Week 6 Flashcards
(21 cards)
What are the three main functions of money?
Money serves as:
- Medium of Exchange: Used to purchase goods/services.
- Unit of Account: Provides a standard measure for pricing and wages.
- Store of Value: Retains value over time, functioning as an asset.
What is seigniorage?
Seigniorage is the profit earned by the government from issuing currency, as money is supplied by a government monopoly.
How is M1 defined in the context of money supply?
M1 includes currency held by the public and current deposits.
What is the difference between M3 and Broad Money?
M3 includes M1 plus all bank deposits, while Broad Money adds borrowings by non-bank depository corporations, subtracting currency and deposits held by these entities.
What is the Quantity Equation of Money?
The Quantity Equation is 𝑀𝑉=𝑃𝑌, where:
𝑀 = Money supply
𝑉 = Velocity of money
𝑃 = Price level
𝑌 = Real GDP, with 𝑃𝑌 representing Nominal GDP.
According to the Quantity Theory of Money, what happens if 𝑀 increases, assuming 𝑉 and 𝑌 are constant?
If 𝑀 increases while 𝑉 and 𝑌 are constant, then 𝑃, the price level, must increase, leading to inflation.
What is the relationship between money supply and inflation in the long run?
In the long run, inflation is a monetary phenomenon, meaning that a sustained increase in the money supply leads to inflation, with money considered neutral in affecting real output.
What is the fractional reserve banking system?
Fractional reserve banking allows banks to hold only a fraction of deposits as reserves, using the rest to make loans, which effectively creates money through the money multiplier.
How is the money multiplier calculated?
Money Multiplier = 1 / reserve ratio.
For example, with a reserve ratio of 10%, the money multiplier is 1 / 0.1 = 10.
What are the RBA’s primary objectives in monetary policy?
The RBA aims to control inflation, targeting a rate of 2-3%, which is low enough to avoid economic distortions, providing a stable anchor for inflation expectations.
How does the RBA set the cash rate?
The RBA uses Open Market Operations (OMO) to influence the overnight cash market rate, buying or selling securities to adjust the supply of funds and maintain the target cash rate.
What is the relationship between bond prices and interest rates?
Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa, as bond yields adjust to reflect current rates.
How does the cash rate affect other interest rates?
Changes in the cash rate influence the entire yield curve, affecting borrowing costs across various loan types and terms, ultimately impacting consumption and investment.
What is an Open Market Operation (OMO)?
OMO involves the RBA buying or selling financial assets to control the cash rate. Buying assets injects cash, lowering rates; selling assets withdraws cash, raising rates.
How does a reduction in the cash rate affect the economy?
Lowering the cash rate reduces borrowing costs, encouraging spending and investment, which can stimulate economic activity and reduce unemployment.
What is inflation targeting?
Inflation targeting is a policy framework where the RBA aims to keep inflation within a set range (2-3%) to maintain price stability and manage inflation expectations.
What is the Taylor Rule, and how does it guide interest rate policy?
The Taylor Rule suggests setting the nominal interest rate based on the inflation gap (difference from target) and output gap, providing a systematic approach to adjusting rates.
How does the real interest rate affect aggregate expenditure?
Higher real interest rates reduce aggregate expenditure by discouraging consumption and investment, while lower rates have the opposite effect.
In the context of aggregate expenditure, what is PAE?
Planned Aggregate Expenditure (PAE) represents total planned spending in the economy, calculated as PAE = C + I_p + G + NX.
What role does the RBA play in managing the output gap?
The RBA adjusts interest rates to influence spending and close the output gap. Lower rates stimulate demand in a recession, while higher rates curb inflation in an expansion.
How does the output gap inform the RBA’s policy decisions?
A positive output gap suggests potential inflationary pressures, leading to rate hikes, while a negative output gap indicates slack in the economy, prompting rate cuts.
