Week 5

Question 1

What’s money?

Answer 1

Money is the stock of assets that is used to carry out transactions.

Question 2

What’s fiat and commodity money?

Answer 2

Fiat money (notes and coins) has no intrinsic value.

Commodity money (gold and silver coins) has intrinsic value.

Question 3

What are the functions of money?

Answer 3

A medium of exchange.

A store of value.

A unit of account.

Question 4

What’s the overall price level?

Answer 4

The overall price level tells us, generally, how much things cost in an economy.

Question 5

What are the ways of capturing the overall price level?

Answer 5

The GDP Deflator

The Consumer Price Index (CPI)

Question 6

What’s the GDP deflator?

Answer 6

The GDP deflator is a proxy for the overall price level which is based on production.

GDP deflator = 100 * (Nominal GDP / Real GDP)

Question 7

What’s the Consumer Price Index?

Answer 7

The CPI is a proxy for the overall price level which is based on consumption.

CPI in month t = 100 * (Et / Eb), where E stands for expenditure on a particular ‘basket of goods’.

Question 8

What’s the money stock / money supply?

Answer 8

The money stock, or money supply, is the total quantity of money that’s circulating in the economy.

Question 9

What are the different measures of the money supply?

Answer 9

Different measures of the money supply are produced and numbered: M0, M1, M2, M3, M4.

M0 and M1 are narrow money.

M2, M3, M4 are broad money.

Question 10

What’s liquidity?

Answer 10

Liquidity is used to describe the ease with which an asset can be converted into cash.

Question 11

What’s inflation?

Answer 11

Inflation is an increase in the overall price level of an economy.

Question 12

What’s deflation?

Answer 12

Deflation is a decrease in the overall price level.

Question 13

What’s the rate of inflation?

Answer 13

The rate of inflation is the percentage change in the overall price level from one period to another (in general we use a 12-month inflation rate).

Question 14

What are the key differences between the GDP deflator and the CPI?

Answer 14

The basket of goods (quantities change every year in deflator but are fixed with CPI).

Prices of capital goods (included in deflator but not in CPI).

Prices of imported consumer goods (excluded from deflator but included in CPI

Question 15

How can the overall price level and inflation be viewed?

Answer 15

The overall price level can be viewed as the price of a representative basket of goods and as a measure of the value of money.

Inflation is related to the value of money.

P = the overall price level.

1/P = the purchasing power of each unit.

If P rises, the value of money goes down.

Question 16

What’s the classical dichotomy?

Answer 16

The classical dichotomy is the idea that variables can be divided into two groups, nominal variables (measured in monetary units) and real variables (measured in physical units).

Question 17

What did Hume and other classical economists think about changes in the money supply?

Answer 17

According to Hume and the classical school of thought, changes in the supply of money have no real effects on the economy.

Question 18

What’s the quantity theory of money formula?

Answer 18

MV = PY, where:

M = the nominal supply of money

V = ‘velocity of money’

P = the overall price level

Y = output

Question 19

What’s the velocity of money?

Answer 19

Velocity refers to the number of times the average monetary unit is used to purchase goods and services.

Question 20

Why does the velocity of money and output remain constant?

Answer 20

The velocity of money is relatively stable over time, therefore it’s reasonable to assume it’s constant.

Output is determined by the factors of production, which are fixed so this remains constant as well.

Therefore, an increase in the money supply will result in a higher price level.

Question 21

What are the costs of expected inflation?

Answer 21

Shoe leather costs – the cost and inconvenience of reducing money balances.

Menu costs – costs to firms associated with changing prices.

Relative price distortions and misallocations of resources – firms facing menu costs may change prices infrequently or at different times.

Inflation-induced tax distortions – taxes may be set at the wrong levels.

General inconvenience and confusion.

Question 22

What are the costs of unexpected inflation?

Answer 22

Many long-term contracts are based on expected inflation. If actual inflation turns out to be different from expected inflation, one side of a transaction gains at the other’s expense.

We say there are ‘arbitrary redistributions of purchasing power’.

Question 23

What happens when inflation is high?

Answer 23

When inflation is high, there is increased uncertainty.

When inflation exceeds 50% per month, we call it hyperinflation.

Question 24

What’s an inflation tax?

Answer 24

When a government raises money through printing money.

Question 25

What are the benefits of inflation?

Answer 25

Inflation can make the market work more efficiently:

An increase in the supply for labour should lead to a fall in wages.

However, workers rarely accept pay cuts.

In the presence of inflation, you can reduce real wages by holding nominal wages constant.

Question 26

What are the key assumptions of the Keynesian model?

Answer 26

Wages and prices are ‘sticky’ or rigid (they are fixed in the short run).

We’re operating in a closed economy.

Question 27

What’s the difference between planned and actual expenditure?

Answer 27

Planned expenditure is AD which represents the amount that economic agents would like to spend on goods and services.

Actual expenditure is how much they actually spend.

Question 28

What are the combinations of planned expenditure and actual output?

Answer 28

If planned expenditure > actual output, there’s excess demand, firms reduce their inventories to satisfy this demand and actual output expands.

If planned expenditure < actual output, there’s excess supply, firms increase their inventories and actual output contracts in response to this.

Question 29

What’s the Money Supply?

Answer 29

The Money supply (M) is the quantity of money in the economy.

Question 30

What’s the real money balances?

Answer 30

Real money balances (M/P) measures what money can buy.

Question 31

What determines the money demand in the market for RMB?

Answer 31

We assume that the demand for money depends on the real interest rate, which is related to opportunity cost.

There’s an inverse relationship between the real interest rate and money demand.

Question 32

What’s the effect of a change in Y on the market for RMB?

Answer 32

A change in Y will result in a shift in money demand (L).

Question 33

What’s the IS-LM model?

Answer 33

The IS-LM model is a short-term model.

IS stands for ‘investment saving’ and is derived from the Keynesian cross.

LM stands for ‘liquidity money’ and is derived from the market for real money balances.

The IS curve graphs all combinations of the real interest rate (r) and output (Y) that result in goods market equilibrium.

Question 34

What’s the effect of expansionary fiscal policy on the market for RMB?

Answer 34

An increase in G translates to a rise in planned expenditure in the Keynesian cross. The result is a higher level of output (Y).

This corresponds with a right shift in the IS curve. The IS-LM model predicts a higher level of the real interest rate.

This is explained by a right shift in the money demand line in the market for RMB.

Question 35

What’s the effect of expansionary monetary policy on the market for RMB?

Answer 35

An increase in M translates to an increase in the real money supply in the market for RMB, resulting in a lower level of the real interest rate.

This corresponds to a right shift in the LM curve. The IS-LM model predicts a higher level of output.

The lower level of r causes investment to increase and we have a rise in planned expenditure in the Keynesian cross.