Week 8 - Monetary policy & inflation

Question 1

3 functions of money

Answer 1

• A medium of exchange - it’s an accepted means of payment for the delivery of goods
• A unit of account - it describes the units in which prices are quoted and accounts are kept
• Store of value - It allowes future purchases

Question 2

Measure money supply through monetrary aggregates (M’s)

Answer 2

• M0 is the narrowest definition covering notes & coins in circulation as well as notes & coins in bank vaults
• M3 is the broadest definition covering notes & coins in circulation, demand, time and saving deposits including OCD and large time deposits
• MB is the monetary base that the central bank can control

Question 3

3 motives why people demand money

Answer 3

• Transactions motive
• Precautionary motive
• Speculative motive

Question 4

Consumer real money balances formula

Answer 4

Question 5

What is the relationship between consumer demand and real money balances? (3)

Answer 5

• Consumers demand money based on what it can buy
• If prices are rising then the value of the money in your wallet is falling
• If prices are falling then the value of money in your wallet is increasing

Question 6

Define transactions demand motive

Answer 6

As real income (Y) increases people demand more money to make transactions

Question 7

Define precautionary demand motive

Answer 7

Based upon psychology where money is demanded due to the possibility of unforeseen circumstances

Question 8

Define speculative demand motive

Answer 8

This is based on interest rates (r), if they go up buy bonds and reduce your demand for money

Question 9

What do the movements along and shifts on a demand for money graph show? (2)

Answer 9

• Movements along the curve show the speculative motive I.e as interest rates (r) increases the demand for money falls
• Shifts shows the transactions motive I.e as real income increases the demand for money, for a given interest rate increases

Question 10

Supply of money - role of the central bank (5)

Answer 10

• The supply base money in the economy is determined by the central bank
• The money supply curve is therefore perfectly inelastic
• In order to expand or contract the money supply the central bank implements an open market operation
• This means buying of selling governments bonds in the actual money markets
• Only the central bank has the power to print money

Question 11

Equilibrium in the money market (4)

Answer 11

• Equilibrium is where MS = MD which is the demand for real money balances = the supply of real balances
• MS is perfectly inelastic and fixed by the central bank
• In the short run money demand will be quite stable and is that continues the central bank can decide the rate of interest
• Once the interest is decided then all other interest rates in the economy adjust with it

Question 12

How can the central bank reduce interest rates?

Answer 12

• Performs an open market operation by printing money electronically and buying government bonds
• This increases the supply of money in the economy so MS shifts from MS1 to MS2
• The reduction in the interest rates increases the speculative demand for money so there is a greater amount of liquidity in the system (L1 to L2)

Question 13

Define inflation

Answer 13

Is the percentage increase in prices over a defined period of time and is always positive

Question 14

Define deflation

Answer 14

• Is the percentage decrease in prices over a period of time
• It’s always negative but doesn’t occur often

Question 15

Define disinflation

Answer 15

Is a situation where prices are increasing at a decreasing rate

Question 16

7 factors that outline the cost of inflation

Answer 16

• Redistribution of wealth from savers to borrowers
• People on fixed income see their standard of living fall
• Disruption of business planning (e.g menu costs)
• Cost of transacting increases (shoe leather costs)
• . Erodes UK competitiveness
• Price mechanism distorted
• Wage price spiral

Question 17

Role of the Bank of England in Uk monetary policy framework (3)

Answer 17

• Bank of England’s objective is to deliver stability through low inflation and support the governments economic objectives
• Price stability is defined by the government’s inflation target of 2%
• The BOE has independent control over the rate of interest in order to meet the target and it is accountable to Parliament and the public for meeting it

Question 18

Role of monetary policy committees (MPC) in the UK monetary policy framework

Answer 18

aim is to set interest rates so that inflation can be bought back to target within a reasonable time frame without creating undue economic instability

Question 19

What is quantitative easing (QE)?

Answer 19

Is where the BOE purchases securities of a more long run nature in order to inject even more cash in the economy (£375 billion in the UK)

Question 20

Forms of monetary policy (4)

Answer 20

• Gold standard
• Exchange rate targeting
• Money supply targeting I.e monetarism
• Nominal GDP targeting I.e market monetarism

Question 21

How does the monetary transmission mechanism work? (3)

Answer 21

• As the interest rate falls this fizzles through to market interest rates (I.e mortgages, bank loans)
• This as result boosts domestic demand this will then create inflationary pressure
• If exchange rates fall import prices become greater which also feeds through into inflationary pressure