Chapter 4

Front 1

Government purchases are said to crowd out investment. why?

Back 1

because an increase in Government spending increases the interest rate

Front 2

money supply

Back 2

the Q of money available in an economy

Control over the money supply is called MONETARY POLICY

Front 3

Central Bank

Back 3

monetary policy is delegated to a partially independent institution the Central Bank

Federal Reserve (Fed) is the U.S.' central bank. FOMC make decisions about monetary policy

Front 4

The primary way the fed controls the supply of money is through

Back 4

open market operations

the purchase and selling of Government bonds.

When the Fed wants to increase the money supply, it uses some of the dollars it has to buy government bonds from the public (buy bonds)

when the fed wants to DECREASE the money supply it sells some government bonds from its own portfolio (sell bonds)

Front 5

Money is the stock of assets used for transactions

Back 5

true

Front 6

The most obvious asset to include in the quantity of money is currency

Back 6

the sum of outstanding paper money and coins

Front 7

Demand deposits

Back 7

funds people hold in their checking accounts

demand deposits are added to currency when measuring quantity of money because they are just as good as cash

Front 8

The most common measures for studying the effects of money on the economy are M1 & M2

Back 8

M1:
Currency + demand deposits + travelers checks + other checkable deposits

M2:
M1 + retail money market mutual fund balances + saving deposits + small time deposits

Front 9

Quantity theory of money

Back 9

the leading explanation for how money affects the economy in the long run.


The quantity of money in an economy is related to the number of dollars exchanged in transactions

Quantity Equation:

<b>Money x Velocity = Price x Transactions

M x V = P x T</b>

Front 10

M x V = P x T

Back 10

The right side tells us about ransactions . T represents teh total number of transactions during some preiod of time.

T is the number of times in a year that goods or services are exchanged.

P x T = the number of dollars exchanged in a year.

Front 11

M x V = P x T

Back 11

The left hand side of the equation tells us the money used to make the transactions.

M is the quantity of money.

V is called the transactions velocity of money:
Measures the rate at which money circulates in that economy.

velocity tells us the number of times a dollar bill changes hands in a given period of time.

Front 12

Velocity =

Back 12

P x T / M

Front 13

Economists use a slightly different version of the Quantity Equation because T is hard to measure.

Back 13

true

Money x Velocity = Price x Output

M x V = P x Y


If Y denotes the amount of output and P denotes the price of one unit of output, then the dollar value of output is PY. We encountered measures for these variables when we discussed the national income accounts.

Y is real GDP, P the GDP deflator, and P x Y nominal GDP thus the quantity equation becomes

M x V = P x Y

because Y is also total income V in this version of the quantity equation is called the <b> Income velocity of money</b>

The income velocity of money tells us the number of times a dollar bill enters someone's income in a given period of time.

This version of the quantity equation is the most used.

Front 14

Real money balances

Back 14

often useful to express teh quantity of money in terms of teh quantity of goods and services it can buy.

M / P

Front 15

Money Demand Function

acts like the demand function for a particular good.

Back 15

an equation that shows the determinants of the quantity of real money balances people wish to hold.

(M/P)^d = k x Y

(where k is a constant that tells us how much money people want to hold for every dollar of income.)

This equation states that the quantity of real money balances demanded <b>is proportional to real income</b>

Front 16

money demand function offers another way to view the quantity equation.

Back 16

add to the money demand function the condition that the demand for real money balances (M/P)^d muste equal the supply (M/P) then:

M/P = kY

or

M(1/k) = P x Y

or

MV = PY

where V = 1/k


<b>1/k = V</b>:
When people want to hold a lot of money for each dollar of income (large k) money changes hands infrequently, or V is small.
When people want to hold only a little money (k is small) money changes hands frequently because V is large.

the money demand parameter k and the velocity of money V, are opposite sides of the same coin

Front 17

Quantity equation can be viewed as a definition

Back 17

it defines Velocity (V) as the ratio of nominal GDP (P x Y) to the quantity of money (M)

Front 18

Quantity theory of money = the price level is proportional to the money supply

Back 18

assume that V is constant

M x Vbar = P x Y

because V is fixed a change in the money supply (M) must have a proportionate change in nominal GDP (PY)

if V is fixed, the quantity of money determines the dollar value of the economy's output.

Front 19

Theory that explains an economy's overall level of prices (3 parts).

It explains what happens when the central bank changes the supply of money

Back 19

1. factors of production function determine the level of output Y ( F(K,L) )

2. The money supply M, determines the nominal value of output (P x Y) becasue V is fixed

3. the price level P is then the ratio of the nominal value of output P x Y to the level of output Y

IN OTHER WORDS:

The productive capability of the economy determines real GDP

The quantity of money determines nominal GDP

and the GDP deflator is the ratio of nominal GDP to real GDP

Front 20

Quantity equation written in % form

Back 20

% change in (M) + % change in (V) = % change in (P) + % change in (Y)

Front 21

The quantity theory of money states

Back 21

that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If teh central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly

Front 22

2 interest rates

Back 22

Real: actual purchasing power of your money

Nominal: what the bank will pay

real = nominal - inflation
r = I - pi

Front 23

Fisher Effect

Back 23

Nominal Interest rate = real interest rate + inflation rate

Front 24

The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate

Back 24

According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increaes in the rate of inflation

According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1%increase in the nominal interest rate

The one-for-one relation between the inflation rate and the nominal interest rate is called the fisher effect