Week 5 - Money & Inflation Flashcards
Money
any asset or item that can be used by people regularly to buy goods/services
Liquidity
the ease and cost with which assets can be turned into cash and used immediately as a means of exchange
What are the functions of money?
Medium of exchange
Unit of account
Store of value
Medium of exchange
facilitates transactions by allowing goods/services to be exchanged for a common, widely accepted medium of exchange
Unit of account
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
Store of value
allows individuals to save for future consumption by maintaining its purchasing power over time
What are the kinds of money?
Commodity money
Fiat money
Commodity money
money whose value comes from a commodity of which it is made (intrinsic value) e.g., the gold standard
Fiat money
a government-issued currency that is not backed by a commodity such as gold (no intrinsic value)
Central banks
the monetary authority and major regulatory bank in a country
What do central banks do?
- Oversee the banking system
- Regulate the quantity of money in the economy
Quantitative easing (QE)
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
Fractional-reserve banking
a system in which only a fraction of bank deposits is required to be available for withdrawal
Reserve ratio
the fraction of deposits that the bank holds as reserves
Reserve requirement
the minimum amount of reserves that banks must hold
Excess reserve
banks may hold reserves above any legal minimum
Money multiplier
the ratio of the money supply to the monetary base (i.e. central bank money)
What does a higher reserve ratio mean for the money multiplier?
- The higher the reserve ratio, the smaller the money multiplier
- Money multiplier = 0, when R = 1
What are the central banks tools of monetary control?
- 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 - 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- Higher refinancing rate reduces money supply, so borrowing will decrease
- Lower refinancing rate increases money supply, so borrowing will increase
- 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- However, this is rarely used as it greatly upsets banks business models
Problems with the central banks tools of monetary control
- 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
Deflation
when the general price levels in a country are falling
Hyperinflation
describe rapid, excessive, and out-of-control general price increases in an economy
What are the effects of monetary injection?
Quantity of money theory
Adjustment process
Quantity of money theory
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.
Adjustment process
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
Classical dichotomy
theoretical separation of nominal and real variables
Nominal variables
variables measured in monetary units e.g., pound, dollar, euro prices
Real variables
variables measured in physical units e.g., relative prices, real wages, real interest rate
Using classical dichotomy what effects do nominal/real variables have in the monetary system?
- Influence nominal variables
- Irrelevant for explaining real variables
Money neutrality
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
Velocity and quantity equation
Quantity equation: M x V = P x Y
M, amount of money
V, velocity of money
P, prices of goods
Y, amount of goods
What does (P x Y) represent?
the pound value of the economy’s output of goods/services
Velocity of money
the rate at which money changes hands in the economy
Velocity of money formula
V = (P x Y) / M
Principle of money neutrality
an increase in the rate of money growth raises the rate of inflation but does not affect any real variable
Real interest rate formula
Real interest rate = Nominal interest rate – Inflation rate
Nominal interest rate formula
Nominal interest rate = Real interest rate + Inflation rate
Fisher effect
the one-for-one adjustment of nominal interest rate to inflation rate when the central Bank increases the rate of money growth
Inflation tax
revenue the government raises by creating (issuing) money rather than raising taxes or selling bonds
The costs of inflation
Shoe leather costs
Menu costs
Market economies and misallocation
Deflation getting worse
Inflation fallacy
believing that a rise in prices means an equal loss in purchasing power
Shoe leather costs
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
Menu costs
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.
