CH4: Financial markets I

What are the three meanings of the word "money" in everyday use?

Income (make money), wealth (have money), and transaction medium (pay money).

What is the economic definition of "money"?

A financial asset that can be used for transactions without conversion—cash or checkable deposits.

How is wealth different from income?

Wealth is a stock (assets – liabilities); income is a flow (earned per time unit).

What are savings?

Savings = Disposable income – Consumption = Y – T – C

What are commercial bank reserves?

Funds held as deposits at the central bank and in cash to satisfy withdrawal demands

What happens if a bank has insufficient reserves?

It sells bonds or borrows from the central bank (lender of last resort)

What is the capital adequacy ratio?

Minimum capital a bank must hold relative to risk-weighted assets to avoid insolvency.

What factors affect money demand?

Nominal income (Y) and the interest rate (i); Md = PY × L(i)

Why do higher interest rates decrease money demand?

Because the opportunity cost of holding money (instead of interest-bearing assets) increases

What is the opportunity cost of holding money?

The foregone interest income from holding bonds or deposits instead of cash/checkable deposits

What is the relation between bond prices and interest rates?

Inversely related: higher bond price → lower interest rate.

What is an expansionary open market operation?

The central bank buys bonds → increases money supply → interest rates decrease

How does the central bank typically control interest rates?

By choosing a target rate and adjusting the money supply via bond transactions

How do banks create money?

By issuing loans which create corresponding deposits.

What is the money multiplier formula (assuming no currency)?

Multiplier = 1 / reserve ratio (q)

How does currency preference (c) reduce the money multiplier?

Some of the central bank injection is held as cash, not recycled through deposits/loans

What is the liquidity trap?

A situation where interest rates are near zero and further increases in money supply don’t lower rates.

Why is monetary policy ineffective in a liquidity trap?

People prefer to hold cash; additional money does not stimulate borrowing or spending.

How is total money demand expressed when people hold cash and deposits?

Md = CU (currency) + D (deposits), with CU = cMd and D = (1 – c)Md