money , interest rates, expected returns and exchange rates

Question 1

what is money?

Answer 1

anything that is acceptable in a market exchange. it can come in the forms of cash, credit or bank accounts
most money has no physical form but instead as list of numbers on a computer record

Question 2

what does the demand for money arise from?

Answer 2

it arises primarily from its use as a medium of exchange.

Question 3

what are the functions of money?

Answer 3

medium of exchange, a measure of value, a standard of deferred payments and a store of value

Question 4

what is the opportunity cost of holding money?

Answer 4

the interest rate earned from investing said money

Question 5

what is the function for the demand of money and what are the necessary assumptions ?

Answer 5

assumiing no inflation, the demand for money in a country is thus a function of national income (Y) and the rate of interest (r)
Dm = f ( Y, r)

Question 6

what is the relationship between the demand for money and the rate of return?

Answer 6

the demand for money vaires inversely with rate of return. the opportunity cost of holding money is the market rate of interest as when you are holding money, it is not generating incomes

Question 7

what is the relationship between income and the demand for money?

Answer 7

people demand money for the medium of exchange. as peoples incomes rise they typically consume more goods. so the demand for money vaires positively with income

Question 8

what does the elasticity of the demand for money depend on?

Answer 8

the elasticity of demand will vary at times depending on the risk and attractiveness of alternative assets

Question 9

what occurs to the demand curve for money when there is an increase in income?

Answer 9

when there is an exogenous increase in income, the demand for money cuvre will shift forward.

Question 10

what are the axis for the demand curve for money?

Answer 10

the price of money is the y axis this can also be called the rate of interest. and on the x axis there will be the quantity of money

Question 11

what is M1?

Answer 11

M1 is defined as narrow money. it is the measure of notes and coins within the circulation. that is the amount of cash in peoples hands and across the counter in the tills of banks and businesses.

Question 12

what is M2?

Answer 12

it is the sum of cash pius the bank deposits, that is current accounts and those short term savings accounts that people customarily use for transactions

Question 13

what is M3?

Answer 13

it is the wider definition of money which is M1 +M2 plus other types of loans and credit accounts of various financial institutions

Question 14

what is the issues with M3?

Answer 14

it is very difficult to define as what source of assets do people use as money, as a result the federal reserve discontinued publishing M3

Question 15

what does the supply of money depend on?

Answer 15

the supply of money depends on the decisions of the financial intermediaries- that is, how much money the many commercial banks, building societies, credit companies. the money supply grows if financial intermediaries create more credit and they decline when they decide to hold back from doing so

Question 16

what makes the supply of money different to the supply of other goods and services?

Answer 16

it is not determined by its price but instead by the business climate, its optimism/pessimism and the speculative tendencies of the various credit creating institutions. we assume the supply of money is given and unchanging as rates of interest chagne

Question 17

what is an exogenous money supply?

Answer 17

the money supply is determined outside the financial markets, that is determined by the central authorities of a country or the authorities of another country/countries

Question 18

what is an endogenous money supply?

Answer 18

the money supply is determined by the market, that is within the economy by the money lending and borrowing agents themselves

Question 19

what is quantative easing?

Answer 19

it is the attempt by a central bank to exogenously increase the money supply ; it buys long term bonds direct from commercial banks thus transferring cash to these commercial banks reserves (a process that in the past was considered dangerously inflationary)

Question 20

when does quantative easing fail to be effective?

Answer 20

it fails to be effective if the commercial banks then do not loan this extra cash on to borrowers. since 2008, the central bank has complained that the money has not been lent out but commercial banks say the extra cash is there but no business want to borrow

Question 21

where is the market rate of interest?

Answer 21

the market rate of interest is given by the intersection of the supply of money and the demand of money. supply of credit is determined by financial markets and demand is determined by peoples willingness to spend.

Question 22

explain the effect of an increase in the money supply on the market rate of interest?

Answer 22

an increase in the money supply will shift the supply curve to the right. this will cause an extension of the money demand curve leading to lower market rate of interest at a greater quantity

Question 23

what is the relationship between the price of a bond and the yield?

Answer 23

as the price of the bonds increease, its yield will decrease. for example if a yield pays 100 after 3 months and it costs you 98 then you make approx 8% a year. but if the price is 99 then you only make 4% a year

Question 24

what are the issues or fears with quantitative easing?

Answer 24

some worry that the flood of cash has encouraged reckless financial behaviour and inflation.
others fear that when central banks sell the assets they have accumulated, interest rates will soar, choking off the recovery

Question 25

what are the advantages of QE

Answer 25

it provides more money into the economy and props up banks that are on the verge of collapse

Question 26

what occurs when there is an increase in the UK money supply assuming the US market remains the same - use expected return curve and the US money market ?

Answer 26

consider an increase in the UK money supply. assuming the US markets remain the same then the UK interest rate will fall. the expected $ return on £ assets will fall ie the curve will shift backwards . the holders of these assets will sell pounds in order to buy dollars thus the dollar will rise and the pound will fall. the exchange rate (£/$) decreases

Question 27

what occurs when there is an increase in the US money supply - use expected return curve and the US money market ?

Answer 27

an increase in the US money supply will decrease the interest rate. this will lead to a fall in $ assets returns meaning people will sell $ and buy £. this will depreciate the $ and appreciate the £ leading to a higher exchange rate (£/$) . as the

Question 28

what occurs when there is an increase in the US money supply - use expected return curve and the US money market taking into account an increase in inflation?

Answer 28

an increase in the US money supply will decrease the interest rate. this will lead to a fall in $ assets returns meaning people will sell $ and buy £. this will depreciate the $ and appreciate the £ leading to a higher exchange rate (£/$) . if people suspect an expected increase in US price levels (inflation) then they will expect a fall in the real value of the $ and a rise in the pound. this will cause them to sell $ and buy £ because they expect £ deposits in the city to earn more. this will shift the expected returns to the right. this will cause the exchange rate (£/$) to be even greater. the rise in the rate of inflation will also decrease the real value of money meaning the money supply falls. this will cause the the real rate of interest to rise and will stimulate a rebound of the exchange rate. the exchange rate will overshoot at first then return a little as expectations adjust

Question 29

what is overshooting?

Answer 29

when the immediate response to a given disturbance is greater, more volatile than the long run postion

Question 30

would you get exchange rate overshooting in theory with perfect knowledge?

Answer 30

In theory, with perfect knowledge, the prices would adjust immediately to their long run position – the increase in the nominal money supply would be immediately discounted by a fall in its real value