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Chapter 26: Money, Price level and Inflation - Coggle Diagram
Chapter 26: Money, Price level and Inflation
Money
- a commodity accepted as a means of payment
- money is also seen as a store of value, it can be held and exchanged later for goods and services
- inflation lowers the value of money as well the tokens used as money
- to test whether an asset is money: can the item serve as a means of payment?
- liquidity is a property that a certain asset has which makes it easy for it to be converted into a means of payment without a loss in value
The money market
- market where demand and supply interact to determine the interest rate
- Money market equilibrium occurs when the quantity of money demanded = quantity of money supplied
When interest rate drops below equilibrium: shortage of money, people want to hold more money than bank can supply ∴ they sell bonds and interest rate risesWhen interest rate goes above equilibrium: surplus of money people want hold less money than bank is willing to supply ∴ the buy bonds and interest rate falls
Banks
- known as a depository institution as its a firm that takes deposits from households and makes loans to other households
- Commercial bank: act as intermediaries between people with excess money and those who are in need of money
- aim of a bank is to maximise net worth of shareholders; they do this by making interest on loans greater than interest on deposits
- however they need to balance these rates or else they could end up in a situation where they can't pay out to depositors if interest on loans is too high
Depository institutions are regulated by forcing them to have sufficient reserves and capital during times of turmoil
How banks create money
- bank create money by creating loans and deposits (which are cash) see pg555
Factors that limit the quantity of money bank system can create
Monetary base
• sum of banknotes and coins in circulation in the economy
Depository institutions earn profit by providing these benefits:
- Create liquidity: by borrowing short and lending long
- Pool risk: lending to many people so that if one person defaults the loss is minimised
- Lowering the cost of borrowing: if these insitutions didn't exist, one would have to look for multiple people to borrow money from. banks remove the cost of looking around for funding
- Lowers the cost of monitoring borrowers: by monitoring borrowers, they can encourage good spending decisions
The reserve bank
- does not service the general public.It fosters a stable financial environment that will allow the economy to thrive
- regulates a nation's depository institutions and controls the quantity of money to help maintain price stability in SA
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Money
Demand for money
- quantity of money demanded is the inventory of money that people plan to hold on any given day
Factors that influence quantity of money demanded
- price level
- nominal interest rate
- Real GDP
- Financial innovation
Price level
- quantity of money measured in rand is nominal money
- quantity of nominal money demanded is proportional to the price level other things remaining the same (e.g if price level rises by 10%, people hold 10% more nominal money)
- Real money is quantity of money measured in constant rand (e.g 2005 rand) and is independent of price level.
(Real money = nominal money ÷ price level)
Nominal interest rate
- The higher the opportunity cost of holding money, the smaller the quantity of real money demanded
- OC of holding money = Nominal I(Assets) - Nominal I (Money)
- The higher the inflation rate, the higher the nominal interest rate
Real GDP
- Quantity of money demanded dependend on the amount that a household wants to spend.
∴ Quantity of money demanded as a whole depends on RGDP
Financial Innovation
- arrival of new financial products influence the quantity of money held, by reducing others costs of getting money
Demand for money curve
- relationship between quantity of real money demanded and nominal interest rate
- quantity of money demanded is negatively related to the nominal interest rate
MOVEMENT ALONG CURVE: Nominal interest rate
- The higher the interest rate the higher the OC of holding money ∴ the lower the quantity of real money demanded (upward movement along demand curve)
.
- The lower the interest rate the lower the OC of holding money ∴ the higher the quantity of real money demanded (downward movement along demand curve)
SHIFT IN CURVE: Real GDP and financial innovation
- decrease in RGDP decreases demand for money (shifts left)
- increase in RGDP increases demand for money (shifts right)
- Financial innovation decreases the demand for money
Supply of money
- relationship between nominal interest rate and money supply
- supply of money is positively related to the nominal interest rate
- Supply of money is determined by actions of reserve bank and banks. It depends on the monetary base and money multiplier
- quantity of money supplied increases as the desired reserve ratio decreases or money multiplier increases
.
- increase in monetary base increases money supply (curve shifts right;surplus of supply)
- decrease in monetary base decreases money supply (curve shifts left, shortage of supply)
↑ see money market equilibrium section
.
- For BANKS: increase in the interest rate implies increase in OC of holding reserves and bank's demand for reserves decreases
∴ banks lend out a larger % of their deposits, & desired reserve ratio ↓
pg561