Week 6 Flowchart

Question 1

Money

Answer 1

The set of assets in an economy that people regularly use to buy goods and services from other people. Money includes cash, deposits and other types of assets, but not credit card (or cheques). In fact, if people use cheques instead of cash, money supply will increase as people no longer carry extra cash.

Question 2

The 3 functions of money

Answer 2

Medium of exchange

Unit of account

Store of value

Question 3

Medium of exchange

Answer 3

An item that buyers give to sellers when they want to purchase goods and services. Money is the most liquid asset available

Question 4

Unit of account

Answer 4

The yardstick people use to post prices and record debts.

Question 5

Store of value

Answer 5

An item that people can use to transfer purchasing power from the present to the future.

Money is not the best store of value (shares, bonds, real estate…). Value of money deteriorates when there are inflationary expectations.

Question 6

Liquidity

Answer 6

The ease with which an asset can be converted into the economy’s medium of exchange.

Question 7

Kinds of money

Answer 7

When money takes the form of a commodity with intrinsic value, it is called commodity money (e.g. gold.)

Flat money: Money without intrinsic value that is used as money because of government decree.

Question 8

Monetary policy in Australia today

Answer 8

The RBA uses the cash rate to influence the level of economic activity rather than attempting to control the money supply. The RBA uses open-market operations to guarantee that its target rate is the equilibrium interest rate in the short-term money.

Question 9

Cash rate

Answer 9

The interest that financial institutions can earn on overnight loans of their currency or reserves.

Question 10

Open-market operations

Answer 10

The purchase and sale of Australian government securities by the RBA

Question 11

Problems in controlling the money supply

Answer 11

Can not control the amount that bankers chose to lend.

Trade-off between inflation and unemployment in short-run

Bank runs

Can not control the amount of money that households choose to hold as deposits in banks.

Question 12

Bank runs

Answer 12

Large numbers of depositors all try to withdraw their deposits at the same time

Question 13

Banks and the money supply

Answer 13

100 per cent reserve banking

Fractional-reserve banking

Question 14

100 per cent reserve banking

Answer 14

Reserves: Deposits that banks have received but have not lent out

In banks hold all deposits in reserve, banks don’t influence the supply of money.

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Question 15

Fractional-reserve banking

Answer 15

A banking system in which banks hold only a fraction of deposits as reserves. Lend out a majority of their deposits thereby creating money.

Reserve ratio

Money multiplier

Question 16

Reserve ratio

Answer 16

The fraction of deposits that banks hold as reserves.

Question 17

The money multiplier

Answer 17

The amount of money the banking system generates with each dollar of reserves.

Question 18

Fractional reserve ratio example

Answer 18

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When banks hold only a fraction of deposits in reserve, banks create money. While new money has been created so has debt. There is no new wealth created by the process. The process of money creation does not continue forever. It stops when the actual reserve-deposit ratio is equal to the desired reserve-deposit ratio.

Question 19

Money in the Australian economy

Answer 19

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Question 20

Money supply

Answer 20

The quantity of money available in the economy.

Currency

Current deposits

Question 21

Currency

Answer 21

The plastic notes and metal coins in the hands of the public.

Question 22

Current deposits

Answer 22

Balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.

Question 23

Central Bank (or The Reserve Bank of Australia)

Answer 23

An institution designed to oversee the banking system and regulate the quantity of money in the economy.

Question 24

Roles of the RBA

Answer 24

Monitor individual banks and ensure their stability

Act as a lender of last resort

Determine monetary policy

Question 25

Monetary policy

Answer 25

The management by the central bank of liquidity conditions in the economy. Liquidity conditions refers to the price and availability of funding for the economy’s expenditure.

Question 26

There is a _____:
a.short-run trade-off between prices and interest rates

b. long-run trade-off between inflation and unemployment
c. short-run trade-off between inflation and unemployment
d. short-run trade-off between inflation and the money supply

Answer 26

ANS: CThe Reserve Bank of Australia (RBA) can choose to pursue the goal of “inflationary pressures” via the use of raised interest rates in order to reduce Aggregate Expenditures (AE) in the economy or it may choose to pursue the goal of “unemployment” by reducing interest rates in order to stimulate/ increase aggregate expenditures.Because the goal of inflation implies the use of high interest rates whilst the goal of unemployment implies the use of low interest rates, both goals cannot be successfully pursued by the RBA simultaneously. Further, the pursuit of one goal moves the economy further away from the attainment of the other goal. Therefore, there is a trade of between inflation and unemployment as the pursuit of one objective leads to worsening problems with the other objective.

Question 27

If the public switches from doing most of its shopping with currency to using cheques instead, and the Reserve Bank takes no action, the money supply will:

Answer 27

Increase

Cheques are a method of deferred payment where the exact amount is transferred out of the cheque

Question 28

If a bank uses $80 of reserves to make a new loan when the reserve ratio is 25 per cent, then:

Answer 28

The level of wealth in the economy will not have changed

New loans lead to an expansion of the money supply. Changes in true wealth however are linked to changes in GDP per capita. That is, the level of goods and services that each average person is endowed with. Increases in the money supply alone, that is not accompanied by increases in GDP per capita do not represent a true change in the wealth of a nation.

Question 29

A decrease in reserve requirements will likely result in banks:

Answer 29

A decrease in reserve requirements means that banks are now required to hold a smaller portion of deposits as required reserves. This means banks have more money available for creating loans. As banks create a larger number of loans, the money supply increases.

Question 30

If you withdraw $100 from your bank, then:

Answer 30

the reserves of your bank will initially fall by $100

Question 31

If banks choose to hold more excess reserves, then:

Answer 31

By holding more reserves, banks are implicitly making fewer loans so the money supply decreases.

Question 32

Store of value deteriorates when

Answer 32

There are inflationary expectations.

Money in currency form loses value when there is inflation because stored money is a fixed amount of money that does not increase in line with inflation. Specifically, when the prices of goods and services increase, stored money is worth less because it now exchanges for (buys) a smaller quantity of goods and services.