money and interest rates- chp37

What are the four functions of money?

1. medium of exchange: allows goods and services to be bought and sold without barter.

2. Measure of value (unit of account): provides a common way to compare prices.

3. Store of value: allows purchasing power to be saved for future use, although inflation reduces its value.

4. Method of deferred payment: allows borrowing and repayment in the future.

What are the six characteristics of money?

1. Durability: lasts over time.

2. Divisibility: can be divided into smaller units.

3. Portability: easy to carry and transfer.

4. Uniformity: units of the same denomination have identical value.

5. Limited supply: scarcity helps maintain value.

6. Acceptability: widely accepted as payment.

Why is money more effective than barter?

Barter requires a double coincidence of wants, meaning both parties must want what the other offers.

Money acts as a universally accepted medium of exchange, making transactions easier and more efficient.

It also provides a common measure of value, a store of value and a method of deferred payment.

What is the money supply and what is the difference between narrow and broad money?

The money supply is the total stock of money available in an economy.

Narrow money (M0) consists mainly of notes and coins in circulation and central bank reserves.

Broad money (M4) includes narrow money plus a wider range of bank deposits and other financial assets.

Broad money therefore measures a larger proportion of the money available in the economy.

How are interest rates determined in the money market?

Interest rates are determined by the interaction of the demand for money and the supply of money.

The equilibrium interest rate occurs where demand equals supply.

If the interest rate is above equilibrium, there is a surplus of money, putting downward pressure on rates.

If below equilibrium, there is excess demand for money, putting upward pressure on rates.

What is a liquidity trap and why does it make monetary policy less effective?

A liquidity trap occurs when interest rates are already extremely low and an increase in the money supply fails to reduce them further.

People may prefer holding cash rather than investing or spending.

This means conventional monetary policy becomes less effective because the central bank cannot stimulate the economy further through interest rate reductions.

How do changes in interest rates affect consumers, firms and aggregate demand?

Lower interest rates reduce the cost of borrowing and the reward for saving.

This encourages consumption and investment, increasing AD and economic growth.

Higher interest rates make borrowing more expensive and saving more attractive, reducing consumption and investment.

This decreases AD and helps reduce inflationary pressure.

Why might the Bank of England increase or decrease interest rates?

The Bank of England may increase interest rates to reduce inflation by discouraging borrowing, consumption and investment, reducing AD.

It may decrease interest rates to stimulate economic growth by encouraging borrowing, consumption and investment, increasing AD.

The effectiveness depends on factors such as consumer and business confidence.

What is the difference between nominal and real interest rates?

The nominal interest rate is the stated interest rate before accounting for inflation.

The real interest rate measures the actual increase in purchasing power after inflation.

Approximate formula: Real interest rate = nominal interest rate − inflation rate.

What is Fisher's equation of exchange and what does each letter represent?

MV = PQ.

M = money supply; V = velocity of circulation (the average number of times each unit of money is spent); P = general price level;Q= real national output.

The equation shows that total spending in the economy equals the money value of national output.

What is the Quantity Theory of Money?

The Quantity Theory of Money suggests that increases in the money supply cause increases in the general price level, assuming velocity of circulation and real output remain constant.

If the money supply doubles while V and Q remain unchanged, the price level will also double.

What are the main assumptions of the Quantity Theory of Money?

1. Velocity of circulation (V) is constant, meaning the frequency with which money is spent does not change.

2. Real output (Q) is independent of the money supply and determined by supply-side factors.

These assumptions mean that increases in the money supply translate directly into increases in the price level.

How can an increase in the money supply cause inflation?

An increase in the money supply gives consumers and firms more money to spend.

This increases aggregate demand, shifting AD to the right.

If the economy is close to full capacity, firms struggle to increase output, creating demand-pull inflation as prices rise.

Higher demand for labour can also increase wages and production costs, potentially creating further cost-push inflation.

What is the relationship between money supply, real output and inflation according to the Quantity Theory of Money?

If the money supply grows faster than real output, inflation is likely to occur, assuming velocity is constant.

This is because more money is chasing the same quantity of goods and services.

If real output grows at the same rate as the money supply, the price level should remain stable.

What is a positive output gap and how can it cause inflation?

A positive output gap occurs when actual real GDP is above the economy's sustainable productive capacity.

Firms face pressure to meet rising demand, causing shortages of resources and labour.

This can push up wages and production costs, leading to inflation.

How can inflation lead to further inflation through wages and production costs?

As prices rise, workers demand higher nominal wages to maintain their real purchasing power.

Higher wages increase firms' production costs, shifting SRAS to the left.

Firms increase prices to protect profit margins, creating further cost-push inflation.

This can create a wage-price spiral.

What happens in the short run and long run following an increase in the money supply?

In the short run, an increase in the money supply may increase AD, leading to higher real output and employment as well as a higher price level.

In the long run, wages and prices adjust, output returns towards its productive capacity, and the main lasting effect is a higher general price level, assuming the economy was initially at full employment.

What are the key limitations of the Quantity Theory of Money?

The assumptions may not hold in reality. Velocity of circulation can change due to confidence, spending habits and financial innovation.

Real output can also increase when spare capacity exists, meaning an increase in the money supply does not necessarily cause inflation.

Therefore, the relationship between money supply and inflation is not always directly proportional.

what is the market for loanable funds?

the notion that households will be influenced by the rate of interest in making saving decisions, which will then determine the quantity of loanable funds avaliable for firms to borrow for investment

what is liquidity?

the extent to which an asset can be converted in short term (to spendable money) without the holder incurring a cost