Introduction to Money and Monetary Theory

These flashcards cover key concepts related to money, monetary systems, and the quantity theory of money, providing definitions and explanations crucial for understanding the topic.

Money

Any liquid asset used to settle transactions.

Functions of Money

1. Store of value - transfer purchasing power into the future. 2. Unit of account - measuring stick for prices. 3. Medium of exchange - what you use to buy goods/services.

Reasons for Holding Money

1. Speculative: waiting for better investment opportunities. 2. Precautionary: emergencies. 3. Liquidity: flexibility in asset mix. 4. Transactions: day-to-day purchases.

Barter

A monetary system requiring double coincidence of wants.

Commodity Money

Money backed by a commodity such as gold or silver.

Fiat Money

Money backed only by government decree.

M0

Currency + reserves.

M1

M0 + chequing deposits.

M2

M1 + savings deposits.

M3

M2 + term deposits.

M2+

M2 + credit union deposits, money market funds, etc.

Monetary Policy Tools

1. Reserve ratios 2. Government deposits 3. Foreign asset transactions 4. Open market operations 5. Bank rate (overnight rate).

Purpose of Changing Money Supply

To influence interest rates, exchange rates, inflation, real GDP, and unemployment.

Quantity Theory of Money (QTM) Core Identity

MV = PY.

Long-Run Theory of QTM

Velocity (V) is assumed constant.

Money Market Equilibrium

MS = Md.

QTM Result #1

Money supply determines nominal GDP in the long run.

QTM Result #2

Money supply determines the price level in the long run.

QTM Result #3

One-to-one relationship; if MS doubles, price doubles in the long run.

No Money Illusion

Real GDP is fixed in the long run, only price adjusts.

QTM Result #4

Inflation is a monetary phenomenon; growth rate form: ΔMM = π + ΔY.

Expected Inflation and Money Supply Growth

If Y and V are constant, π = ΔMM.

QTM Result #5 - Fisher Effect

i = r + π; r is determined by savings & investment.

Interest Rate Adjustment

Interest rate adjusts one-for-one with inflation.

Expected Fisher Effect

i = r_e + π_e; if expected MS growth increases, expected inflation increases.

Inflation Surprises: Correct Expectations

π = πᵉ.

Inflation Surprises: Unexpected Inflation

π > πᵉ → borrowers gain.

Inflation Surprises: Overestimated Inflation

π < πᵉ → lenders gain.

Classical Dichotomy in the Long Run

Nominal variables do not affect real variables.

Real vs Nominal Economy

Real economy and nominal economy are separate.

Role of Central Banks

Central banks use monetary policy to control the money supply.

Types of Monetary Systems

1. Barter 2. Commodity money 3. Fiat money.

M0 Definition

A measure of the money supply consisting of physical currency and reserves.

Importance of Liquidity in Money Holdings

Liquidity allows flexibility in asset mix.

Impact of Monetary Policy on Real GDP

Monetary policy can influence real GDP in the short run.

Consequences of Unexpected Inflation

Borrowers benefit when inflation is higher than expected.

Long-Run Effects on Price Level

In the long run, monetary supply affects the price level.

Real GDP Stability

Real GDP is fixed in the long run while prices adjust.

Short-Term vs Long-Term Monetary Policy Effects

Monetary policies may have different effects in the short run and long run.

Overall Monetary Phenomena

Inflation is primarily driven by money supply changes.

Rational Expectations in Inflation

Individuals form expectations based on current and past economic data.