Chapter 8: Money, Price Level, and Inflation

money

any commodity or token that is generally acceptable as a means of payment

means of payment

method of settling a debt

money’s three other functions

medium of exchange, unit of account, and store of value

medium of exchange

an object that is generally accepted in exchange for goods and services

barter

exchange (goods or services) for other goods or services without using money.

unit of account

an agreed measure of stating the prices of goods and services

store of value

money can be held for a time and later exchanged for goods and services

currency

notes and coins held by individuals and businesses

two official measures of money in the US

M1 & M2

M1

currency plus demand deposits and other liquid deposits owned by individuals and businesses that can be withdrawn on demand

M2

M1 plus small-denomination time deposits and retail money market mutual funds.

depository institution

a firm that takes deposits from households and firms and makes loans to other households and firms

3 types of depository institution

commercial banks, thrift institutions, and money market mutual funds

commercial bank

a private firm that is license by the Comptroller of the Currency or by a state agency to receive deposits and make loans

thrift institutions

savings and loan associations, savings banks, and credit unions

money market mutual fund

a fund operated by a financial institution that sells shares in the fund and holds assets such as US Treasury bills.

commercial bank put the depositors’ funds into three types of assets

cash assets, securities, loans

cash assets

notes and coins in its vault or its deposit at the Federal Reserve

securities

US government Treasury bills and commercial bills and longer-term US government bonds and other bonds such as mortgage-back securities

Loans

commitments of fixed amounts of money for agreed-upon periods of time

depository institutions provide four benefits

create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers

Federal Reserve System

central bank of the US

central bank

public authority that regulates a nation’s depository institutions and controls the quantity of money.

federal funds rate

the interest rate that banks charge each other on overnight loans of reserves.

key elements in the structure of the Fed

the board of governors, the regionals federal reserve banks, and the federal open market committee

open market operation

the purchase or sale of government securities by the Fed from or to a commercial bank or the public.

an open market purchase

increases the Fed’s assets and liabilities

an open market sale

decreases the Fed’s assets and liabilities

discount rate

the interest rate paid by discount window borrowers.

discount window

an imaginary window that is always open and through which the fed makes loans to commercial banks and other depository institutions

What is the monetary base?

The sum of currency held by individuals and businesses plus banks' reserve deposits at the Fed.

How do banks create money?

When banks make loans, they create new deposits, which are part of the money supply.

What is the desired reserve ratio?

The ratio of reserves to deposits that a bank plans to hold.

What is the currency drain ratio?

The ratio of currency held by the public to deposits; a leakage of reserves when banks create money.

What is the money multiplier?

The ratio of the change in the quantity of money to the change in the monetary base.

What determines the size of the money multiplier?

The desired reserve ratio and the currency drain ratio. The smaller these ratios, the larger the money multiplier.

What is the demand for money?

The relationship between the quantity of money demanded and the nominal interest rate, all else constant.

What is the opportunity cost of holding money?

The nominal interest rate forgone by not holding an interest-earning asset.

What three factors shift the demand for money curve?

The price level, real GDP, and financial innovation.

How does the price level affect the quantity of money demanded?

The quantity of money demanded is proportional to the price level. If the price level rises, people demand more money.

How does real GDP affect the demand for money?

An increase in real GDP increases aggregate expenditure, which increases the demand for money.

What happens to the demand for money with financial innovation?

Financial innovation that lowers the cost of switching between money and interest-earning assets decreases the demand for money.

What does the supply of money depend on?

The Fed's monetary policy strategy: it can target the monetary base, the nominal interest rate, or the quantity of money.

If the Fed targets the quantity of money, what does the supply curve look like?

Vertical.

If the Fed targets the nominal interest rate, what does the supply curve look like?

Horizontal

What happens in the short run when the Fed increases the quantity of money

People have more money than they want; they buy bonds, raising bond prices and lowering the interest rate.

In the long run, what happens if the Fed increases the quantity of money?

Real GDP, employment, the real quantity of money, and the real interest rate are unchanged. The price level rises by the same percentage as the increase in the quantity of money.

What is the quantity theory of money?

The proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

What is the equation of exchange?

MV=PY, where

M = quantity of money, V = velocity of circulation, P = price level, and Y = real GDP.

When does the equation of exchange become the quantity theory of money?

When M does not influence V or Y, so changes in M lead to proportional changes in P.

What is the velocity of circulation?

The average number of times in a year a dollar is used to purchase goods and services in GDP