Week 19 - Chapter 22: Money and Prices [WIP]

Question 1

Money

Answer 1

An asset that can be used in making purchases.
It is not a measure of wealth but part of wealth.

Question 2

Reason for money

Answer 2

Makes bartering easier as people can trade for money rather than trading an amount of one item for an amount of another.
Allows people to specialise in producing different goods/services and use money to buy what they don’t make. This increases economic efficiency.

Question 3

Wealth

Answer 3

The value of all property including money and assets such as bonds, stocks, land, houses, furniture, cars, art etc.

Question 4

3 principle uses of money

Answer 4

• Medium of exchange: money can be used as an asset in purchasing goods and services
• Unit of account: money can be used as a basic measure of economic value for a variety of things. E.g., measuring stocks, wages, current accounts, financial assets, goods, services.
• Store of value: money as an asset can be used as a means of holding wealth – it allows you to retain purchasing power into the future as it is a store of a value. E.g., you can keep money in a banking account for spending later.

Question 5

Liquidity

Answer 5

The ease and speed at which an asset can be converted into a medium of exchange.

Question 6

Liquidity of money

Answer 6

Money is the most liquid asset of all as it is the medium of exchange – it doesn’t need to be converted into anything else to make purchases.
Moneys liquidity is the reason it is often used for purchase - using other assets requires transaction costs when they are converted to money.

Question 7

Reasons for holding money

Answer 7

• Illegal activities – drug/arms trafficking, tax evasion – cash is harder to trace than banking transactions.
• Corruption.
• Fear of political and economic instability, banking crises – if the banks or economy is unstable, it is safer to hold cash rather than keep money in banks in case they collapse.
• Fear of deflation and negative interest rates – prices will be lower in the future so keeping hold of cash will increase its value over time.

Question 8

Measuring the US money supply

Answer 8

M1 money supply: sum of currency outstanding and balances held in chequing accounts.
M2 money supply: all assets in M1 but including some assets that can be used in making payments but at a greater cost/inconvenience than using currency or cheques.

Question 9

Portfolio allocation decision

Answer 9

The decision about the forms to hold your wealth in.

Question 10

Demand for money

Answer 10

The amount of wealth an individual chooses to hold in the form of money

Question 11

Opportunity cost of holding wealth as money

Answer 11

The nominal interest rate i - the money you would earn if the wealth was not in the form of money.

Question 12

Money demand curve

Answer 12

Shows the relationship between aggregate quantity of money demanded (M) and the nominal interest rate (i).
The demand curve slopes down as increased nominal interest rate increases opportunity cost for holding money which reduces quantity of money demanded.
An increase in GDP or the price level will increase the amount of money that people want to hold.

Question 13

Bank reserves

Answer 13

Cash/similar assets held by commercial banks for meeting depositor withdrawals and payments.

Question 14

Fractional-reserve banking

Answer 14

A banking system where banks reserves are less than its deposits.
Fractional banking leads to the money multiplier effect - banks can lend more money than it physically has through cycles of lending and borrowing.

Question 15

Desired reserve ratio

Answer 15

Desired reserve ratio = bank reserves / bank deposits
Can be re-arranged to find deposits from initial reserves and desired reserve ratio: deposits = initial reserves / desired reserve ratio

Question 16

Currency value

Answer 16

The total amount of money held outside of banks.

Question 17

Money supply

Answer 17

currency value + total deposits
or
currency value + bank reserves/reserve deposit ratio

Question 18

Securitisation

Answer 18

Banks can pool similar illiquid assets such as loans and sell them to another financial institution in the form of securities like bonds.
It allows illiquid assets to be sold in the form of a liquid asset.
It can reduce risk as it spreads credit risk among various investors.

Question 19

The Federal Reserve

Answer 19

The central bank of the US.
It is responsible for conducting monetary policy and overseeing and regulating financial markets.

Question 20

Monetary policy

Answer 20

Deciding and manging the size of the nations money supply.

Question 21

Indirectly increasing money supply

Answer 21

Money supply and bank reserves can be increased by open market purchases of government bonds by the federal reserve from the public.
When the fed does on open market purchase of a bond from the public, the fed pays the bond holder with new money which then enters the economy and the bond which was not money, leaves the economy.
Receipts are deposited which leads to a multiple expansion of the money supply.

Question 22

Indirectly decreasing money supply

Answer 22

Money supply and bank reserves can be decreased by open market sales of government bonds by the federal reserve to the public.
When the fed does an open market sell of a bond to the public, the bondholder pays with checking funds (which was money) which then leaves the economy. The bond which is not money then enters the economy.
Bank reserves decrease which leads to a multiple contraction of the money supply.

Question 23

Money supply curve

Answer 23

The initial money supply set is not affected by nominal interest rate meaning the money supply curve is a vertical line.
Open market sales/purchases to/from the public causes the money supply curve to shift left/right.

Question 24

Money market equilibrium

Answer 24

Equilibrium interest rate where Money demand = money supply.
The central bank can decrease/increase nominal interest rate by increasing/decreasing money supply.
At the equilibrium interest rate the amount of money the public wants to hold is equal to the money supply.

Question 25

How were bank panics disincentivised

Answer 25

Deposit insurance was created which protects deposits of less than $250,000 by ensuring they will be repaid, even if the bank is bankrupt.

Question 26

Quantity theory of money

Answer 26

How the price level is determined and how it might change over time. It is used to explain long run determinants of price level and inflation rate.

Question 27

Nominal variables

Answer 27

Variables measured in monetary units.

Question 28

Real variables

Answer 28

Variables measured in physical units.

Question 29

Quantity equation

Answer 29

Money supply * Velocity = Nominal GDP (Price level * Real GDP) M * V = P * Y

Question 30

What does the quantity equation show

Answer 30

An increase in the quantity of money in an economy must be reflected in either: - rise in price levels - rise in quantity of output - fall in velocity of money

Question 31

According to the quantity equation, what is affected when the fed changes the money supply in the short run

Answer 31

Changes to the money supply causes proportionate changes in the nominal value of output (P * Y)

Question 32

Relationship between money and price level in the long run according to the quantity equation

Answer 32

Assuming both velocity and output remain constant, a 10% increase in money supply would cause a 10% increase in price level, in other words 10% inflation.

Question 33

Is output affected by money in the long run

Answer 33

No, because output is only affected by real factors like labour and capital, money does not affect output in the long run. Money is neutral in the long run - changes will only affect inflation in the long run. In the long run, real variables only affect other real variables and nominal variables only affect other nominal variables.

Question 34

Money neutrality

Answer 34

In the long run money is neutral to nominal variables, it will only affect real variables like inflation.

Question 35

Money velocity

Answer 35

A measure of the speed at which money circulates. Measures how frequently currency changes hands through transactions of final goods/services. Higher velocity is a sign that the same amount of money is being used for a number of transactions.

Question 36

Money velocity equation

Answer 36

Velocity = Nominal GDP / Money supply. V = P*Y / M

Question 37

What does a high money velocity indicate

Answer 37

High velocity indicates high inflation.

Question 38

Inflation tax

Answer 38

When governments raise revenue by printing money, it is said to levy an inflation tax on everyone who holds money. The "tax" is in the form of lost purchasing power from decreased value of money.

Question 39

Monetarism

Answer 39

Argues that Inflation is primarily a monetary phenomenon, caused by an excessive growth in the money supply. Argues that the government should control inflation by controlling the money supply, rather than through price controls or wage freezes etc.

Question 40

Fiscal Theory of Price Level (FTPL)

Answer 40

Argues that the price level in an economy is ultimately determined by the government's budget decisions, rather than by the quantity of money in circulation. According to FTPL, fiscal policy dominates monetary policy in determining price level. Argues that changes in government spending and taxation have a greater impact on the price level and inflation than changes in the money supply.

Question 41

Payment system

Answer 41

The method of conducting transactions in the economy.

Question 42

Commodity money

Answer 42

Any money made up of precious metals or another valuable commodity. Until a few centuries ago commodity money was the main medium of exchange but this was very heavy and hard to transport between places.

Question 43

Paper currency

Answer 43

Pieces of paper functioned as the main medium of exchange. Much easier to transport and exchange than commodity money. Paper currency was initially backed – its value was directly linked to the value of a commodity e.g., gold standard backed paper currency with gold. Paper currency came after commodity money.

Question 44

Fiat money

Answer 44

Paper currency that is not convertible into or tied to any commodity but that the government still declares as legal tender. It can be printed and changed at will and its value is determined by market forces like supply and demand. Today most countries in the world use fiat money

Question 45

Electronic payments

Answer 45

Any transaction initiated through an electronic terminal. More convenient, cheaper, faster and safer than paper payments

Question 46

E-money

Answer 46

Money that only exists in electronic form e.g., debit accounts, credit cards, e-cash (PayPal).

Question 47

What are the 2 tiers in the current payment system

Answer 47

- the public has digital accounts with commercial banks which they can make payments and withdraw physical cash. - commercial banks have digital accounts with the central bank which they use to settle payments and hold reserves.

Question 48

Cryptocurrency

Answer 48

A digital asset designed to be a medium of exchange. It is decentralised meaning it can be transferred between people without identification and with no centralised clearing authority. It is based on a network that verifies and records transactions using cryptography and blockchain technology.

Question 49

Central Bank Digital Currencies (CBDC)

Answer 49

Public/ central bank issued digital currencies. Inspired by bitcoin but are not cryptocurrencies and do not use a distributed ledger such as a blockchain. Its value is fixed by the central bank and is equivalent to the countries fiat currency.

Question 50

Pros and cons of Central Bank Digital Currencies (CBDC)

Answer 50

+ Fast secure and has low transaction costs and can allow people without bank accounts to engage in different transactions. - Not tested in periods of crisis and might not affect monetary policy transmission. It also gives the central bank a lot of power.