Lecture 4

Question 1

Things that can shift savings curve

Answer 1

• Public saving: fiscal policy changes in G or T
• Private saving: preferences + tax laws that affect saving e.g. replace income tax with consumption tax

Question 2

Things that can shift investment curve

Answer 2

• Certain technological innovations: to take advantage of the innovation, firms must buy new investment goods
• Tax laws that affect investment: investment tax credit

Question 3

Real interest rate model

Answer 3

Compares todays vs tomorrows prices: r determined by demand for tomorrow’s consumption (investment) = supply of today’s consumption (savings)

Question 4

Money

Answer 4

An asset that can be immediately liquidated to carry out transactions

Question 5

What counts as money?

Answer 5

• Cash and coins are money
• Debit card can be considered money
• Credit cards are not money as they just enable the user to delay the payment (take out a short term loan)

Question 6

4 functions of money

Answer 6

1. Medium of exchange
2. Store of value
3. Unit of account
4. Liquidity

Question 7

Medium of exchange: money is liquidity

Answer 7

• Users agree that it can be used for transactions
• Solves double coincidence of wants

Question 8

Store of value

Answer 8

• Can be saved to be used for future transactions
• Since we agree it can be used for transactions, we can hold on to it and use it whenever we want to
• Although the real value will depreciate

Question 9

Unit of account

Answer 9

• Used to express prices (relative values)
• Can compare all goods and services in a single unit since we all agree to use it

Question 10

Liquidity

Answer 10

Easy access to funds, facilitates markets

Question 11

Types of Money

Answer 11

1. Commodity money
2. Fiat money
3. Cryptocurrencies

Question 12

Commodity money

Answer 12

• Has intrinsic value
• E.g. coconuts, gold
• We agree that it can be used to buy/sell various goods and services

Question 13

Fiat money

Answer 13

• No intrinsic value, gov backed
• The coins and paper bills that we are used to
• Only has value because we agree that we can trust the gov that issued it
• Debit cards (checking accounts) are also at money since it can be used exactly in the same way as coins and bills

Question 14

Cryptocurrencies

Answer 14

• No intrinsic value, nor government-backed
• If at some point, we all agree it can be used for all transactions, it can become money

Question 15

From commodity money to fiat money

Answer 15

• Commidity money: makes sense to use something most people agree have value as money
• Various forms of commodity money existed even in prehistoric era
• Gold, silver or bronze played role of money until recent
• Gold standard largely abandoned during interwar period
• Fiat money: How did worthless pieces of paper become money?
• Checking purity of gold was hard, so govs standardised them
• Carrying around gold was hard, so govs started issuing gold-backed securities
• Nobody cared to actually ask the gov back for gold, so the pieces of paper became money

Question 16

100% reserve banking

Answer 16

Has no impact on size of money supply

Question 17

Fractional reserve banking

Answer 17

• Banks create money in a fractional reserve banking system but it doesn’t create wealth
• In reality, the CB restricts banks to hold at least some reserves: reserve requirements
• Then banks may hold more: excess requirements
• So rr = R/D = (required+excess)/deposits

Question 18

Money supply

Answer 18

Ms = C + D
- Amount people think they can use
- Because D (deposits) affect money supply, only certified banks are allowed to create such checking accounts
- Other financial intermediaries are not allowed to create such account

Question 19

Monetary base

Answer 19

B = C + R
- Amount that was actually issued
- Available amount if everyone tries to withdraw all their deposits at the same time

Question 20

CB can affect either rr or B

Answer 20

1. Lenient reserve policy
2. But if rr is too low banking system too risky: becomes more likely that banks do not have enough reserves for people to withdraw their deposits from bank runs
3. More often CB tries to control B

Question 21

How would CB control monetary base, B?

Answer 21

• An easy way is to just print more money
• In reality CB alters B through open market operations: buy and sell gov bonds (issued by treasury)

Question 22

Lender of Last Resort

Answer 22

CB can also lend to banks so that they increase their reserves

Question 23

Discount rate

Answer 23

Interest rate at which banks borrow from CB

Question 24

What does it mean when CB increased money supply?

Answer 24

• It means that they lowered the discount rate
• Becomes cheaper for banks to borrow so they can borrow more from CB
• At the same time since interest rates are lower banks sell bonds to CB because bonds are a form of saving

Question 25

Reserve requirement

Answer 25

- The CB may impose a minimum reserve deposit ratio - Lowering the rr ratio requirement increases the money supply - BoE does not have a reserve requirement but keeps a check on reserves via averaging reserves over a given period + agreeing a target with banks

Question 26

Interest on excess reserves

Answer 26

- The CB has current accounts for banks to hold their excess reserves which pays interest usually in line with the bank rate - If interest paid on excess reserves is low then banks want to keep less reserves deposited at the CB and the rr ratio decreases (money increases)

Question 27

What does the central bank care about?

Answer 27

- Independent Central Banks care about keeping the economy healthy, e.g. price stabilisation, output stabilisation, low unemployment, liquidity and smooth market functioning - Some central banks explicitly state their monetary policies - Inflation targetting: BoE: price stability = 2% target with 1% band ECB: price stability = less than 2% inflation - Employment target, stable prices, and moderate long-term interest rates: US Fed + recently, BoE

Question 28

How much Ms actually changes depends on:

Answer 28

1. cr: how much currency is held by consumers instead of being saved 2. rr: how much reserves are held by banks whether by choice or law - If (cr, rr) falls => more loans => more money circulated (increased Ms)