4.2.4 Financial Markets and Monetary Policy

money

anything that is widely accepted as a medium of exchange

acceptability, durability, portability, divisibility, uniformity, scarcity/limited supply, stability of value

Characteristics of money

medium of exchange, store of value/wealth, unit of account, standard deferred payment

Four main functions of money

medium of exchange

Function of Money: Used to buy and sell goods and services, avoiding the need for barter

store of value/wealth

Function of Money: can be saved and used in the future without losing value quickly

unit of account/measure of value

Function of Money: used to compare the value of goods/services

Standard of deferred payment

Function of Money: allows transactions where payment can happen later(credit)

money supply

the total amount of money in an economy at a given time

inflation, interest rates, economic growth, employment

What does the money supply affect?

liquidity

how quickly and easily an asset can be converted into cash without losing value

affects how quickly economic agents can spend money

Why does liquidity matter?

Cash, immediate, property or art, value

____ is the most liquid as it is easier to be used to meet _________ financial needs whilst _______ or ___ is less liquid as it takes time sell and may lose ______.

narrow money(M₀, M₁)

most liquid forms of money — used for immediate transactions. Includes notes and coins in circulation, central banks reserves, current accounts/demand deposits, and money in debit cards.

broad money(M₂, M₃,M₄)

includes less liquid forms of money — used for saving, investing, and large-scale transactions. Includes assets that are still “money” but not instantly spendable, such as saving accounts, time deposits, retail bank deposits, and corporate deposits.

MV = PQ

The Fisher Equation of Exchange

money supply

The Fisher Equation of Exchange: M

velocity of circulation, how often money changes hands

The Fisher Equation of Exchange: V

price level

The Fisher Equation of Exchange: P

output of the economy or real GDP

The Fisher Equation of Exchange: Q

V and Q are constant in the short-run, so increase in M makes P increase(inflation)

What does the Quantity Theory of Money assume?

V not constant, Q can rise instead of P if there is spare capacity, reverse causation - rise in P makes M rise

Keynesian Criticisms of the Fisher Equation of Exchange

too much money→inflation, too little money→deflation→recession risk

Why does the money supply matter for inflation?

central banks lower it for more borrowing and spending, and raise it for less borrowing and less inflationary pressure

Why does the money supply matter for interest rates?

stable money supply supports investment and consumption

Why does the money supply matter for economic growth?

higher spending from more money raises demand and employment

Why does the money supply matter for employment?