Fall 2003 ECO 2013 Cobbe Third Midterm Review
Abbreviated list of key points:
Money; what it is.
Functions – unit of account, medium of exchange, store of value.
Has value because
people are confident it will be accepted in payment.
M1 – currency outside banks, balances in checkable deposits,
M2 less liquid, adds saving and time deposits.
Liquid means ‘means of payment.’
Banks exist to
make profit; must keep a percentage of deposits as reserves, the percentage they must keep is the required reserve ratio.
Reserves are currency in the bank plus deposits with the Fed [Federal Reserve System].
Bank assets are reserves,
loans, securities; liabilities are customer deposits.
Banks make loans, create liquidity, pool risk, make payments; they
create liquidity by borrowing short [checking deposits] and lending long.
The Monetary Base is currency plus bank
reserves with the Fed.
The monetary base [except for coin] consists of the Fed’s IOU’s, so the Fed can create or
destroy monetary base and thereby the money supply.
The required reserve ratio implies $1 of reserves can support
$(1/required reserve ratio) of deposits, so open market operations [Fed buying, to expand; or selling, to reduce, bonds
thus changing reserves available to banks] expand or contract the money supply.
Other theoretical tools of monetary
policy [not really used] are changes in the required reserve ratio and changes in the discount rate.
Money Creation and Control.
Same as chapter 11 but repeated with a bit more detail.
Money, interest, and inflation.
Money demand refers to how much of their wealth people want to hold as
money [generally not interest-earning].
Quantity of money demanded varies with its opportunity cost, the nominal
interest rate; to the demand for money graphs the nominal interest rate vertically, the quantity of money horizontally.
Higher the nominal interest rate, the less money people want to hold because the opportunity cost is higher.
for money shifts with real GDP, wealth, technology of finance.
Supply of money is in short run set by the Fed, because
it controls the supply of reserves to the banking system via its open market operations.
Hence Fed can target the
Federal Funds Rate, short-term nominal interest rate.
Nominal interest rate equals real interest rate plus expected
Velocity of money is defined by equation of exchange, MxV = PxQ where Q is real GDP, P price level,
so PxQ = nominal GDP.
If V only changes slowly, follows that P varies directly with money supply, and in long run,
if V does not change, the rate of change of P [inflation rate] plus rate of change of real GDP [economic growth rate]
equals rate of growth of money supply.
Inflation has costs, they increase as inflation increases and is more