Money Prices And Inflation Flashcards
3 functions of money
Medium of exchange
Unit of account
Store of value
M1 (narrow) money examples (3)
Currency
Bank deposits
Financial instruments e.g credit cards
M0, m2, and m3
M0 -monetary base (currency)
M1 - money as means of payment (3 given earlier)
M2 - M1+ non transactions deposits which can be converted rapidly into money
M3 - highly liquid stores of value such as money market funds
M4 - broad money supply
Money supply formula
M=Ch+D
M= money supply
Ch =household demand for currency
D = demand deposits
How do we find D?
Use concept of fractional reserve banking
Fractional reserve banking (slide 135 Mankiw)
In FRACTIONAL reserve banking, banks hold a fraction of their deposits in reserves, and lend out the rest.
The borrower of “the rest” can continue the money creation process, putting in a bank, who will also hold a fraction in reserves, and lend out again.
So with each deposit and loan, more money created.
What is the formula for to work out the total amount of money the original deposit can make?
(1/rr) to the n x original deposit
N is the number of lending rounds.
Rr is the reserve deposit ratio
E.g if deposit is 1000, and 200 is kept in reserve, rr=0.2.
Is this fractional reserve banking realistic in real life?
In reality banks have other sorts of assets e.g securities to protect them against sudden liquidity issues.
What is the total increase in deposits?
Initial deposit / fraction of reserve (rr)
So we have the narrow definition of money
M = Ch + D
What assumption do we have to make
Ch = cD
A proportion (c) of deposits (D) are held as currency
E.g c=0.05, 5% of deposits are held as currency
For banks, Cb = kD
A proportion k of deposits are held as reserves.
What can we find from this?
The monetary base (B), since total currency held must be held by either banks or households.
So what is the monetary base equation (B)
And from this, what is the D formula?
B= Ch + Cb = cD + kD
We can expand the last one to B = D(c+k) , and rearrange to find D
D=B/(c+k)
Then, using the narrow money supply definition we can sub our D value in to get…
M= cD + D = (1+c)D = (1+c)/c+k x B
Then, using the narrow money supply definition we can sub our D value in to get…
M= (1+c)/c+k x B
B is monetary base
The rest is the money multiplier.
(Shown in prev card repeat)
What can we observe from this money supply equation: what is money supply a function of?
Money supply is a function of B (monetary base) and parameters c and k (cash, and reserve ratio)
Ways to control the money supply (5)
Open market operations
Lender of last resort
Auction
Changing interest rates
Required reserve ratio
Open market operations
Central bank buy/sell government bonds to increase the monetary base.
Central bank buys securities to increase the base, sell to remove money from system.
Lender of last resort
Lend directly to banks through the discount window, with an adjustable interest rate.
Auction
Central banks can announce in advance the amount of funds they will lend, and then banks bid.
Changing interest rates
Reserves can earn interest can be changed.
Required reserve ratio and example country
Require banks to hold a particular ratio in reserves.
E,g China
Money supply and monetary base during the Great Depression (application)
Monetary base increased (by Q.E) , but money supply fell. (Total currency held increased, but money in circulation fell since banks held more in reserves k increased, and households held more cash c)
Using the equation, we can see B increased. So for M to fall, the money multiplier 1+c/c+k must’ve fell.
Why did the money multiplier 1+c/c+k fall
Banks held more in reserves (higher K)
Household held more in cash (c)
Monetary supply during pandemic
What risk was there?
Large growth rate in money supply (M) as households held more MONEY (Ch) (NOT THE SAME AS CASH C)
This growth could cause inflation, however controlled by increased interest rates and a rollback of QE.
Fiat money
money without intrinsic value e.g notes, which would have little value if not widely accepted as money
in a bank sheet, what are the 3 assets vs liabilities
Assets
reserves
loans
security
Liabilities
Deposits
Debt
Capital (owners equity)
Leverage ratio:
banks total assets to banks capital.
What would an fall in the currency-deposit ratio do?
Fall in c would increase money multiplier and money supply.
What would an decrease in the reserve-deposit ratio do?
A fall in k would increase MM and money supply
