L3-4: Money Demand, Interest Rates, and Monetary Policy Transmission

Flashcards covering money demand, interest rates, and monetary policy transmission based on lecture notes.

Why do individuals hold money?

Money provides liquidity for transactions and is universally acceptable as payment.

Why do individuals hold bonds?

Bonds provide a financial return through interest rates.

What factors determine how much money we want to hold?

1. Frequency of transactions

2. Institutional and technological factors

3. Nominal GDP

4. Interest rates

How does nominal money demand relate to nominal GDP?

Nominal money demand is proportional to nominal GDP. As nominal GDP increases, the demand for money also increases, reflecting the higher overall level of economic activity.

How does real money demand relate to real GDP?

Real money demand is proportional to real GDP. As real GDP increases, the demand for money also increases, indicating a higher level of economic activity adjusted for inflation.

What is the relationship between interest rates and real money demand?

Real money demand decreases with higher interest rates. Higher interest rates discourage holding money as an asset due to opportunity costs.

What is the traditional view of central banks regarding money supply?

Central banks control the nominal money supply in the economy. They aim to regulate inflation and stabilize economic growth.

What is 'narrow money' or the 'monetary base'?

Currency plus cash reserves held at the central bank.

Under what conditions can the central bank control the real money supply?

If prices are fixed, typically in a short-run macroeconomic model.

How do interest rates adjust to reach equilibrium in the money market?

Interest rates adjust through the interaction of money supply and demand. When demand for money increases, interest rates rise to restore equilibrium, while a decrease in money demand lowers interest rates.

How do central banks typically manage interest rates?

Central banks set the interest rate and adjust the money supply to enforce their desired interest rate as a market equilibrium, passively.

Why do modern central banks prefer using interest rates as an instrument?

• Uncertainty about the money multiplier

• unpredictability of money demand due to non-money assets

What is the major target for central banks today?

Price stability - a low and stable inflation rate; also output and employment.

How does monetary policy affect aggregate demand in a closed economy?

Monetary policy affects aggregate demand in a closed economy by altering interest rates, which influences consumption and investment spending.

Lower interest rates typically encourage borrowing and spending, while higher rates may dampen economic activity.

How do falling interest rates affect the price of company shares and bonds?

Lower interest rates make the price of corporate shares and bonds rise and make households wealthier.

This occurs because cheaper borrowing costs encourage investment and spending, increasing demand for assets.

How does expansionary monetary policy impact consumer credit?

It makes more credit available to consumers and lowers the cost of that credit. This leads to increased consumer spending, stimulating economic growth.

What is forward guidance?

An indication by the central bank of the future interest rate it intends to achieve.

What is the transmission mechanism of monetary policy?

Short-term interest rates affect long-term interest rates, which influence aggregate demand by affecting the cost of borrowing for consumption and investment.

What are government bond yields a benchmark for?

A lot of other interest rates in the economy (auto-loans, mortgages, etc.).

What determines yields on long-term government debt?

Yields on long-term government debt are primarily determined by market expectations of future interest rates, inflation, and the overall economic outlook.

What does the yield curve show?

The interest rates at which the government can borrow money over different time horizons.

What does a downward-sloping yield curve indicate?

Potential recession

How are investment demand and interest rates related?

Investment demand is inversely related to interest rates.

What factors affect investment demand?

Expectations of future output demand and cost of capital goods.