5.1 Money and interest rates

• Define narrow money

  Physical currency as well as deposits and liquid assets in the central bank.
• Define broad money

  The entire money supply, it includes liquid and less liquid assets
• Define money supply

  The stock of currency and liquid assets in an economy.It includes cash and money held in savings accounts.
• Functions of money: 1. medium of exchange

  Exchanges could only take place if there was a coincidence of wants (both parties want the good the other party offers). Using money eliminates the issue of when goods and services exchanged were not always of the same exchange.
• Functions of money: 2. measure of value

  Money provides a means to measure the relative values of different goods and services. Money also puts a value on labour.
• Functions of money: 3.store of value

  Money has to hold its value to be used for payment. It can be kept for a long time without expiring. However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.
• Functions of money: 4. a method of deferred payment

  Money can allow for debts to be created as people can pay for things without having money in the present, and can just pay for it later. This relies on money storing its value.
• Characteristics of money: 1. durability

  So that money can physically last between transactions, unlike for instance wheat.
• Characteristics of money: 2. divisibilty

  So that the exact value can be traded. Artwork, for example, cannot be divided to give an exact value.
• Characteristics of money: 3.portability

  Coins and notes are easy to carry around, unlike, for example, a block of iron.
• Characteristics of money: 4. uniformity

  The value should be consistent
• Characteristics of money: 5. limited supply

  Money should be scarce enough that it has a value and can be earned.
• Characteristics of money: 6. acceptability

  Consumers and firms should have enough confidence in money to accept it.
• Interest rate diagram

  A change in the supply of money does not change the interest rate. This means the monetary policy cannot be used to influence consumption and investment.

  
• What does the Quantity theory of money (Fisher equation of exchange) state?

  It states that there is inflation if the money supply increases at a waste rate than national income.
• What does each component stand for in the Fisher equation: MV=PQ?

  M is the supply of money.

  V is the velocity of circulation.

  P is the price level

  Q is the quantity of real goods sold (real GDP).

  Therefore, the value of expenditure on goods equals the value of total output.
• Assumptions of the Fisher equation:

  It assumes V is constant, and that Q is independent of the supply of money. Only supply-side factors affect Q. V is assumed to be constant because the frequency that workers are paid does not change often.
• Fisher equation: increasing money supply causes inflation

  Consumers have more money to spend as the money supply rises, so AD shifts to the right. Firms then increase supply in S.R., resulting in an inflationary positive output gap. As a result, more people are hired, and wages rise. Therefore, firms' costs rise, and prices rise. As a result of the inflationary pressure, the real value of money decreases. There is a decrease in demand since money can buy less. To offset the increase in inflation, workers want greater wages, causing the SRAS curve to shift. The output level readjusts, while the price level rises.