Money Prices And Inflation

Question 1

3 functions of money

Answer 1

Medium of exchange
Unit of account
Store of value

Question 2

M1 (narrow) money examples (3)

Answer 2

Currency
Bank deposits
Financial instruments e.g credit cards

Question 3

M0, m2, and m3

Answer 3

M0 -monetary base (currency)
M1 - money as means of payment (3 given earlier)
M2 - M1+ non transactions deposits which can be converted rapidly into money
M3 - highly liquid stores of value such as money market funds
M4 - broad money supply

Question 4

Money supply formula

Answer 4

M=Ch+D

M= money supply
Ch =household demand for currency
D = demand deposits

Question 5

How do we find D?

Answer 5

Use concept of fractional reserve banking

Question 6

Fractional reserve banking (slide 135 Mankiw)

Answer 6

In FRACTIONAL reserve banking, banks hold a fraction of their deposits in reserves, and lend out the rest.

The borrower of “the rest” can continue the money creation process, putting in a bank, who will also hold a fraction in reserves, and lend out again.

So with each deposit and loan, more money created.

Question 7

What is the formula for to work out the total amount of money the original deposit can make?

Answer 7

(1/rr) to the n x original deposit

N is the number of lending rounds.
Rr is the reserve deposit ratio
E.g if deposit is 1000, and 200 is kept in reserve, rr=0.2.

Question 8

Is this fractional reserve banking realistic in real life?

Answer 8

In reality banks have other sorts of assets e.g securities to protect them against sudden liquidity issues.

Question 9

What is the total increase in deposits?

Answer 9

Initial deposit / fraction of reserve (rr)

Question 10

So we have the narrow definition of money
M = Ch + D

What assumption do we have to make

Answer 10

Ch = cD

A proportion (c) of deposits (D) are held as currency
E.g c=0.05, 5% of deposits are held as currency

For banks, Cb = kD
A proportion k of deposits are held as reserves.

Question 11

What can we find from this?

Answer 11

The monetary base (B), since total currency held must be held by either banks or households.

Question 12

So what is the monetary base equation (B)

And from this, what is the D formula?

Answer 12

B= Ch + Cb = cD + kD

We can expand the last one to B = D(c+k) , and rearrange to find D

D=B/(c+k)

Then, using the narrow money supply definition we can sub our D value in to get…

M= cD + D = (1+c)D = (1+c)/c+k x B

Question 13

Then, using the narrow money supply definition we can sub our D value in to get…

Answer 13

M= (1+c)/c+k x B

B is monetary base
The rest is the money multiplier.

(Shown in prev card repeat)

Question 14

What can we observe from this money supply equation: what is money supply a function of?

Answer 14

Money supply is a function of B (monetary base) and parameters c and k (cash, and reserve ratio)

Question 15

Ways to control the money supply (5)

Answer 15

Open market operations

Lender of last resort

Auction

Changing interest rates

Required reserve ratio

Question 16

Open market operations

Answer 16

Central bank buy/sell government bonds to increase the monetary base.

Central bank buys securities to increase the base, sell to remove money from system.

Question 17

Lender of last resort

Answer 17

Lend directly to banks through the discount window, with an adjustable interest rate.

Question 18

Auction

Answer 18

Central banks can announce in advance the amount of funds they will lend, and then banks bid.

Question 19

Changing interest rates

Answer 19

Reserves can earn interest can be changed.

Question 20

Required reserve ratio and example country

Answer 20

Require banks to hold a particular ratio in reserves.

E,g China

Question 21

Money supply and monetary base during the Great Depression (application)

Answer 21

Monetary base increased (by Q.E) , but money supply fell. (Total currency held increased, but money in circulation fell since banks held more in reserves k increased, and households held more cash c)

Using the equation, we can see B increased. So for M to fall, the money multiplier 1+c/c+k must’ve fell.

Question 22

Why did the money multiplier 1+c/c+k fall

Answer 22

Banks held more in reserves (higher K)

Household held more in cash (c)

Question 23

Monetary supply during pandemic

What risk was there?

Answer 23

Large growth rate in money supply (M) as households held more MONEY (Ch) (NOT THE SAME AS CASH C)

This growth could cause inflation, however controlled by increased interest rates and a rollback of QE.

Question 24

Fiat money

Answer 24

money without intrinsic value e.g notes, which would have little value if not widely accepted as money

Question 25

in a bank sheet, what are the 3 assets vs liabilities

Answer 25

Assets
reserves
loans
security

Liabilities
Deposits
Debt
Capital (owners equity)

Question 26

Leverage ratio:

Answer 26

banks total assets to banks capital.

Question 27

What would an fall in the currency-deposit ratio do?

Answer 27

Fall in c would increase money multiplier and money supply.

Question 28

What would an decrease in the reserve-deposit ratio do?

Answer 28

A fall in k would increase MM and money supply