Questions and Answers
What is the primary difference between monetary policy and fiscal policy?
What are the main functions of money?
Medium of exchange, store of value, unit of account
How does the money creation process work in a fractional reserve system?
New money created is a multiple of new excess reserves available for lending by banks.
What factors influence the demand for money?
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What does the Fisher effect state?
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What roles do central banks fulfill?
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What costs does expected inflation impose on the economy?
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What are some tools central banks use to implement monetary policy?
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What qualities characterize effective central banks?
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How does monetary policy affect economic growth and inflation?
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What is the current trend in how central banks target inflation?
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Study Notes
Monetary and Fiscal Policy
- Fiscal policy involves government taxation and spending to influence the economy.
- Monetary policy is conducted by central banks to control the money supply.
- Both aim for economic growth and price stability, though fiscal policy also serves social objectives.
Functions and Definitions of Money
- Money is a widely accepted medium of exchange.
- Functions include:
- Medium of exchange
- Store of value
- Unit of account
Money Creation Process
- In a fractional reserve system, new money creation is based on excess reserves in banks.
- The money multiplier is the reciprocal of the reserve requirement, showing the relationship to money supply.
Theories of Demand and Supply of Money
- Money demand is influenced by:
- Transaction demand: for purchasing goods/services.
- Precautionary demand: for unforeseen future needs.
- Speculative demand: for investment opportunities.
- Money supply is controlled by central banks to manage inflation and economic goals.
Fisher Effect
- The Fisher effect demonstrates that the nominal interest rate equals the real interest rate plus the expected inflation rate, applicable in the long run.
Roles and Objectives of Central Banks
- Central banks:
- Supply currency.
- Act as bankers to the government and other banks.
- Regulate the payments system and act as lenders of last resort.
- Hold gold and foreign currency reserves.
- Conduct monetary policy.
- Objectives include controlling inflation and maintaining economic stability and growth.
Costs of Inflation
- Expected inflation raises opportunity costs, leading to reduced cash balances.
- Unexpected inflation presents significant costs by:
- Distorting price signals.
- Worsening economic cycles.
- Shifting wealth from lenders to borrowers.
- Inflation uncertainty reduces business investment.
Implementation of Monetary Policy
- Central banks utilize policy tools such as:
- Policy rate (discount rate in the U.S., refinancing rate in the ECB, 2-week repo rate in the U.K.).
- Reserve requirements.
- Open market operations.
- Expansionary measures include lowering policy rates and purchasing securities.
- Contractionary measures involve raising rates and selling securities.
Qualities of Effective Central Banks
- Effective central banks must exhibit:
- Independence from political influence.
- Credibility in following through on policy intentions.
- Transparency in communicating economic indicators.
Relationships in Monetary Policy
- Monetary policy impacts interest rates, asset prices, growth expectations, and exchange rates.
- These factors influence domestic and external demand, ultimately affecting economic growth and inflation.
- Central banks can stimulate the economy by purchasing securities to lower interest rates, fostering increased investment and consumption.
Targeting Inflation, Interest Rates, and Exchange Rates
- Most central banks now prioritize inflation targets of 2% to 3%, moving away from direct interest rate targeting.
- Adjustments in money supply are based on expected inflation deviations from targeted levels.
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Description
This quiz covers the foundational concepts of monetary and fiscal policy, including their definitions, functions of money, and the money creation process. Explore how these policies influence the economy and contribute to economic stability and growth.
