Chapter 4 Flashcards
(24 cards)
What kinds of money are there? + basic info on money
Currency: coins and bills
Checkable deposits: the bank deposits on which you can write checks or use a debit card.
Having money is free, but will pay no interest.
Basic info on bonds
Bonds pays a positive interest rate, i, but cannot be used for transactions.
Buying or selling bonds implies costs, for example call to broker and transaction fee.
How to determine how much money vs bonds?
Depends on:
Your level of transactions
The interest rate on bonds
What are money market funds?
Money market funds: pool together funds of many people. These are then used to buy bonds, typically government bonds. Pay an interest rate close to but slightly below the interest rate on the bonds they hold.
How do you derive the demand for money?
The amount of money people demand = Md
The sum of all individuals and firms’ demand. Therefore it depends on the overall level of transactions in the economy and on the interest rate.
The overall level of transactions is roughly proportional to nominal income —> if nominal income increases by 10%, it’s reasonable to think that the dollar value of transactions in the economy would also increase by roughly 10% —> a relation between demand for money, nominal income and interest rate
Md = $Y L(i) (-)
The demand for money is equal to nominal income times a decreasing function of the interest rate. Interest rate has a negative effect on money demand. An increase in the interest rate decreases the demand for money.
Basic conclusions on money demand
The demand for money increases in proportion to nominal income.
The demand for money depends negatively on the interest rate.
For a given interest rate, an increase in $Y increases the demand for money and shifts the money demand curve.
What is equilibrium in financial markets?
Md = MS.
Since MS = M,
M = $Y L(i)
This equation tells us that the interest rate i must be such that, given their income $Y, people are willing to hold an amount of money equal to the existing money supply.
What does a higher interest rate do to demand and supply of money?
A higher interest rate implies a lower demand for money.
The supply of money is independent of the interest rate.
How do changes in $Y affect the equilibrium?
An increase in nominal income increases the level of transactions which increases the demand for money at any interest rate. Shifting the money demand curve to the right. For a given money supply, and increase in nominal income leads to an increase in the interest rate. Because at the initial interest rate, the demand for money exceeds supply. The increase in interest rate decreases the amount of money people want to hold and reestablishes equilibrium.
How do changes in MS affect the equilibrium?
An increase in money supply of money by the central bank leads to a decrease in the interest rate. Shifts the money supply curve to the right. The decrease in the interest rate increases the demand for money so it equals the now larger money supply.
What are open market operations?
Central banks typically change the supply of money through buying or selling bonds in the bond market.
If a central bank wants to increase the amount of money in the economy it buys bonds and pays for them by creating money.
If it wants to decrease the amount of money it sells bonds and removes from circulation the money it receives in exchange for the bonds.
What is a balance sheet?
Balance sheet: a list of its assets and liabilities at a point in time. The assets are the sum of what the bank owns and what is owed to the bank by others. The liabilities are what the bank owes to others.
The assets of the central bank are the bonds it holds in its portfolio. Its liabilities are the stock of money in the economy. Open market operations lead to equal changes in assets and liabilities.
What is Expansionary open market operations?
Expansionary market operations: if the central bank buys 1 million dollar worth of bonds, the amount of bonds it holds is 1 million higher, and so is the amount of money in the economy.
central bank buys bonds and pays for them by creating more money. —> demand for bonds goes up which increases their price. —> the interest rate goes down. —> the central bank has increase the money supply. And vice versa with decreasing money supply.
What is Contractionary open market operations?
Contractionary open market operations: if the central bank sells 1 million dollar worth of bonds, the amount of bonds it holds is 1 million lower, and so is the amount of money in the economy.
Basic info on bond markets
What is determined in bond markets are the bond prices, not the interest rates. From this we can derive the interest rate.
Price of a bond today = $PB
If a bond promise a payment of $100 in a year from now, if you buy the bond now the rate of return on holding the bond for a year is ($100 - $PB) / $PB = I
The higher the price of the bond the lower the interest rate.
The lower the interest rate the higher the price of the bond.
If hearing “bonds went up today” it means that the prices of bonds went up and therefore the interest rates went down.
Choosing money or choosing interest rate?
The central bank usually carries this through by choosing interest rate in today’s economies. They typically think about the interest rate they want to achieve and then move the money supply so as to decrease money supply today.
What are financial intermediaries?
Financial intermediaries: institutions that receive funds from people and firms and use these funds to buy financial assets or to make loans to other people and firms.
The assets of these institutions are the financial assets they own and the loans they have made. Their liabilities are what they owe to the people and firms from whom they have received funds.
Banks are one type. Their liabilities are money. People can pay for transactions by writing checks up to the amount of their account balance.
Why do banks keep reserves?
There’s no reason for inflows and outflows of the bank to be exact equal.
What one bank owes to another bank can be larger or smaller than what the other bank owes to it.
Banks are required to hold reserves.
Loans represent ca 70 % of a bank’s non reserve assets. Bonds - 30 %.
What are the liabilities of a bank?
Since people anytime can withdraw all the money they have in the bank, the liabilities of the bank = the value of these checkable deposits.
What is the liquidity trap?
The interest rate cannot go below zero: zero lower bound.
When the interest rate is down to zero, monetary policy cannot decrease any further. Monetary policy no longer works, and the economy is said to be in a liquidity trap.
What happens when the interest rate becomes zero?
Once people hold enough money for transaction purposes, they are then indifferent between holding the rest of their financial wealth in the form of money or in the form of bonds. The reason they are indifferent is that both money and bonds pay the same interest rate, namely zero.
As the interest rate decreases, people want to hold more money (and thus fewer bonds): the demand for money increases.
As the interest rate becomes = 0, people want to hold an amount of money equal to the distance OB (graph). But they’re willing to hold even more money (and therefore fewer bonds), because they are indifferent between money and bonds.
If the central bank increases the money supply the interest rate first moves from A to B. If it would continue to increase the money supply it would have no effect on the interest rate.
What does demand for money depend on?
… negatively on the interest rate i: the higher i, the more you want to hold bonds rather than money
… positively on the level of transactions: the more you spend, the more money you need to have available for your purchases. Use nominal income $Y as a proxy (more income→more spending→more transactions)
What happens with money demand when interest rate increases? What happens when nominal income changes?
When the interest rate decreases, money demand increases (and vice versa), we move along the money demand curve.
→ The interest rate is on one of the 2 axes.
When nominal income changes, the money demand curve shifts
upwards or downwards.
→ Nominal income is NOT on one of the 2 axes.
Why this difference? Because the interest rate is an endogenous variable (=determined within the model, an equilibrium object), but the nominal income is an exogenous variable (=determined outside of the model).
Explain expansionary and contractionary open market operations
Expansionary open market operations: purchase of bonds, increase in money supply
Contractionary open market operations: sale of bonds, decrease in money supply
What happens when the central bank keeps increasing the supply of central bank money?
As the central bank keeps increasing the supply of money, the interest rate will eventually decrease so far that it hits zero. Any further monetary policy will have no effect on i
When the interest rate is equal to zero, people are indifferent between holding their wealth in currency or in bonds. The interest rate cannot become negative otherwise the demand for bonds by households will be zero.
