Week 5 - Money & Inflation

Question 1

Money

Answer 1

any asset or item that can be used by people regularly to buy goods/services

Question 2

Liquidity

Answer 2

the ease and cost with which assets can be turned into cash and used immediately as a means of exchange

Question 3

What are the functions of money?

Answer 3

Medium of exchange
Unit of account
Store of value

Question 4

Medium of exchange

Answer 4

facilitates transactions by allowing goods/services to be exchanged for a common, widely accepted medium of exchange

Question 5

Unit of account

Answer 5

it is a measure of economic value and a standard unit of measure for the value of goods/services/financial assets, allowing individuals and business to compare price and make informed decisions

Question 6

Store of value

Answer 6

allows individuals to save for future consumption by maintaining its purchasing power over time

Question 7

What are the kinds of money?

Answer 7

Commodity money
Fiat money

Question 8

Commodity money

Answer 8

money whose value comes from a commodity of which it is made (intrinsic value) e.g., the gold standard

Question 9

Fiat money

Answer 9

a government-issued currency that is not backed by a commodity such as gold (no intrinsic value)

Question 10

Central banks

Answer 10

the monetary authority and major regulatory bank in a country

Question 11

What do central banks do?

Answer 11

• Oversee the banking system
• Regulate the quantity of money in the economy

Question 12

Quantitative easing (QE)

Answer 12

a form of expansionary monetary policy in which a nation’s central bank tries to increase the liquidity in its financial system, typically by purchasing long-term government bonds

Question 13

Fractional-reserve banking

Answer 13

a system in which only a fraction of bank deposits is required to be available for withdrawal

Question 14

Reserve ratio

Answer 14

the fraction of deposits that the bank holds as reserves

Question 15

Reserve requirement

Answer 15

the minimum amount of reserves that banks must hold

Question 16

Excess reserve

Answer 16

banks may hold reserves above any legal minimum

Question 17

Money multiplier

Answer 17

the ratio of the money supply to the monetary base (i.e. central bank money)

Question 18

What does a higher reserve ratio mean for the money multiplier?

Answer 18

• The higher the reserve ratio, the smaller the money multiplier
• Money multiplier = 0, when R = 1

Question 19

What are the central banks tools of monetary control?

Answer 19

1. Open market operations – the outright purchase and sale of government bonds by the Central Bank
   i. To increase the money supply: The CB buys government bonds from the public
   ii. To reduce the money supply: The CB sells government bonds to the public
2. The refinancing rates – the interest rate at which the Central Bank will lend to commercial banks on a short-term basis
   i. Banks lend money to one another, and borrow from the CB in a so called ‘money market’
   ii. The CB is effectively able to control the going rate of interest in this market
   iii. This in term affects retail interest rates
   
   1. Higher refinancing rate reduces money supply, so borrowing will decrease
   2. Lower refinancing rate increases money supply, so borrowing will increase
3. Reserve requirements – regulations on minimum number of reserves that banks must hold against deposits
   i. An increase in the reserve requirement decreases the money supply, so the multiplier decreases
   ii. A decrease in the reserve requirement increases the money supply, so the multiplier increases
   
   1. However, this is rarely used as it greatly upsets banks business models

Question 20

Problems with the central banks tools of monetary control

Answer 20

• The CB’s control of the money supply is not precise, so the money multiplier can vary due to fractional reserve banking
• The CB doesn’t control the amount of money that households choose to hold as deposits in banks
• The CB doesn’t control the amount that bankers choose to lend rather than keep as reserves

Question 21

Deflation

Answer 21

when the general price levels in a country are falling

Question 22

Hyperinflation

Answer 22

describe rapid, excessive, and out-of-control general price increases in an economy

Question 23

What are the effects of monetary injection?

Answer 23

Quantity of money theory
Adjustment process

Question 24

Quantity of money theory

Answer 24

the quantity of money available in the economy determines the price level
o This is because the more the money supply grows the more prices grow.

Question 25

Adjustment process

Answer 25

o Excess supply of money leads to an increase in the demand for goods/services
o So, the price of goods/services increase
 The economy’s ability to supply goods/services is not affected by the money supply in the long run
o Therefore, the increase in prices leads to an increase in the quantity of money demanded

Question 26

Classical dichotomy

Answer 26

theoretical separation of nominal and real variables

Question 27

Nominal variables

Answer 27

variables measured in monetary units e.g., pound, dollar, euro prices

Question 28

Real variables

Answer 28

variables measured in physical units e.g., relative prices, real wages, real interest rate

Question 29

Using classical dichotomy what effects do nominal/real variables have in the monetary system?

Answer 29

• Influence nominal variables
• Irrelevant for explaining real variables

Question 30

Money neutrality

Answer 30

Changes in the money supply don’t affect real variables
* Not completely realistic in the short run, but most economists believe it is correct in the long run

Question 31

Velocity and quantity equation

Answer 31

Quantity equation: M x V = P x Y

M, amount of money
V, velocity of money
P, prices of goods
Y, amount of goods

Question 32

What does (P x Y) represent?

Answer 32

the pound value of the economy’s output of goods/services

Question 33

Velocity of money

Answer 33

the rate at which money changes hands in the economy

Question 34

Velocity of money formula

Answer 34

V = (P x Y) / M

Question 35

Principle of money neutrality

Answer 35

an increase in the rate of money growth raises the rate of inflation but does not affect any real variable

Question 36

Real interest rate formula

Answer 36

Real interest rate = Nominal interest rate – Inflation rate

Question 37

Nominal interest rate formula

Answer 37

Nominal interest rate = Real interest rate + Inflation rate

Question 38

Fisher effect

Answer 38

the one-for-one adjustment of nominal interest rate to inflation rate when the central Bank increases the rate of money growth

Question 39

Inflation tax

Answer 39

revenue the government raises by creating (issuing) money rather than raising taxes or selling bonds

Question 40

The costs of inflation

Answer 40

Shoe leather costs
Menu costs
Market economies and misallocation
Deflation getting worse

Question 41

Inflation fallacy

Answer 41

believing that a rise in prices means an equal loss in purchasing power

Question 42

Shoe leather costs

Answer 42

the costs that people incur to minimize their cash holdings during times of high inflation.
o Withdraw smaller amounts at the bank, but visit it more often
o Don’t store money but convert to a kore stable store of value. This can be substantial

Question 43

Menu costs

Answer 43

costs incurred by a firm when it changes its prices
o These can include printing the new price lists, changing the price of its websites and advertising materials, and point of sale systems.