Understanding Money, Interest Rates, and Exchange Rates: A Comprehensive Guide, Slides of Economics

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Money, Interest

Rates, and the

Exchange Rate

CHAPTER 14

• Anything that can be used for final discharge a debt.
• Credit card is not money
• Balance in checking account is money
• Coins and currency are money

What is money?

3. Store of Value

• Save now spend later
• Smoothes inconsistencies between money earned and money spent
• Note: Individuals in high inflation countries my keep other currencies or goods as a store of value.

What can money be used for?

• Coins and paper currency act as primary mediums of exchange – money.
• Demand deposits held at banks and depository institutions provide the same function as currency – money.

What is the Supply of Money?

What is Monetary Base

(B)?

• Cash held by the public (C) and the total quantity of bank reserves (R) on deposit at central bank

B = C + R

• The percentage of deposits (r) banks are legally required to keep on deposit with the central bank

What is Reserve Requirement?

Example

• €80 = Cash in hands of the public
• €230 = Bank Reserve
• Required reserve = 0.
• What is MS?
• MS = 1/0.1 * (310)
• MS = 3100

Monetary policy

Refers to central bank changing money supply by changing the monetary base and/or the money multiplier.

• MS = M1 = 1/r * B MS↑ if B↑ or if r↓

2. Changing reserve requirement (r):
   • Lower reserve requirement means banks could make more loans.
     • If r↓  MM↑ MS↑
   • Rarely used b/c effect too powerful

How can the central bank

change B or r?

3. Open Market Operations, refinancing :

• Buying and selling bonds by central bank
• If the central bank buys bonds, money is given to bond seller (public or bank) and more money is in the economy  B↑ MS↑

How can the central bank

change B or r?

I received a question

• Can you please explain again with some examples the open market operations? thank you

Answer

• Bank of Ireland has some government bonds.
• If the central bank wants to increase the supply of money - Offer higher than normal prices for bonds - Bank of Ireland sell their €1000 bond to the central bank - Central bank makes a €1000 deposit into their Bank of Ireland Reserve Account at the central bank. - Bank of Ireland’s reserves goes up Bank of Ireland make more loans that means the people (borrowers) will have more money in their checking accounts (borrowed)  M goes up MS goes up

1. To buy goods and services.

• Transactions demand for money
• Varies directly with nominal GDP

2. In case of emergencies that require purchases above normal spending levels  Precautionary demand for money
3. As an asset

Why do we demand money

(M1)?

• If interest rates go up, do we demand more or less money?
• Less
• interest rate is the opportunity cost of holding money
• If the price level goes up, do we demand more or less money?
• More
• need more money to cover our purchases

Three motivations for holding money combine to create the aggregate demand for money