Week 4 - Money, Banks and Bonds Flashcards
What are the 5 roles of a Central Bank
- Issue bank notes
- Lender of last resort
- Banker to the government
- Policing the Financial system
- Controlling money supply, interest rates and inflation
What are 3 ways the Central bank can monitor the money supply
- Reserve requirements
- Setting the bank rate
- Open market operations
What is the Base rate
The interest rate the central bank charges commercial banks when they borrow money from it
What are Reserve requirements
The minimum amount of reserves that commercial banks must hold, instead of lending out
What are Open market operations
When the central bank buys or sells financial securities in the open market
What are the 3 benefits to Holding money
- Transaction
- Precautionary
- Asset
What are the costs of Holding money
All wealth held in money rather than bonds forgoes the interest that bonds earn
What are the Endogenous and Exogenous variables in the Money market
Endogenous variables:
- Interest rates, r
Exogenous variables:
- Income/output, Y
- Nominal money balances, M
- Price level, P
What does the IS curve show
Combinations of interest rates and output where the goods market is in equilibrium
What does the MP curve show
The relationship between the real interest rate and the inflation rate, as influenced by central bank monetary policy decisions
When is the Goods market in equilibrium
Defined by output level Y*, such that aggregate demand and actual income are equal
When is the Money market in equilibrium
Defined by interest rate r*, such that money demand is equal to money supply
How does lowering Interest rates (and therefore money supply) effect the real economy
Households:
- Lower interest rates imply higher price of bonds ⇒ Households feel wealthier,
consumption increases
- Lower interest rates imply lower cost of borrowing, increasing spending on
consumer durables (housing, cars, furniture) , consumption increases
Investment by firms:
- Lower interest rates imply lower cost of borrowing, increasing investing by
firms
How does changing the Real economy affect interest rates
Households:
- Higher income increases the demand for real money balances
- This shifts the LL curve right (in r, L space) and increases the equilibrium
interest rate
What effect will an increase in Real output have on interest rates in the money market
Increase interest rates
How is the Goods market equilibrium defined
The goods market equilibrium is defined by output level 𝑌∗, such that aggregate demand and actual income (output) are equal.
How is the Money market equilibrium defined
The money market equilibrium is defined by interest rate 𝑟∗, such that money demand is equal to money supply.
Define the following schedules:
IS schedule
MP schedule
- The IS schedule shows combinations of Y and r for which the goods market is in equilibrium
- The MP schedule shows combinations of Y and r for which the money market is in equilibrium
What is the slope of the MP schedule and why
The MP schedule slopes up: higher output induces higher interest rates to keep money demand in line with money supply
What is the slope of the IS schedule and why
The IS schedule slopes down: lower interest rates boost aggregate demand and output
What shifts the IS schedule
Anything that shifts the AD curve for a given interest rate (changes in G, exogenous changes in I or C that are not due to changes in r)
What shifts the MP schedule
Changes in the money supply (L) for a given level of income
