Macroeconomics 3
Quantity Theory of Money
-a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate
Central bank
-an institution designed to oversee the banking system and regulate the quantity of money in the economy
Medium of exchange
-an item that buyers give to sellers when they want to purchase goods and services
Store of value
-an item that people can use to transfer purchasing power from the present to the future
Money refers to what?
-assets that people regularly use to buy goods and services from other people
The economies output of goods and services (Y) is determined by
-available resources and technology -money is neutral, changes in money supply do not affect output
Demand deposits
-balances in the bank accounts that depositors can access on demand by writing a check
If banks hold all deposits in reserve
-banks do not influence the supply of money
What are the ways that people try to get ride of excess supply?
-buy goods and services with the excess funds -make loans to others by buying bonds or depositing the money in a bank account (these loans are then used to buy goods and services)
Principle of monetary neutrality asserts?
-changes in the quantity of money influence nominal variables but not real variables
Persistent growth in the in the quantity of money supplied leads to?
-continuing inflation
Second job that the Fed performs is?
-control the quantity of money available in the economy
The immediate effect of an increase in money supply is to
-create an excess supply of money
Higher-than-expected inflation transfers purchasing power from
-creditors to debtors
Lower-than-expected inflation transfers purchasing power from
-debtors to creditors -deflation increases the real value of debt
The sale of government bonds
-decreases the money supply
Reserves
-deposits that banks have received but have not loaned out
Higher Discount Rate
-discourages banks from borrowing from the Fed and likely encourages banks to hold onto larger amounts of reserves -lowers the money supply
We use money to measure
-economic transactions
Lower Discount Rate
-encourages banks to lend their reserves (and borrow from the Fed) - increase the money supply
Hyperinflation ends when
-government cuts its spending and eliminates the need to create more money
The demand of money reflects
-how much wealth people want to hold in liquid form
If inflation is unexpected
-imposes risk on both creditors and debtors
The purchase of government bonds
-increases the money supply
When Fed increases the rate of growth of the money supply
-inflation rate increases, this will lead to increase in nominal interest rate
When central bank increases the supply of money then-
-it causes the price level to rise
If the Fed wants to increase money supply
-it creates dollars and uses them to purchase government bonds from the public through the nations bond market
If the Fed wants to decrease money supply
-it sells government bonds from its portfolio to the public -money is then taken out of the hands of the public and the supply of money falls
When central banks change the quantity of money (M)
-it will change the nominal value of output (P*Y)
Large increase in money supply leads to
-large amount in inflation
The amount of money created by banking systems depends on?
-loans made
A high value of money means
-low price level
To calculate velocity
-nominal GDP/money supply -velocity = P(price level, GDP deflator) * Y(real GDP) / M(quantity of money)
Tax laws do not deferentiate between
-nominal and real interest rate income and capital gains
What 2 groups should economic variables be divided into?
-nominal variables -real variables
Changes in money supply effect
-nominal variables but not real variables
Fisher Effect
-one application of the principle of monetary neutrality -when inflation rate rises the nominal interest rate rises at the same amount so that the real interest rate remains the same
Fiat Money
-paper dollars -money without intrinsic value, would be worthless if not used as money
If the price level is below equilibrium
-people will want to hold less money than than available and price will rise
If the price level is above equilibrium level
-people will want to hold more money that is available and prices will decline
What are important macroeconomic variables?
-production -employment -real wages -real interest rates
One of the jobs performed by the Fed is?
-regulation of banks to insure the health of the nation's banking system -monitors each banks financial condition and facilitates bank transaction by clearing checks -makes loans to banks they want or need to borrow
Reserve Requirements
-regulations of the minimum amount of reserves that banks must hold against deposits -this can affect the size of the money supply through changes in the money multiplier -the Fed rarely uses this because of the distribution in the banking industry that would be caused by frequent alterations of reserve requirements
Debtors
-repay their dept with dollars that aren't worth much -hyperinflation diminishes the real value of debt
Commodity Money
-such as gold -money that has intrinsic value, would be valued even if not used as money
Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money
-supply of money shifts to the right -the equilibrium value of money falls and the price level rises
The supply of money is determined by
-the Fed -meaning that the quantity of money supplied is fixed until the Fed decides to change it -meaning that the supply of money will be vertical
Money Multiplier
-the amount of money the banking system generates with each dollar of reserves
Most economist believe that monetary neutrality describes
-the behavior of the economy in the long run
Federal Reserve (Fed)
-the central bank of the United States
Mean Costs
-the cost of changing prices -during period of inflation firms must change their prices often
The overall price level adjusts to the level at which
-the demand for money equals the supply of money
If the sale or purchase of government bonds affects the amount of deposits in the banking system
-the effect will be made larger by the money multiplier
Reserve Ratio
-the fraction of deposits that banks hold as reserves
What are the different patterns that most hyperinflation follows
-the government has a high level of spending and inadequate tax revenue to pay for its spending -the government's ability to borrow funds is limited as a result is turns to printing money for its spending
Growth in the money supply determines
-the inflation rate
Discount Rate
-the interest rate of the loans that the Fed makes to banks
The higher the price level
-the more money needed for transaction -a higher price level (and a lower value of money) leads to a higher quantity of money demand
The more money households deposit
-the more reserves the bank has and the more money the banks system can create
If inflation catches borrowers and lenders by surprise
-the nominal interest rate will fail to reflect the rise in prices
Currency
-the paper bills and coins in the hand of the public
One variable that is important in determining the demand for money is
-the price level
Open Market Opportunity
-the primary way in which the Fed increases or decreases the supply of money -which involves the purchase or sale of U.S. government bonds
Monetary Neutrality
-the proposition that changes in money supply do not affect real variables
Open Market Opportunity
-the purchases and sales of U.S. government bonds by Fed -are easy for the Fed to conduct and are therefore the tool of monetary policy
If P is price level then
-the quantity of goods and services that can be purchased with $1 is equal to 1/P
Money Supply
-the quantity of money available in the economy
Money stock
-the quantity of money circulating in the United States
Velocity of Money
-the rate at which money changes hands
The supply and demand for loanable funds determines
-the real interest rate
Shoeleather costs
-the resources wasted when inflation encourages people to reduce their money holding -this cost can be considerable in countries experiencing hyperinflation
When central banks increase money supply rapidly
-the result is a high level of inflation which in result leads to hyperinflation
Increase in the money supply makes dollars more plentiful
-the result is an increase in the price level that makes each dollar less valuable
Inflation Tax
-the revenue that the government raises by creating money
Monetary Policy
-the setting of the money supply by policymakers in the central bank
Federal Funds Rate
-the short term interest rate that banks charge one another for loans
The less money households deposit
-the small the amount the reserves banks have and the less money the bank system creates
The value of money is determined by
-the supply and demand for money
Classic Dichotomy
-the theoretical separation of nominal and real variables
Unit of account
-the yardstick people use to post prices and record debts
Relative prices are real
-they are not measured in money terms
Prices in economy are nominal
-they are quoted in units of money
Nominal Variables
-variables measured in monetary units
Real Variables
-variables measured in physical units
P increases
-when there is a change in M
Money Multiplier Equation
1/reserve ratio
Real Interest Rate Equation
nominal interest rate-inflation rate
Nominal Interest Rate Equation
real interest rate+inflation rate
Fisher effect
the one-for-one adjustment of the nominal interest rate to the inflation rate
Money serves 3 functions
-1st) it serves as a medium of exchange, provides item used to make transaction -2nd) it severs as a unit of account, provides the way in which prices and other economic values are record -3rd) it serves as a store of value,provides a way of transferring purchasing power from the present to the future
The Inflation Fallacy
-As price rises so does income which means that inflation does not reduce the purchasing power of incomes. This implies that the higher prices paid by the consumers are exactly offset by the higher incomes received b the seller. Individuals often get pay increases over time to compensate for increases in the cost of living.
Quantity Equation
-M*V=P*Y -which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services -price level must rise, output must rise, or velocity must fall -explains how the increase in the quantity of money effects price level
M*V=P*Y
-M=quantity of money -V=velocity -P=price level, GDP deflator -Y=real GDP
Many people think that inflation what?
-Many people think that inflation makes them poorer because it raises the cost of what they buy, this view is false because inflation also raises nominal income
Fractional Reserve Banking
-a banking system in which banks hold only a fraction of deposits as reserves