand for money.
What if the nominal interest rate is kept at a certain level despite inflationary expectations?
The real interest rate will continue to drop, fuelling an even greater increase in nonmonetary demand for credit and thus faster runaway inflation.
What happened during the Volcker credit crunch?
Sudden abrupt stop to the previously increasing money stock, which caused money demand to exceed real money balances and a SR increase in the real interest rate. Eventually, however, the price level declined due to the readjustment of inflation expectations, which readjusted money demand and thus caused real interest rates to return back to equilibrium level.
Effects of a temporary increase in M versus the effects of a permanent increase in M?
In the former case, real interest rates return to their original level, and inflationary expectations remain constant.
For the latter case, real interest rates continue to decrease but inflation continues to increase, causing runaway inflation. (nominal interest rate remains constant as part of policy)
Exact definition of inflation
A sustained increase in prices.
State an equation that illustrates the relationship between M and P.
Pt+1 = Pt (1+M), inflation in the long run is the growth rate of money mui (u)
How can an increase in M cause money demand to increase, and therefore return r back to its equilibrium level?
An increase in M causes real money balances to increase, and therefore causes the real interest rate to decrease. Demand for NM decreases as a result, and demand for money increases.
Define the nonmonetary demand for credit
The tradeoff between consumption of present and future goods. At lower interest rates, the amount of future goods that must be given up for present consumption is lower. Therefore, the nonmonetary demand for credit is high.
What is the primary function of the credit market?
To allow people to trade command over present goods for command over future goods.
Define credit
Command over present goods.
