Week 19 - Money and Prices Flashcards
1
Q
How does the definition of money in economics differ from everyday use?
A
In economics, money refers specifically to any asset that can be used for making purchases, such as currency, checking account balances, and traveler’s checks.
2
Q
How do economists distinguish between income, saving, and wealth?
A
Income: Money received, typically from work (e.g., a paycheck).
Saving: The portion of income that is not spent.
Capital Gain: An increase in the value of investments like stocks.
Wealth: The total value of assets owned, which can grow when assets (like a house) appreciate.
3
Q
What role does money play in an economy?
A
Money acts as a medium of exchange, eliminating the inefficiencies of barter and facilitating trade.
4
Q
What is barter, and why is it inefficient?
A
Barter is the direct exchange of goods and services. It is inefficient because it requires a double coincidence of wants, meaning both parties must have exactly what the other wants at the same time.
5
Q
What are the advantages of a money-based economy over a barter system?
A
Eliminates the double coincidence of wants, making transactions easier.
Encourages specialization, allowing individuals to focus on producing specific goods/services rather than everything they need.
Increases economic efficiency, as resources are allocated more effectively when trade is simplified.
6
Q
What are the three principal functions of money?
A
Medium of Exchange – Used to purchase goods and services.
Unit of Account – Serves as a standard measure of economic value.
Store of Value – Holds purchasing power for future use.
7
Q
What does it mean for money to be a medium of exchange?
A
Money is an asset that facilitates transactions by eliminating the need for barter, allowing people to trade efficiently.
8
Q
Why is money more efficient than barter?
A
Money removes the need for the double coincidence of wants, where both parties must want what the other has at the same time.
9
Q
What does it mean for money to be a unit of account?
A
Money provides a consistent measure of value, allowing easy comparison of different goods, services, and financial assets.
10
Q
Why is the unit of account function important in the economy?
A
It simplifies economic decision-making by providing a standard for comparing prices and values.
11
Q
Example of the unit of account function?
A
Comparing the economic value of 1,000 liters of milk versus a tonne of coal becomes easier when both are priced in the same currency.
12
Q
What does it mean for money to be a store of value?
A
Money retains its purchasing power over time, allowing people to save and delay spending.
13
Q
Why is money useful as a store of value?
A
It enables people to hold wealth in a liquid form without needing to convert it into another asset.
14
Q
Example of money as a store of value?
A
Keeping money in a checking account means part of your wealth is held in liquid form for future use.
15
Q
What is an advantage of holding cash?
A
Cash is anonymous and difficult to trace, offering privacy in transactions.
16
Q
How is the word “money” often misused in everyday language?
A
People often use “money” as a synonym for wealth or income, but in economics, money has a more specific meaning.
17
Q
What is the difference between wealth and money?
A
Wealth includes all assets a person owns, such as bonds, stocks, land, houses, furniture, cars, and art, not just money.
Money is only the portion of wealth that is used as a medium of exchange, such as cash and checking account balances.
18
Q
Example of confusing wealth with money?
A
Saying “Maria is rich—she has so much money” is misleading because Maria’s wealth includes more than just money.
19
Q
What is the difference between income and money?
A
Income is a flow of earnings received over time (e.g., salary per month).
Money is a stock that exists at a particular moment (e.g., the balance in a bank account).
20
Q
Why is it incorrect to say “Victor earns a lot of money” in economic terms?
A
Economists distinguish between income (which Victor earns over time) and money (a stock that can be used for transactions).
21
Q
Why are people willing to exchange goods and services for money, even though it has no intrinsic value?
A
Because of confidence—people believe they will be able to use money in the future to buy goods and services.
22
Q
What type of money is used today?
A
Most modern money is fiat money, which is issued by governments and not backed by a physical commodity like gold.
23
Q
If fiat money has no intrinsic value, why do people accept it?
A
People accept fiat money because they trust the government to maintain its value and ensure it remains widely accepted.
24
Q
How does the government maintain the value of money?
A
By managing the money supply, controlling inflation, and ensuring economic stability through policies
25
What would happen if people lost trust in the government’s ability to maintain money’s value?
People might stop accepting the currency.
Hyperinflation or financial instability could occur.
Alternative forms of exchange, like foreign currency or barter, might emerge.
26
If other assets (like stocks, bonds, or real estate) are better stores of value, why do people still hold money?
Because of liquidity—money is the easiest and fastest asset to use for transactions.
27
What is liquidity in economics?
Liquidity refers to how easily and quickly an asset can be converted into a medium of exchange (money).
28
Why is liquidity important?
A highly liquid asset allows people to make purchases immediately without delays or transaction costs.
29
Why is money considered the most liquid asset?
Because it is already a medium of exchange, so it does not need to be converted into anything else for transactions.
30
Why are stocks, bonds, land, or jewellery less liquid than money?
They require conversion into money before they can be used for purchases, which involves:
Time delays (selling assets takes time).
Transaction costs (fees, taxes, or price fluctuations).
31
Example of a less liquid asset?
Selling a house takes time, involves legal processes, and may have high transaction costs, making it much less liquid than cash.
32
Besides liquidity, why else do people hold money?
People may hold money for reasons such as:
Illegal activities – Avoiding detection in crimes like drug trafficking, arms dealing, and tax evasion.
Corruption – Bribes and illicit financial transactions often involve cash to avoid tracing.
Political and economic instability – Fear of banking crises or government collapse may lead people to hold cash instead of keeping money in banks.
Deflation concerns – If prices are expected to fall, people may prefer to hold cash instead of spending or investing.
Negative interest rates – If banks charge interest on deposits, people may withdraw their money to avoid losing value.
33
Why do criminals prefer cash for illegal transactions?
Cash is anonymous and difficult to trace, making it useful for tax evasion, bribery, and illicit trade.
34
How does economic or political instability affect people's preference for cash?
During crises, people may withdraw cash because they:
Fear bank failures (bank runs).
Mistrust the government or financial system.
Prefer to hold a stable currency instead of volatile investments.
35
Why might people hold cash during deflation?
When prices fall, the purchasing power of money increases, so people delay spending, expecting goods to be cheaper in the future.
36
According to Yuval Noah Harari, why is money significant in human history?
Money is a universal trust system that enables people to cooperate across cultural, religious, and social differences.
37
How does Harari argue that money is the "apogee of human tolerance"?
Unlike language, laws, or religions, money does not discriminate based on religion, gender, race, age, or nationality—anyone can use it.
38
How does money differ from other social systems like laws or religion?
While laws, religions, and cultural codes divide people, money unites them by enabling transactions and cooperation, even between strangers.
39
Why does Harari describe money as a "trust system"?
Money has value because people believe it will be accepted by others in the future, creating a global system of trust.
40
How has money helped bridge cultural gaps?
Money allows trade and collaboration between people who do not know or trust each other, making it a key driver of globalisation.
41
Why do economists need to measure money?
To determine how much money exists in an economy and to analyse its impact on inflation, interest rates, and economic growth.
42
What challenge do economists face when defining money?
They must decide which financial assets qualify as "money" since some assets are more liquid than others.
43
hat are the two main definitions of money used by the U.S. Federal Reserve?
M1 – A narrow definition of money.
M2 – A broader definition that includes M1 plus additional liquid assets.
44
What does M1 include?
Currency outstanding (cash in circulation).
Balances in checking accounts (demand deposits).
45
Why is M1 considered "narrow"?
It only includes the most liquid forms of money—those that can be immediately used for transactions.
46
What additional assets does M2 include beyond M1?
Savings accounts
Money market accounts
Time deposits (e.g., certificates of deposit under $100,000)
47
Why are these assets part of M2 but not M1?
They can be used for payments but involve greater cost or inconvenience than cash or checking accounts.
48
How do M1 and M2 help economists analyse the economy?
M1 helps track money available for immediate spending.
M2 provides insight into broader liquidity and how easily assets can be converted into money for spending.
49
What is the portfolio allocation decision?
It is the decision about how to distribute wealth across different assets, balancing return and risk.
50
Why do people prefer assets with high returns and low risk?
Because they want to maximise their wealth while minimising potential losses.
51
What specific aspect of portfolio allocation do economists analyse when studying the demand for money?
They focus on how much of a person’s wealth is held in the form of money rather than other assets.
52
Why do people hold money if it doesn’t earn interest?
Because of liquidity—money allows for immediate transactions without conversion costs.
53
What is the assumed return on holding money?
Zero nominal interest rate (money itself does not earn interest).
54
How is the real interest rate (r) calculated?
r = i - π
i = = Nominal interest rate
π = Expected inflation
55
What does the real interest rate represent?
It shows the true return on assets after adjusting for inflation.
56
How does a higher real interest rate (r) affect the demand for money?
People will prefer interest-bearing assets over holding cash, so the demand for money decreases.
57
How does a lower real interest rate (r) affect the demand for money?
People are less incentivised to hold other assets, so they hold more money instead.
58
What is the demand for money?
The amount of wealth an individual chooses to hold in the form of money rather than other assets.
59
What determines the opportunity cost of holding money?
The nominal interest rate (i)—it represents the return foregone by holding money instead of interest-earning assets like bonds.
60
Why does holding money have an opportunity cost?
Money earns zero nominal interest, while other assets (e.g., bonds) earn a positive return.
61
How is the real return on any asset calculated?
r = i - π
i = = Nominal interest rate
π = Expected inflation
62
What is the real return on holding money?
Since money has a zero nominal interest rate, its real return is:
0 - π = - π
This means money loses value over time due to inflation.
63
How do we calculate the opportunity cost of holding money?
(i - π) - (0 - π) = i
Since money earns no interest, the opportunity cost of holding money is simply the nominal interest rate (i).
64
What happens to the demand for money when nominal interest rates (i) rise?
The opportunity cost of holding money increases, so people reduce their money holdings and invest in higher-yield assets.
65
What happens when nominal interest rates (i) fall?
The opportunity cost of holding money decreases, so people hold more money instead of investing.
66
Kim's restaurants are currently holding €50,000 in cash. Why might she want to reduce her cash holdings?
By reducing her cash holdings, Kim could free up money to purchase other assets or use it for investment opportunities that could generate a return.
Options 1 for reducing Kim's cash holdings:
Increase the frequency of cash pick-ups by the armoured car service.
This would reduce her cash holdings to €40,000, and the cost would be €500 annually.
Option 2 for reducing Kim’s cash holdings:
Increase the frequency of pick-ups (same as Option 1).
Add a computerized cash management service to track cash inflows and outflows more accurately.
This would reduce her cash holdings to €30,000, and the total cost would be €700 annually.
67
What is the benefit of Option 1 and Option 2 of Kims holdings?
Option 1: By reducing her cash holdings to €40,000, Kim can free up €10,000 that could be invested in higher-return assets.
Option 2: It reduces her cash holdings to €30,000, freeing up €20,000.
It provides better control over her cash management, improving operational efficiency.
68
What is the total cost of each option, and how much cash does Kim hold under each scenario?
Option 1:
Cost: €500 annually
Cash holdings: €40,000
Freed-up cash: €10,000
Option 2:
Cost: €700 annually
Cash holdings: €30,000
Freed-up cash: €20,000
69
Which option would likely be better for Kim in terms of freeing up cash?
Option 2 would free up €20,000 (double the amount of Option 1), but it comes at a higher cost of €700 annually. If the benefits of better cash management and the extra freed-up cash outweigh the cost, it might be the better option.
70
What is the return Kim gets from investing €10,000 in bonds at a 6% nominal interest rate?
Each €10,000 invested in bonds gives a return of €600 (6% of €10,000).
Option 1 (increase the frequency of pick-ups):
Cost: €500 annually
Benefit: She can reduce cash holdings by €10,000, which can be invested in bonds, yielding €600 in returns.
Net benefit from Option 1: Benefit - Cost = 600 - 500 = 100
Option 2 (extra pick-ups + cash management service):
Cost: €700 annually for the cash management service
Benefit: She reduces cash holdings by €20,000, which can be invested in bonds, yielding €1,200 in returns.
Net benefit from Option 2:
Benefit - Cost = 1200 - 700 = 500
71
Based on the returns and costs, which option should Kim choose?
Option 1 gives a net benefit of €100.
Option 2 gives a net benefit of €500.
While Option 2 provides a higher net benefit, it involves a higher cost of €700, compared to €500 in Option 1.
The return of €600 from reducing €10,000 in cash holdings with Option 1 exceeds the €500 cost, leading to a net benefit of €100. Even though Option 2 offers a higher net benefit (€500), the costs are greater, and Option 1 is the lower-cost solution, making it the better choice for Kim.
72
What does the money demand curve represent?
It shows the relationship between the aggregate quantity of money demanded (M) and the nominal interest rate (i).
73
Why does the money demand curve slope downward?
A higher nominal interest rate (i) increases the opportunity cost of holding money.
As a result, people hold less money and invest more in interest-bearing assets.
This causes the quantity of money demanded to decrease.
74
What happens when the nominal interest rate rises?
Holding money becomes more expensive because people lose out on potential interest earnings.
As a result, the quantity of money demanded decreases.
75
What happens when the nominal interest rate falls?
The opportunity cost of holding money decreases.
People hold more money since they are less incentivised to invest in bonds or other interest-bearing assets.
76
What causes a movement along the money demand curve?
A change in the nominal interest rate (i).
77
What factors can shift the money demand curve?
Changes in Real GDP (Y):
Higher GDP → More transactions → Higher money demand → Rightward shift.
Lower GDP → Fewer transactions → Lower money demand → Leftward shift.
Changes in Price Level (P):
Higher prices → More money needed for purchases → Rightward shift.
Lower prices → Less money needed → Leftward shift.
Changes in Financial Technology & Payment Systems:
More digital banking/payment options → Less need for cash → Leftward shift.
78
What are bank reserves?
Cash or similar assets held by commercial banks to meet depositor withdrawals and payments.
79
Is cash in a bank's vault part of the money supply? Why or why not?
No, because it is unavailable for payments or transactions.
80
What part of bank deposits is considered part of the money supply?
Deposits available for use in transactions (e.g., checking accounts).
81
What is 100% reserve banking?
A banking system where banks hold reserves equal to 100% of their deposits.
82
What happens under 100% reserve banking?
Banks cannot lend out deposits.
The total money supply does not increase through banking activities.
The only money available is what has been physically deposited in the bank.
83
Describe the financial habits of Euroland's citizens.
They don’t like carrying cash and prefer to deposit their money in commercial banks.
All citizens keep their money in the banks instead of holding physical currency.
84
How does this setup affect the banking system in Euroland?
Banks control nearly all the money in the economy.
The way banks handle reserves, loans, and deposits will determine how much money circulates in Euroland.
85
What does a bank’s balance sheet look like under 100% reserve banking?
Assets
Reserves: $1,000,000
Liabilities
Deposits: $1,000,000
The bank holds all deposits as reserves.
No loans are made, so the money supply does not expand.
Banks recognise they don’t need to hold all deposits in reserves—they can lend out a portion while keeping enough to cover withdrawals.
Fractional reserve banking: A banking system where banks hold only a fraction of deposits as reserves and lend out the rest.
banks decide to keep as reserves: 10% of deposits (€100,000)
banks lend out: 90% of deposits (€900,000) to firms and businesses
updated balance sheet:
Assets
Reserves: $100,000
Loans: $900,000
Liabilities
Deposits: $1,000,000
The bank now holds only 10% as reserves (€100,000).
The bank lends out €900,000, which enters circulation and increases the money supply.
Borrowers spend the €900,000 (on wages, suppliers, etc.).
These payments become new deposits in other banks.
The new banks also keep 10% and lend out 90% again.
This cycle continues, expanding the money supply through repeated lending.
The banks’ final balance sheet will look like this:
Assets
Currency (=reserves) $1,000,000
Loans $9,000,000
Liabilities
Deposits $10,000,000
The money supply, which is equal to total deposits, is €10,000,000 at the end of
the process.
86
How does fractional reserve banking create more money?
Banks keep only a fraction of deposits as reserves and lend out the rest, which gets re-deposited and re-loaned, expanding the money supply.
87
f banks keep 10% reserves, how many Euros in deposits does each Euro of reserves support?
Each €1 in reserves supports €10 in deposits (1 / 0.10 = 10).
88
What is the general formula for calculating total deposits in the banking system?
Bank deposits = Bank reserves/ Desired reserve-deposit ratio
89
If a bank holds €1,000,000 in reserves and has a 10% reserve ratio, what is the total deposit amount?
Bank deposit = 1,000,000/ 0.1
= 10,000,000
This means €1,000,000 in reserves can support €10,000,000 in deposits.
90
What is the money multiplier formula?
Money multiplier = 1/ Reserve ratio
91
What is the money multiplier if the reserve ratio is 10% (0.10)?
1/ 0.1 = 10
92
What does a money multiplier of 10 mean?
It means that for every €1 of reserves, the banking system can generate €10 in total money supply through lending and re-depositing.
93
What are the components of the money supply in an economy with currency and deposits?
The money supply consists of:
Currency held by the public
Bank deposits (created through the banking system)
94
How is the total money supply calculated?
Money Supply = Currency held by public + Bank deposits
95
How much currency and deposits do Eurozone residents initially hold in the example?
Currency held by public = 500,000 Euros
Deposits in banks = 500,000 Euros
Total initial money issued by the central bank = 1,000,000 Euros
total bank deposits calculated using the reserve-deposit ratio:
Total bank deposits = 500,000/0.1
This occurs due to the money multiplier effect, where banks create additional deposits by lending.
Total money supply = currency held by public + bank deposits
= 500,000 + 5,000,000 = 5,500,000 euros
If people prefer holding more currency, banks receive fewer deposits, reducing their ability to create money.
If people prefer holding more deposits, banks can expand money supply more through lending.
The currency-deposit ratio influences the total money supply.
96
What is the reserve-deposit ratio in the example, and what does it mean?
Reserve-deposit ratio = 10% (0.10)
This means banks must hold 10% of deposits as reserves and can lend out the rest.
97
What is securitisation?
Securitisation is the process by which banks pool existing loans and sell them to other financial institutions, converting illiquid assets (like mortgages) into tradeable securities.
98
What are the initial assets and liabilities of the bank in the given example?
Deposits = €10 million (Liabilities)
Loans = €9 million (Assets)
Reserves = €1 million (Assets)
Reserve-Deposit Ratio = 10%
Why can't the bank issue new loans in the current situation?
The bank holds €1 million in reserves, which is 10% of total deposits (€10 million).
Since the reserve-deposit ratio is already at the required 10%, the bank cannot lend more money without increasing reserves or reducing loans.
How much of the bank’s loans are mortgages?
Out of €9 million in total loans, €6 million are mortgages.
How does securitisation help the bank issue new loans?
The bank sells €6 million of mortgages to another financial institution.
This converts illiquid assets (mortgages) into cash, increasing available reserves.
With additional reserves, the bank can grant new loans or mortgages.
99
What is the main benefit of securitisation?
It increases the supply of credit, as banks can recycle funds into new loans instead of being constrained by reserve requirements.
100
101
What are the risks associated with securitisation?
It depends on the creditworthiness of borrowers (if loans default, investors lose money).
It relies on the willingness of capital markets to purchase securitised debt.
If markets lose confidence, securitisation can dry up, reducing credit availability.
102
What is the Federal Reserve?
The Federal Reserve (or "the Fed") is the central bank of the United States.
103
What are the two main responsibilities of the Federal Reserve?
Conducting monetary policy (managing money supply and interest rates).
Overseeing and regulating financial markets (ensuring stability and efficiency).
104
What role does the Federal Reserve play in financial crises?
The Fed acts as a lender of last resort, providing liquidity to prevent banking collapses and financial instability.
105
In what year did the Federal Reserve begin operations?
1914
106
Does the Federal Reserve operate to make a profit?
No, the Fed does not seek to maximise profit. It focuses on public policy objectives.
107
What are the main economic goals of the Federal Reserve?
Economic growth
Low inflation
Stable and efficient financial markets
