Economics - Money Demand Concepts
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Questions and Answers

What is the primary reason individuals hold money for transactions?

  • To invest in stocks
  • As a medium of exchange for everyday transactions (correct)
  • To generate interest income
  • To save for retirement

Precautionary demand for money is positively related to interest rates.

False (B)

What are the three motives for holding money according to Keynes?

Transactions motive, precautionary motive, speculative motive

In the speculative motive, money serves as a __________ of wealth.

<p>store</p> Signup and view all the answers

Match each motive for holding money with its description:

<p>Transactions Motive = Medium of exchange for daily transactions Precautionary Motive = Cushion against unexpected wants Speculative Motive = Store of wealth Demand for money = Varies with changes in income and interest rates</p> Signup and view all the answers

What term describes the decline in the demand for money relative to income as payment technology advances?

<p>Payment technology impact (D)</p> Signup and view all the answers

Nominal quantities of money are the same as real quantities of money.

<p>False (B)</p> Signup and view all the answers

If the money supply is 2 trillion and the aggregate output is 10 trillion with a velocity of 5, what is the price level?

<p>1 (B)</p> Signup and view all the answers

Doubling the money supply results in a doubling of the price level.

<p>True (A)</p> Signup and view all the answers

The precautionary motive for holding money is similar to the __________ motive.

<p>transaction</p> Signup and view all the answers

What does the equation  = %M + %V − %Y represent?

<p>The inflation rate.</p> Signup and view all the answers

If the aggregate output is growing at 3% per year and the growth rate of money is 5%, the inflation rate is ___%.

<p>2</p> Signup and view all the answers

Match the components of the equation to their meanings:

<p>M = Money supply growth rate V = Velocity of money P = Price level growth rate Y = Aggregate output growth rate</p> Signup and view all the answers

With a money supply of 4 trillion, an aggregate output of 10 trillion, and a velocity of 5, what is the new price level?

<p>2 (A)</p> Signup and view all the answers

If the velocity of money is constant, it has a growth rate of zero.

<p>True (A)</p> Signup and view all the answers

What is the formula for the quantity theory of money in terms of inflation?

<p>π = %ΔM − %ΔY</p> Signup and view all the answers

How is the demand for real money balances related to interest rates?

<p>Negatively related (B)</p> Signup and view all the answers

Higher income levels tend to decrease the demand for real money balances.

<p>False (B)</p> Signup and view all the answers

Name one asset that individuals may hold as part of their overall portfolio.

<p>Money</p> Signup and view all the answers

As interest rates rise, the demand for real money balances tends to ______.

<p>fall</p> Signup and view all the answers

Match the factors affecting the demand for money with their effect:

<p>Interest rates = Negatively affects demand Income = Positively affects demand Wealth = Positively affects demand Liquidity of other assets = Negatively affects demand</p> Signup and view all the answers

Which theory supports the idea that the demand for real money balances is positively related to income?

<p>Portfolio Theory (D)</p> Signup and view all the answers

The expected return on money changes as interest rates rise.

<p>False (B)</p> Signup and view all the answers

What is one consequence of higher interest rates on money relative to bonds?

<p>Money becomes less desirable.</p> Signup and view all the answers

What formula is used to calculate the Present Value (PV) of cash flows?

<p>PV = CF / (1 + i)^n (B)</p> Signup and view all the answers

A coupon bond pays interest payments periodically until maturity.

<p>True (A)</p> Signup and view all the answers

What does the term 'yield to maturity' primarily refer to?

<p>The most accurate measure of interest rates (C)</p> Signup and view all the answers

What is the cash flow (CF) in two years for the calculation provided?

<p>250</p> Signup and view all the answers

A dollar paid to you in the future is considered to be more valuable than a dollar paid today.

<p>False (B)</p> Signup and view all the answers

A ______ bond is also known as a zero-coupon bond.

<p>discount</p> Signup and view all the answers

Match the following credit market instruments with their descriptions:

<p>Simple Loan = Amount repaid at maturity with interest. Fixed Payment Loan = Repayment in equal installments over time. Coupon Bond = Fixed interest payments until maturity. Discount Bond = Bought at discount, repaid at face value.</p> Signup and view all the answers

What is the formula to calculate the present value?

<p>PV = CF / (1 + i)^n</p> Signup and view all the answers

In a fixed payment loan, how are the repayments structured?

<p>Fixed amounts repaid periodically including principal and interest. (B)</p> Signup and view all the answers

In one year, $100 with an interest rate of 10% will amount to ______.

<p>$110</p> Signup and view all the answers

Discount bonds pay periodic interest payments to the bondholder.

<p>False (B)</p> Signup and view all the answers

Match the following terms with their definitions:

<p>Present Value = The current worth of a future sum of money Future Cash Flow = Payments expected in the future Interest Rate = The percentage charged on borrowed money Yield to Maturity = The total return anticipated on a bond if held until it matures</p> Signup and view all the answers

What is the annual interest rate (i) used in the Present Value calculation?

<p>0.15</p> Signup and view all the answers

The cash flows from different debt instruments can have the same timing and amounts.

<p>False (B)</p> Signup and view all the answers

What is the first step to working backward from future amounts to the present?

<p>Use the present value formula.</p> Signup and view all the answers

What does the nominal interest rate represent?

<p>Interest rate before considering inflation (C)</p> Signup and view all the answers

A real interest rate of 4% means that the purchasing power has increased by 4%.

<p>False (B)</p> Signup and view all the answers

What is the Fisher Equation used for?

<p>To calculate nominal and real interest rates.</p> Signup and view all the answers

The lender earned $8 on the $100 loan, but due to an inflation rate of 5%, the real increase in purchasing power was only $____.

<p>3</p> Signup and view all the answers

What happens to borrowing incentives when the real interest rate is low?

<p>Incentives to borrow increase (C)</p> Signup and view all the answers

An increase in an individual's wealth does not affect the demand for assets.

<p>False (B)</p> Signup and view all the answers

What is the expected outcome when inflation is higher than the nominal interest rate?

<p>Real interest rate becomes negative.</p> Signup and view all the answers

Flashcards

Equation of Exchange

The equation that shows the relationship between the money supply (M), velocity of money (V), price level (P), and real output (Y). It states that the product of money supply and velocity equals the product of the price level and real output.

Quantity Theory of Money

The idea that changes in the money supply lead to proportional changes in the price level. If the money supply doubles, the price level also doubles, assuming other factors remain constant.

Inflation Rate

The percentage change in the price level over a period of time. It measures the rate of inflation.

Quantity Theory of Inflation

The equation that shows the relationship between the inflation rate, the growth rate of the money supply, and the growth rate of real output. It states that the inflation rate equals the growth rate of the money supply minus the growth rate of real output, assuming velocity is constant.

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Money Supply Growth Rate

The rate at which the money supply is increasing. It's usually measured as a percentage change over a year.

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Real Output Growth Rate

The rate at which the economy's output of goods and services is expanding. It's usually measured as a percentage change in real GDP over a year.

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Constant Velocity of Money

A key assumption in the quantity theory of money and inflation, stating that the average number of times a dollar is spent on goods and services in a given period remains constant.

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Money Supply and Price Level Relationship

The relationship between the money supply and the price level. If the money supply doubles, the price level doubles, holding other factors constant.

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Transactions Motive

The desire to hold money for everyday transactions, like buying groceries or paying bills.

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Precautionary Motive

The motive to hold money as a buffer against unexpected expenses or opportunities.

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Speculative Motive

The desire to hold money as a store of wealth, anticipating potential future price increases.

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Velocity of Money

The amount of times, on average, that a unit of currency is used for transactions within a specific time period.

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Income-Demand for Money Relationship

The relationship between the demand for money and the level of income in the economy.

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Payment Technology

The impact of technological advancements on how people pay for goods and services, which can influence the demand for money.

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Opportunity Cost of Holding Money

The cost of holding money instead of investing it, represented by the interest that could be earned from investment.

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Interest Rate-Demand for Money Relationship

The relationship between interest rates and the demand for money, primarily influenced by the precautionary motive.

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Portfolio Theories of Money Demand

The amount of money people choose to hold as a portion of their assets. It depends on factors like income, interest rates, and preferences.

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Keynesian Liquidity Preference

Keynes's theory suggests that the demand for money increases with income because people need more money to spend and decreases with interest rates due to the opportunity cost of holding money.

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Relative return on money

As interest rates rise, the relative return on holding money compared to other assets (like bonds) decreases, leading to a lower demand for money.

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Wealth & Demand for Money

The desire to hold money falls when wealth increases because people can allocate more funds to other assets.

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Payment Technology and Money Demand

The demand for money is influenced by how easy it is to make payments without cash. For example, widespread use of digital payment systems can reduce demand for physical money.

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Inflation and Demand for Money

Higher inflation means money loses value faster. This reduces the demand for money as people seek to hold assets that don't depreciate in value.

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Liquidity of Other Assets

If other assets (like bonds) are easily converted to cash, the demand for money is lower. People readily move money into these assets when needed.

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Riskiness of Other Assets

The demand for money is affected by how risky other assets are. If other assets are perceived as riskier, people may hold more money for safety.

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Present Value

The value of a future payment today, considering the time value of money.

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Simple Present Value Calculation

It's a method to calculate the present value of a series of future cash flows, assuming a constant interest rate.

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Time Value of Money

A dollar earned today is worth more than a dollar earned in the future, due to the potential for earning interest.

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Yield to Maturity

The interest rate that makes the present value of all future cash flows of a debt instrument equal to its current market price.

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Cash Flow

A series of payments that a debt instrument holder receives over its lifetime.

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Present Value of a Stream of Cash Flows

The process for calculating the present value of a series of uneven cash flows by discounting each individual cash flow back to the present.

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Present Value Technique

The present value of future cash flows discounted at the appropriate discount rate.

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Discount Rate

The interest rate that makes the present value of the future cash flows of a debt instrument equal to its market price.

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Fixed Payment Loan

A loan where the borrower repays the principal and interest in equal installments over a set period.

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Coupon Bond

A bond that pays regular interest payments (coupons) until maturity, when the principal is repaid.

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Discount Bond

A bond that is bought at a discount to its face value and pays no interest. The face value is repaid at maturity.

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Simple Loan

A loan where the borrower repays the principal and interest in a single payment at maturity.

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Present Value (PV)

The present value of a future cash flow, discounted back to the present using the interest rate.

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Interest Rate (i)

The rate of return on an investment, expressed as a percentage.

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Number of Years (n)

The number of years until a financial instrument matures.

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Face Value (Par Value)

The total amount of money to be repaid at maturity.

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Nominal Interest Rate

The interest rate that does not take inflation into account. It reflects the raw percentage increase in the amount borrowed. For example, if you borrow $100 at 8% nominal interest, you owe $108 back.

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Real Interest Rate

The real interest rate is adjusted for inflation, reflecting the true increase in purchasing power for the lender. It considers the erosion of purchasing power due to inflation. For example, if you borrowed $100 at 8% nominal interest but inflation was 5%, the real interest rate is only 3%, as the lender truly gained 3% in purchasing power after inflation.

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Fisher Equation

The equation that relates nominal interest rate (i), real interest rate (ir), and expected inflation rate (πe). It shows how the nominal interest rate compensates for inflation.

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Wealth

The total resources owned by an individual, including assets like cash, investments, and property.

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Wealth Impact on Asset Demand

A higher level of investor wealth generally leads to a higher demand for assets, including bonds and stocks. With more resources, individuals are more likely to invest.

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Real Interest Rate and Borrowing/Lending

The higher the real interest rate, the less incentive people have to borrow money, as the cost of borrowing is higher. Conversely, lenders find lending more attractive.

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Treasury Bills

Treasury bills are short-term debt securities issued by the government, considered very safe investments. They are used as a benchmark for other interest rates in the market.

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Government Securities

Government securities are debt instruments issued by the government to finance its spending. They can be short-term (like T-bills) or long-term (like bonds), offering different maturities and yields.

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Study Notes

Introduction

  • This document appears to be study notes for a course on money and banking.
  • It covers various topics, including financial markets, financial institutions, monetary policy, and international finance.
  • The notes are designed to be easy to digest and understand, focusing on key concepts and details.

Chapter 1: Why study Money, Banking and Financial Markets?

  • Financial markets transfer funds from surplus to deficit entities.
  • They promote economic efficiency.
  • Well-functioning markets lead to high economic growth.
  • Poorly functioning markets hinder economic growth.
  • Bond markets (and interest rates) are important to economic activity
  • They enable corporations and governments to borrow funds
  • Interest rates represent the cost of borrowing

Chapter 2: An Overview of the Financial System

  • Direct finance: borrowers borrow directly from lenders in financial markets (by selling securities).
  • Indirect finance: borrowers borrow through intermediaries (banks, etc), channeling funds from savers to borrowers.
  • Financial markets allocate capital, increasing production.
  • Well-functioning markets result in better consumer choices.
  • Financial markets are increasingly integrated globally.
  • Function of financial markets is to channel funds
  • Direct finance involves people borrowing directly from lenders in financial markets
  • Indirect finance involves intermediaries borrowing funds from lenders
  • Well functioning financial market promotes economic efficiency by producing efficient allocation of capital.

Chapter 3: What is Money?

  • Money is anything generally accepted as payment for goods and services or to repay debts.
  • Functions of money: medium of exchange, unit of account, store of value. -Types of money:
    • Commodity money: made from precious metals
    • Fiat money: paper currency issued by the government
    • Checks: instructions for transferring funds
    • Electronic money (e-money)
  • Money supply (M1 and M2): M1 (most liquid forms of money); M2 includes M1 plus other assets
  • Monetary aggregates: tools to measure money supply (e.g., M1 and M2)

Chapter 4, Part 1: Quantity Theory, Inflation, and the Demand for Money

  • Quantity theory of money: money supply, price level, and aggregate output are related
  • Equation of Exchange: MV = PY (Money supply x Velocity = Price level x Output)
  • Velocity of money: the number of times a unit of currency is used in a given period
  • The quantity theory suggests that changes in the money supply directly affect the price level and nominal income.
  • The equation can be modified to show the relationship between inflation and money growth

Chapter 4, Part 2: Quantity Theory, Inflation, and the Demand for Money

  • Keynesian liquidity preference theory's 3 money demand motives: transactions, precautionary, speculative.
  • People hold money for transactions, in case of emergencies (precautionary), and for anticipated changes in interest rates (speculative).
  • Portfolio choice theory: the quantity of money demanded is related to wealth, the rate of return between assets, the risk of the assets and the assets liquidity.

Chapter 5: The Meaning and Behavior of Interest Rates

  • Interest rates are the cost of borrowing money.
  • Present value: the current worth of a future sum of money.
  • Calculating yield to maturity: determining the interest rate that equates the present value of future cash flows to the current market price of an asset
  • Real interest rates account for inflation

Chapter 6, Part 1 & 2: Banking and the Management of Financial Institutions

  • Bank balance sheets list assets and liabilities.
  • Assets (loans, securities, reserves), liabilities (deposits, borrowing).
  • Banks make profit by earning interest on assets higher than their liability costs.
  • Asset, Liability & Capital Adequacy Management principles help banks to maximize profit, reduce risk, and maintain liquidity
  • The role of reserves, which include required reserves (based on regulatory requirements), and excess reserves
  • Credit risk, adverse selection, and moral hazard, screening and monitoring, loan commitments, and compensating balances.

Chapter 7: Central Banks

  • Central banks control the money supply in the economy.
  • A central bank can print notes and coins, hold reserves for other banks, supervise banks, and manage public debt.
  • Central banks are involved in managing monetary policy and maintaining financial stability
  • Central Banks operate as "bankers' banks"

Chapter 8: Tools of Monetary Policy

  • Tools used by central banks to control money supply and interest rates: Open market operations, discount lending, and reserve requirements.
  • Open market operations: buying and selling of securities, affecting the money supply and interest rates
  • Discount policy and lender of last resort: loans to commercial banks during emergencies
  • Reserve requirements: regulation on the portion of deposits banks must hold in reserve.

Chapter 10: Financial Crises

  • Financial crises are characterized by sharp declines in asset prices and failures of financial institutions.
  • The stages include: credit booms and busts, banking crises, and debt deflation
  • Global financial crisis of 2007-2009: caused by subprime mortgages, housing price bubbles, and financial innovations.
  • Results: sharp declines in asset values, bank failures. and major recessions.

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Money, Banking, and Financial Markets: PDF

Description

Test your understanding of the motives for holding money as discussed in Keynesian economics. This quiz covers transaction, precautionary, and speculative demands for money, along with related concepts such as the relationship between money and interest rates. Challenge yourself with questions about money supply, velocity, and inflation rates.

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