Money and Monetary Policy Flashcards
1
Q
Explain a Central Bank use of monetary policy
A
- Main tool is the nominal interest rate (IR targeting)
- Central Bank choose a rate of interest and adjusts it for economic condition changes
- Sets Sm at a level where r is at target
- This is done by buying/selling bonds to set Sm at the fixed rate
2
Q
Explain Open Market Operations
A
- To increase the Supply of Money, Central Banks will buy bonds which the banks lend out to consumers (reduces i)
- To decrease the Supply of Money, Central Banks will sell bonds which the banks lend out to consumers (increases i)
3
Q
What is the distinction between the Supply of Money and the Demand for Money?
A
- Supply of Money is controlled by the Central Bank
- Demand for Money is the amount of wealth held in money form
- This means that i is the opportunity cost of demanding money
4
Q
What shifts Sm?
A
- Central Bank decision on QE and interest rates
5
Q
What shifts Dm?
A
- Changes in aggregate spending, changes in transaction technology, changes in spending patterns
6
Q
What is the Money Equation?
A
- M = C + D
- Where C is money in circulation and D is checking deposits
- Central banks don’t direct create money by printing anymore; instead issue currency to commercial banks
- Banks and their customers create checking deposits
7
Q
What is a Monetary Base? What is the Base Equation?
A
- The Base is the total amount of money created by the central bank
- B = C + R
- Where C is money in circulation and R is bank reserves
- C & R are seen as liabilities to the private sector
- Currency circulation is the money that we have
- Reserves are in bank vaults and BoE deposits
8
Q
What are assets to the Private Sector
A
- Bonds
- Loans to Banks
9
Q
What are liabilities to the Private Sector
A
- Currency in Circulation
- Reserves
10
Q
What is the Money Supply Formula?
A
- M/B = (C+D) / (C+R)
- If you divide by D,
M/B = [(C/D) + 1] / [(C/D) + (R/D)] - Hence, M = [(C/D) + 1] / [(C/D) + (R/D)] X B
11
Q
If M= αB (where α>0), what is the formula for α?
A
- α = [(C/D) + 1] / [(C/D) + (R/D)]
12
Q
In Bank Runs, what happens to the multiplier and thus the Money Supply?
A
- In a bank run, people withdraw their deposits
- This reduces the α multiplier
- If B is constant, M will reduce
- R will increase from the Bank’s perspective
13
Q
What does increases in either R/D or C/D mean to α or M?
A
- Increasing either R/D or C/D will reduce α and thus reduce M
14
Q
What is a Reserve Requirement?
A
- Regulations that set a minimum ratio for the R:D level (can go above)
- Increasing the RR will decrease α and M
15
Q
How can Historical Case Studies by Examined (1929 WSC) ?
A
- Both R/D and C/D increased- (Higher reserves and increased Demand for Cash)
- Money Multiplier went from 3.8 to 2.4 in 3 years
- As base stayed fairly fixed, M fell by 33% and RGDP fell by 31%
- M fell due to actions of Public & Banks
- FED allowed M to fall; prioritised B
- Could have increased B which would have seen M fall less
16
Q
How can Historical Case Studies by Examined (2009 GFC) ?
A
- R/D increased, but C/D fell
- This could’ve been from QE or they may have learnt from mistakes
- However, Huge reduction in lending to reassess debt levels
- Learned to increase B and make M falling impact lower
- However, banks could sit on the money (multiplier turns to a divider)
- M was fairly stable from B increasing
17
Q
What does MRU say about What is Money?
A
- Money is a medium of exchange that can be used to purchase goods or services
- For an asset to be counted as ‘money’, it must be easily converted into cash (i.e. Stocks, Shares, Mutual funds)
- Monetary Base [Currency + Reserves]
- M1 [Currency + Checking/Savings Deposits]
- M2 [M1 + Other less liquid forms of money]
- Base is important, as it is the most easily affectable- but they must also manipulate M1 and M2 in the Long Run
18
Q
What does MRU say about the Money Multiplier?
A
- US reserve requirement must be at least 10% but can be higher if the firm wants to be more liquid
- System increases money supply as people who receive loans get the money in their bank account, which isn’t the case with a cheque
- The Money Multiplier (1/RR) is the amount of additional money created by an extra unit of deposit
- Central Bank has an indirect control of the money supply, and the money multiplier is often much lower than 1/RR, as during periods of low confidence banks can sit on money
19
Q
What does MRU say about the FED before 2009?
A
- Targeted the Federal Fund Rate (LIBOR) via open market operations
- To increase the money supply, the Central Bank would buy bonds, increasing the cash in an economy for banks to loan out, reducing the interest rate
- Communication of the central bank is vital in signalling their intentions of how they want markets to act
20
Q
What does MRU say about the FED after 2009?
A
- Falling IR and structural changes to industries meant that traditional OMO were flawed
- Hence, the Fed bought other assets to impact different sectors of the economy (mortgages, primes…)
- QE increases banks reserves and improves liquidity (1,350x increase since 2008 at $2bn)
- Fed put a rate on deposits held there to manipulate the market further
- Repo and Reverse Repo schemes were used in conjunction with OMO to control the Money Supply
21
Q
What does Tutor2U say about Liquidity Traps?
A
- A Liquidity trap is where low nominal interest rates fail to stimulate demand due to interest elasticity of demand being low
- Banks become risk-averse, so lend out less or charge more as a risk premium
- Confidence is often low in these times so the propensity to take out a loan is smaller
- To overcome a liquidity trap; Fiscal policy, QE to increase liquidity between banks, Negative nominal IR or changing the EXR
