Money and Savings

Question 1

What is money?

Answer 1

A medium of exchange

Question 2

What are the 3 functions of money?

Answer 2

1. Acceptability = must be accepted as widely as possible
2. Unit of account = having a common unit
3. Store of value = exchange is more costly if money loses value between transactions

Question 3

What are the money aggregates: currency, M0, M1, M2?

Answer 3

Currency = physical notes and coins
M0 = currency + funds deposited in central bank
M1 = M0 + demand deposits issued by financial institutions
M2 = M1 + term deposits and money market shares

Question 4

Is money procyclical? What does that mean?

Answer 4

Yes - they grow when economy grows and falls when the economy is in recession

Question 5

What are 4 additional desirable characteristics of money?

Answer 5

1. Fast and low cost transactions
2. Transactions should be private but auditable by law enforcement authorities
3. Recourse (reverse fraudulent transactions)/ fidelity (money balances should reflect past transactions
4. Accessibility

Question 6

How can an individual bring consumption forward?

Answer 6

Borrowing

Question 7

What is diminishing marginal returns to consumption?

Answer 7

The value to an individual of an additional unit of consumption ina given period declines the more it is consumed.

Question 8

What is the quantity theory of money?

Answer 8

MV = PY where,
M = money stock
V = velocity
P = price level
Y = real GDP

Question 9

How do you calculate the rate of return on a bond?

Answer 9

i = V/P

(velocity/price level)

Question 10

What happens if the rate of return on a bond is higher than the interest rate?

Answer 10

Increases demand for bonds -> increases price for bonds -> reduces rate of return until it is equal to the interest rate

Question 11

What are the 3 types of arbitrage?

Answer 11

1. Yield
2. Triangular
3. Spatial

Question 12

Explain yield arbitrage?

Answer 12

Two bonds, A and B where A has lower annual payments (so a lower rate of return) -> supply of A would increase and demand for B would increase -> rate of return on A increases as B decreases -> continues until rates of return are equal

Question 13

Explain triangular arbitrage

Answer 13

Making profits through swapping currencies e.g. £ to $ to Euro to £ again

Question 14

What is uncovered interest rate parity? (UIP)

Answer 14

The difference in the interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period

Question 15

What is the equation for the UIP condition?

Answer 15

(1+ domestic interest rate) = [nominal exchange rate*(1+foreign interest rate)]/(nominal exchange rate in next period)

Question 16

What would happen to the exchange rate in country A if country B announced stronger than expected performance?

Answer 16

increased performance in B -> signal likely increase in future interest rates -> so country A nominal exchange rate would depreciate

Question 17

Why is the exchange rate volatile in the short-run?

Answer 17

Determined by news of future rates which causes fluctuations