Week 19 - Money and Prices Pt2 Flashcards
What is the Federal Reserve System (the Fed)?
The Fed is the central bank of the U.S., responsible for monetary policy and regulation of financial markets.
What is monetary policy?
Monetary policy involves managing the money supply and interest rates to influence the economy.
Does the Fed directly control the money supply?
No, the Fed controls the money supply indirectly through monetary policy tools like open-market operations.
What happens when the Fed buys government bonds from the public (open-market purchase)?
Increases bank reserves
Increases the money supply
Encourages lending and investment
What happens when the Fed sells government bonds to the public (open-market sale)?
Decreases bank reserves
Reduces the money supply
Slows down lending and economic activity
Why does the Fed buy and sell government bonds?
To influence the money supply and control inflation, employment, and economic growth.
What are open-market operations (OMOs)?
Open-market operations are the buying and selling of government bonds by the Federal Reserve to influence the money supply.
What happens when the Fed purchases bonds from the public?
The Fed pays bondholders with new money.
The new money enters the economy.
The bond (which was not money) leaves the economy.
Deposits increase, leading to a multiple expansion of the money supply.
What happens when the Fed sells bonds to the public?
The bondholder pays with checking funds (which are money).
These checking funds leave the economy.
The bond (which is not money) enters the economy.
Bank reserves decrease, leading to a multiple contraction of the money supply.
How do open-market purchases and sales affect the economy?
Purchases: Increase money supply, boost lending, and stimulate economic activity.
Sales: Decrease money supply, reduce lending, and slow down the economy.
Why does an open-market purchase lead to a multiple expansion of the money supply?
New money increases bank reserves.
Banks use these reserves to make loans.
Loans get redeposited, leading to further money creation through the money multiplier effect.
How is the total money supply calculated?
Money supply = Currency held by public + Bank reserves/Reserve-Deposit ratio
Given 1,000 shekels in currency and 200 shekels in bank reserves, with a reserve-deposit ratio of 0.2, what is the initial money supply?
Money supply = 1,000 + 200/0.2
= 1,000 + 1,000
= 2,000 shekels
What happens when the central bank buys a bond for 100 shekels from the public?
The central bank injects 100 shekels into the economy.
If all 100 shekels are deposited into banks, reserves increase to 300 shekels.
The new money supply is:
Money supply = 1,000 + 300/0.2
= 1,000 +1,500
= 2,500 shekels
A 100-shekel increase in reserves leads to a 500-shekel increase in the money supply due to the money multiplier effect.
Why does a 100-shekel increase in reserves lead to a 500-shekel increase in the money supply?
The money multiplier is determined by the reserve-deposit ratio:
Money multiplier = 1/ Reserve-Deposit ratio
= 1/0.2 = 5
Every shekel added to reserves can create 5 shekels in total money supply.
100 × 5 = 500 shekels increase in money supply.
How does an open-market purchase by the central bank affect the money supply?
Buys bonds → Injects reserves → Expands money supply.
The effect is multiplied by the money multiplier, depending on the reserve-deposit ratio.
What does the money supply curve represent?
The money supply curve shows the total amount of money available in the economy, which is set by the central bank.
How does the central bank control the money supply?
The central bank sets the money supply at MS1 through tools like open-market operations (buying or selling government bonds).
What happens to the money supply curve when the central bank purchases government bonds?
An open-market purchase increases the money supply.
This shifts the money supply curve right from MS1 to MS2, reflecting the increase in the amount of money in circulation.
What happens to the money supply curve when the central bank sells government bonds?
An open-market sale decreases the money supply.
This shifts the money supply curve to the left as the amount of money in circulation decreases.
How do open-market operations affect the money supply curve?
Open-market purchases shift the money supply curve right (increase money supply).
Open-market sales shift the money supply curve left (decrease money supply).
What does equilibrium in the market for money mean?
Equilibrium occurs when the quantity of money the public wants to hold is equal to the money supply set by the central bank.
How does the interest rate affect the amount of money people want to hold?
As the interest rate rises, the opportunity cost of holding money increases, so people demand less money (they prefer to hold interest-bearing assets).
As the interest rate falls, people demand more money because the opportunity cost of holding money is lower.
How is the equilibrium interest rate determined?
The equilibrium interest rate is the rate at which the quantity of money the public wants to hold is equal to the money supply. At this rate, there is neither an excess nor a shortage of money in the economy.
What happens if the money supply is greater than the equilibrium demand for money?
There will be excess supply of money.
People will increase their spending or invest the excess money, causing the interest rate to fall until equilibrium is restored.
What happens if the money supply is less than the equilibrium demand for money?
There will be excess demand for money.
People will reduce spending or sell assets to increase their money holdings, causing the interest rate to rise until equilibrium is restored.
How does the market for money reach equilibrium?
Equilibrium is reached when the demand for money matches the money supply, and the interest rate adjusts to bring this balance.
How can the central bank lower the nominal interest rate?
The central bank can lower the nominal interest rate by increasing the money supply which affects the equilibrium in the money market.
What happens to the equilibrium in the money market when the central bank increases the money supply?
An increase in the money supply shifts the money supply curve from MS to MS’.
This shift moves the equilibrium point from E to F, leading to a lower nominal interest rate from i to i’ (y axis).
Why does increasing the money supply lower the equilibrium nominal interest rate?
More money in the economy leads to excess supply of money at the initial interest rate.
To restore equilibrium, people will increase spending or investment, which puts downward pressure on the interest rate.
The interest rate falls until the demand for money equals the increased supply.
What is the impact of an increase in the money supply on the money market?
The money supply curve shifts right (from MS to MS’).
The equilibrium interest rate falls from i to i’ as the money supply increases.
This encourages more borrowing and spending in the economy.
What is the main takeaway about how the central bank controls the nominal interest rate?
By increasing the money supply, the central bank can shift the money supply curve rightward, which lowers the nominal interest rate and stimulates economic activity.
What was the primary motivation for creating the Federal Reserve?
The primary motivation for creating the Federal Reserve was to stabilise financial markets and the economy, preventing financial instability and panics.
What causes banking panics?
Banking panics occur when customers believe one or more banks may be bankrupt.
Depositors rush to withdraw their funds, fearing the bank will run out of money.
As everyone tries to withdraw funds, banks cannot meet the demand because they have inadequate reserves, leading to a collapse.
What are the effects of a banking panic?
Banks close because they can’t meet withdrawal demands.
This leads to a loss of confidence in the financial system and a worsening of economic conditions.
How does the Federal Reserve prevent banking panics?
The Fed supervises and regulates banks to ensure they have adequate reserves and follow sound practices.
It acts as a lender of last resort, loaning banks funds if they face liquidity problems to prevent failure.
Why was the Federal Reserve not effective in preventing bank panics between 1930 and 1933?
During the Great Depression, the Federal Reserve did not take sufficient action to stabilise the banking system, allowing widespread panics and bank failures.
How did the Federal Reserve improve its effectiveness in preventing bank panics after 1933?
After the banking crises of the early 1930s, the Fed became more effective at preventing future panics through stronger regulations, better supervision, and timely interventions.
What happened during the bank panics of 1930-1933?
During this period, one-third of banks closed, worsening the Great Depression and making it difficult for small businesses and consumers to access credit.
How did bank closures during 1930-1933 affect the economy?
The closures made it difficult for small businesses and consumers to obtain credit.
The money supply decreased, exacerbating the economic downturn.
How did the lack of federal deposit insurance contribute to the banking crisis?
Without federal deposit insurance, depositors feared losing their money if a bank closed.
As a result, people held more cash rather than depositing it in banks, reducing bank reserves.
How did holding cash during the Great Depression affect bank reserves?
Holding cash reduced the amount of deposits in banks, leading to lower bank reserves.
This created a vicious cycle, where lower reserves led to a decreased money supply, which in turn worsened the economic crisis.
How did the decrease in bank reserves affect the money supply?
A decrease in bank reserves led to a decrease in the money supply by a multiple of the change in reserves due to the money multiplier effect.
How did the closure of banks affect small businesses and consumers?
With many banks closed, it became difficult for small businesses and consumers to obtain credit, worsening the economic conditions of the Depression.
How did bank closures affect the money supply?
The closure of banks caused a decrease in the money supply, as deposits were lost, and fewer loans were made.
Why did people start holding more cash during the bank panics?
Without federal deposit insurance, people feared losing their deposits if banks closed.
As a result, they withdrew funds and held cash, further reducing banks’ reserves.
How did people holding cash affect banks’ reserves?
When people held cash, it reduced the bank reserves, leading to a decrease in the money supply.
How did lower bank reserves affect the money supply during the panics?
Lower reserves led to a decrease in the money supply by a multiple of the change in reserves due to the money multiplier effect.
The reduction in reserves resulted in a greater contraction of the money supply.
What did banks do in response to the banking panics of 1930-1933?
Banks increased their reserve-deposit ratio, meaning they held a higher percentage of deposits as reserves instead of lending them out.
How did increasing the reserve-deposit ratio impact the money supply?
Less money was available for lending, reducing the creation of new deposits.
The money multiplier decreased, leading to a further decline in the money supply.
How does the reserve-deposit ratio affect the money multiplier?
The money multiplier is given by:
Money multiplier = 1/ Reserve-Deposit ratio
A higher reserve-deposit ratio means a lower money multiplier, which reduces the total money supply in the economy.
Why did banks increase their reserve-deposit ratio during the Great Depression?
Banks were afraid of further withdrawals and possible bank runs.
Without federal deposit insurance, banks held onto more reserves as a precautionary measure.
What were the consequences of banks increasing their reserves?
Less lending, leading to credit shortages for businesses and consumers.
Further contraction of the money supply, worsening the Great Depression.
When was deposit insurance created, and why?
Congress created deposit insurance in 1934 to prevent future bank panics by guaranteeing deposits up to a certain limit.
What does deposit insurance guarantee?
It ensures that deposits under $250,000 will be repaid even if the bank goes bankrupt, reducing the risk for depositors.
How does deposit insurance reduce the risk of bank runs?
Since deposits are guaranteed, people are less likely to withdraw their money based on rumors, decreasing the likelihood of bank panics.
How effective has deposit insurance been in preventing banking crises?
There have been no significant bank panics since 1934, showing that deposit insurance has greatly improved financial stability.
What is a potential downside of deposit insurance?
With less risk to depositors, people pay less attention to whether banks are making safe investments.
This can lead to riskier banking behavior since banks know depositors will not withdraw their funds.
How did deposit insurance contribute to the Savings and Loan Crisis in the 1980s?
Many savings and loan associations took excessive risks, knowing depositors were protected, leading to widespread failures
What role does the Federal Reserve play in preventing banking failures?
The Fed acts as the lender of last resort, providing emergency funds to banks in crisis to prevent failures.
How do banks increase the quantity of money in the economy?
Banks increase the money supply by loaning out deposits, which creates new money through the money multiplier effect.
Why can’t the Federal Reserve fully control the money supply?
The Fed cannot directly control:
How much households deposit in banks.
How much banks choose to lend.
These factors affect the money creation process, making Fed control imperfect.
How do household deposits affect the money supply?
If people deposit more money, banks have more reserves to lend, increasing the money supply.
If people hold more cash, banks have fewer reserves, decreasing the money supply.
How do banks’ lending decisions affect the money supply?
If banks lend more, the money supply expands.
If banks hold more reserves (e.g., in times of crisis), the money supply contracts.
How does the Federal Reserve influence the money supply?
The Fed uses tools like:
Open-market operations (buying/selling government bonds).
Changing the reserve requirement.
Adjusting the discount rate (interest rate for bank borrowing).
However, its influence is not absolute due to bank and household behaviours.
How are the amount of money circulating and price levels related in the long run?
In the long run, the money supply and price levels are closely linked—an increase in the money supply generally leads to higher prices (inflation).
What economic theory explains the link between money supply and prices?
The Quantity Theory of Money, expressed as:
MV = PY
M - money supply
V - velocity of money (how often money circulates)
P - price level
Y - real output (GDP)
If V and Y are stable, an increase in M leads to a proportional increase in P (inflation).
What happens when the money supply grows at a high rate?
Sustained high inflation occurs when the money supply grows too rapidly compared to economic output.
Can you give an example where excessive money growth led to inflation?
Hyperinflation in Zimbabwe (2000s): The government printed excessive money, causing prices to rise uncontrollably.
Weimar Germany (1920s): Rapid money printing to pay war debts led to extreme hyperinflation.
How can central banks control inflation?
By limiting excessive growth of the money supply through:
Open-market operations (selling bonds to reduce money supply).
Raising interest rates to slow borrowing and spending.
Setting higher reserve requirements to limit bank lending.
How does inflation affect money as a store of value?
The ability of money to store value depends on the price level—when prices rise (inflation), money loses value.
What happens if all prices double?
The value of money is cut in half, meaning each unit of currency buys 50% less than before.
What happens if all prices are halved?
The value of money doubles, meaning each unit of currency buys twice as much.
How does inflation affect the value of money?
When inflation is high, the price level rises rapidly, and money loses purchasing power quickly.
People become reluctant to hold money and prefer assets that retain value, such as gold or real estate.
What happens during hyperinflation?
Prices rise at an extremely fast rate (e.g., daily or hourly).
Money becomes virtually worthless—people rush to spend it immediately before it loses even more value.
Historical example: Zimbabwe (2000s) and Weimar Germany (1920s).
What do people do to protect their wealth in high-inflation periods?
Shift money into assets that hold value, like real estate, gold, or stocks.
Reduce cash holdings and prefer foreign currency or commodities.
What does the Quantity Theory of Money explain?
It explains how the price level is determined and why it changes over time.
How does the quantity of money in the economy affect its value?
When the money supply increases, the value of money falls, leading to higher prices (inflation).
When the money supply decreases, the value of money rises, leading to lower prices (deflation).
What is the main cause of inflation according to the Quantity Theory of Money?
Inflation occurs when the money supply grows faster than the supply of goods and services in the economy.
What happens if the central bank injects more money into the economy?
Short term: Economic activity may rise as spending increases.
Long term: Higher money supply leads to higher inflation as more money chases the same amount of goods.
What are nominal variables?
Variables measured in monetary units, such as wages ($/hour) or prices ($/unit).
What are real variables?
Variables measured in physical units, such as real GDP (output of goods and services) or real wages (purchasing power of wages).
What is the classical dichotomy?
The idea that nominal variables (money-related) and real variables (physical quantities) are separate in the long run.
What is the quantity equation in economics?
MV = PY
M - money supply
V - velocity of money (how often money circulates)
P - price level
Y - Real GDP (economic output)
What does the quantity equation show about money and inflation?
If velocity (V) and real GDP (Y) are constant, then:
An increase in money supply (M) leads to a proportional increase in the price level (P).
This explains how excessive money growth causes inflation.
What is velocity (V) in the quantity equation?
Velocity represents the number of times a unit of money is spent in a given period (e.g., a year).
If velocity is high, what does that indicate?
Money is circulating quickly, leading to higher spending.
Higher velocity can amplify inflation if money supply grows too fast.
If velocity is low, what does that indicate?
Money is being held rather than spent (e.g., during recessions).
This can lead to slower economic activity and deflationary pressure.
If M increases by 10% and V and Y remain constant, what happens to P?
P (price level) must increase by 10%, meaning 10% inflation.
If Y (real GDP) increases, how does it affect inflation?
Higher Y offsets the impact of M on P, leading to lower inflation or stable prices.
What is the long-run effect of rapid money supply growth?
If money supply grows faster than GDP, inflation occurs.
If money supply grows at the same rate as GDP, price levels remain stable.
If the money supply (M) increases, what must happen to maintain the equation?
One of the following must occur:
P (price level) rises → Inflation.
Y (real GDP) rises → More production/output.
V (velocity) falls → People hold onto money instead of spending it.
What happens if velocity (V) falls?
Fewer transactions occur in the economy.
Economic activity slows down.
Possible deflationary pressure as demand decreases.
What causes a decrease in velocity?
People hoarding cash instead of spending.
Increased savings during economic uncertainty.
Lack of confidence in the economy.
What happens if velocity (V) rises?
More transactions occur in the economy.
Higher spending can lead to inflation if the money supply stays constant.
Can signal economic expansion.
What happened to velocity during the 2008 financial crisis?
People saved more and spent less, causing velocity (V) to fall.
This led to lower economic activity and deflationary pressure.
The Federal Reserve increased the money supply (M) to counteract this.
How does velocity (V) behave over time?
Velocity is relatively stable in the long run, meaning changes in money supply (M) mainly affect P × Y (nominal GDP).
When the Federal Reserve (Fed) increases money supply (M), what happens?
Since V is stable, the increase in M causes a proportional increase in nominal GDP (P × Y).
What does this imply about inflation?
If Y (real GDP) remains constant, then an increase in M leads directly to an increase in P (inflation).
What does it mean to say that money is neutral?
In the long run, changes in money supply (M) only affect price levels (P), not real output (Y).
Why does money not affect real GDP (Y) in the long run?
Real GDP is determined by productivity, resources, and technology, not money supply.
Money supply only affects nominal variables like prices and wages.
According to the Quantity Theory of Money, what is the primary cause of inflation?
Excessive growth in the money supply (M) relative to economic output (Y).
If money supply grows by 5% and real GDP grows by 2%, what happens to inflation?
Inflation will be approximately 3% (since P≈ M-Y)
What is the classical dichotomy?
The idea that real variables (like output and employment) and nominal variables (like money supply and price level) are separate in the long run.
What are real variables?
Variables measured in physical terms, such as:
Real GDP (Y) – total output of goods and services.
Real wages – purchasing power of wages.
Real interest rate – adjusted for inflation.
What are nominal variables?
Variables measured in monetary terms, such as:
Money supply (M)
Nominal wages – wages in dollar terms.
Price level (P)
What is monetary neutrality?
The idea that changes in the money supply affect nominal variables but not real variables in the long run.
If the central bank doubles the money supply, prices double but output, employment, and real wages remain unchanged.
Which economist is most associated with the Classical Dichotomy and Monetary Neutrality?
David Hume and later classical economists.
How does modern economics view these ideas?
In the long run, monetary neutrality holds.
In the short run, changes in the money supply can affect real variables due to sticky prices and wages.
If monetary neutrality holds, can central banks boost long-term economic growth by printing more money?
No—in the long run, increasing the money supply only leads to inflation and does not improve real GDP.
