Money And Inflation Part 2

Question 1

3 instruments of monetary policy

Answer 1

Policy rate
Open market operations
Reserve requirements

Question 2

Why borrow from central bank

Answer 2

If need funds, it acts as lender of last resort. It is safe, it wont go bust

Question 3

Policy rate/base rate relationship with commercial bank rate

Answer 3

Positive. Policy rate is an input cost for commercial banks, so they increase their interest rates too

Question 4

Higher policy rate on money supply and AD

Answer 4

Withdrawal from circular flow (more saving)

Fall in AD

Question 5

Open market operations

Answer 5

Refer to the purchase and sale of non monetary assets to/from the banking sector by the central bank.

I.e the bank can manipulate money supply by buying or selling to commercial banks e.g bonds.

Issuing bonds decrease money supply, increase interest rate

Question 6

Reserve requirements

Answer 6

Commercial banks must hold money in reserve.

Thus limiting extent to which banks can give out loans. Less money circulating.

Question 7

Expansionary characteristics (3)

Answer 7

Decrease policy rate
Create money and buy bonds (open market operations)
Lower reserve requirements (commercials have to hold less money, more circulation)

All these increase money supply

Question 8

Contractionary characteristics

Answer 8

Increasing policy rate
Sell bonds
Raise reserve requirements

All these lower money supply

Question 9

2008 financial crisis approach

Answer 9

Very focused on policy rate. However rate was already near 0 so quantitative easing, and statements of intent to influence economic agents.

Question 10

Inflation+ Overall price level can be measured through CPI or value of money.

How is the value of money measured.

Answer 10

1/P.

Shows how many goods can be bought with one 1 monetary unit. (Shows purchasing power of each monetary unit=pound)

Higher price=lower purchasing power

Question 11

Assumption about supply of money and what it looks like on the graph, and name axis

Answer 11

Exogenous. Determined by central bank and so is fixed.

Vertical line. Price/value of money on y axis, quantity on x axis

Question 12

Demand for money depends on.. (classical view)

Answer 12

Demand depends on prices.

Higher prices=more money required so more demand for money

Positive relationship between demand for money and price.

Question 13

Relationship between money demand and value of money

Answer 13

Inverse. If value is high, we need less money to purchase so demand low

Question 14

Time horizons in short run and long run for price

Answer 14

LR-price level adjusts to where MD=MS (Classical view)

SR-prices are less flexible and money demand depends on other things e.g interest rates like in Keynesian, where interest rates influence opportunity cost of holding money

Question 15

Expansionary monetary policy on value of money

Answer 15

Increases money supply, so value of money decreases and prices increase. (MORE ACTIVITY INCREASES PRICES)

Money supply and price-positive relationship.

Question 16

Classical dichotomy

Answer 16

Variables can be divided into nominal variable (monetary units) and real variables (physical units) e.g nominal wages and real wages.

Question 17

What did Hume argue

Answer 17

Determinants of the monetary system influence nominal variable but are irrelevant when it comes to real variables. (See next card)

E.g in Loanable funds market, the determination of real interest rate had nothing to do with money

Question 18

Monetary neutrality

Answer 18

According to Hume and the classical school of thought, changes in the supply of money have no real effects on the economy.

I.e. although money supply doubles, price level doubles, as does wages. So REAL VARIABLES are unchanged.

Question 19

Quantity theory

Answer 19

Changes in money supply lead to changes in price level.

Growth in the quantity of money is the primary cause of overall price increases (the money growth rate determines the inflation rate)

Question 20

Quantity theory equation

Answer 20

M x V = P x Y

M=nominal money supply
V=velocity of money (no. of times the average monetary unit (pound in UK) is used.)
P=price level
Y=output

Question 21

What is constant in that equation

Answer 21

V-is stable over time so we can cancel out from equation.
And Y is determined by factors of production and tech so it doesn’t change either

Question 22

What must happen for money supply to increase

Answer 22

Output or Price increase or velocity falls
But we know velocity is constant and output depends on production factors so it can’t be V or Y

Question 23

Given these assumptions of constant velocity and Y being determined by L and K:

Answer 23

% change in M=% change in P

Question 24

Nominal interest rate vs real interest rate

Answer 24

Nominal is interest offered by banks

Real is nominal corrected for inflation (minus inflation)

If real>inflation-interest on saving is greater than rise in cost so purchasing power rises

If real<inflation-interest is less than rise in prices so purchasing power falls

Question 25

What does the real interest rate show+ formula

Answer 25

Purchasing power. (See previous slide)

Nominal-inflation

Question 26

Why negative REAL rate is useful (cannot have a negative nominal)

Answer 26

If weak economy, incentivise spending.

Because implies inflation>nominal rate. So purchasing power is falling, thus better to spend.

Question 27

Fisher equation shows what and formula

Answer 27

Shows nominal interest rate can change because real interest changes or inflation rate changes.

I=r+inflation (notated as pie)

Basically just rearranged the real interest rate formula (I-inflation=r)

Question 28

Classical view on whether inflation is a problem.

Answer 28

Inflation is not a problem, just a change in units of the measurement. E.g prices rise but other variables rise too (monetary neutrality)

Question 29

Costs of expected inflation (5)

Answer 29

Shoe leather-inconvenience of moving money
Menu costs
Price distortions and misallocation of resources-firms may change prices infrequently or at different times
Inflation-induced tax distortions-e.g fiscal drag (nominal income increased but not real but paying higher tax)
General inconvenience and confusion.

Question 30

Costs of unexpected inflation

Answer 30

If actual inflation is different than expected inflation, one side of the transaction gains at the others expense

If unexpected (actual) is greater than expected inflation (predicted)-inflation is underestimated so interest received by lenders is worth less so lenders worse off. (Vice versa)

Question 31

High inflation main problem.

Answer 31

Uncertainty

Question 32

What is Inflation tax

Answer 32

When government raises money through printing money. Money supply increases so value falls.

Thus, inflation tax is a ‘tax’ on people who hold more money
• Broadly, inflation tax might be regarded as a progressive tax (i.e. the richer you are, the more the tax will affect you) – however we might debate this
• Consider: what kind of people hold money in a liquid form? (Do very rich people have lots of cash?)

Question 33

Benefits of inflation

Answer 33

Reduce real wages by holding nominal wages constant.

Wages constant (not keeping up with inflation, real costs actually gets cheaper for firms)

Question 34

What is hyperinflation caused by

Answer 34

Excessive growth in money supply (quantity theory-changes in money supply cause changes in overall price level (inflation))

Question 35

Inflation targeting example and formula

Answer 35

% change in M= % change in P x % change in Y

E.g if inflation target=2, and change in y=4

Change in M must be 6 (2+4=6)