Quiz 2

Front 1

Is the supply of "Money" and its control by central banks part of the short term or long term financial market?

Back 1

Short Term

Front 2

What is Money?

Back 2

The asset used to conduct transactions.

A financial asset which is liquid

Front 3

Money=

a) Total Wealth

b) Liquid financial assets

c) Income

Back 3

B) Liquid financial assets

Front 4

True or False:

To a macroeconomist, "Money" is the financial asset kept to defer current command over goods to the future (and earn some return)

Back 4

False. Money is the financial asset kept primarily for doing transactions

Front 5

What are the 2 reasons why people switch some of their portfolios between "Money" and other short term financial assets?

Back 5

1. Transactional Needs (how much liquidity do you need?)

2. Interest Rates (Determine demand for $ because interest= alternatives)

Front 6

Why is the Money Supply and control of $ important?

Back 6

Control of the money supply by a central bank lets it affect or even set short term interest rates.

- important for short-term economic movements

- will have an effect on the market for loanable funds (moreso in the short term); affects savings and investment

Front 7

Which elements of the economy are especially sensitive to short term interest rates?

Back 7

- Consumer durable spending (cars, etc)

- Some housing (shorter term mortgages)

- Business credit costs (less inventory demand and more caution in business short term planning

**In an open economy: Can affect the exchange rate and therefore exports and imports

Front 8

If the economy is weak, should interest rates be increased or decreased?

Back 8

Interest rates should be lowered to incentivize consumption.

Front 9

What is credit rationing?

Back 9

Those who would like to borrow at the current low rates are turned away because banks and other financial institutions are extremely cautious.

This occurred in the recent financial crisis.

Credit rationing causes the relationship of short term interest rates and expenditures to break down.

Front 10

Why does credit rationing occur?

Back 10

Banks are constrained from lending because their asset base's value is uncertain. Making more loans with even relatively low risk makes the overall portfolio riskier and may even be disallowed by regulations.

Front 11

Name 3 definitions of money.

Back 11

a) Currency

b) M1: includes Currency+ Personal Checking Accounts+ Current (Business) Accounts

c) M2: All of the above + Savings Deposits + Personal term deposits

*NOTE: credit cards further complicate the definition of money.

Front 12

TRUE or FALSE:

In the short run, we can assume inflation expectations are fixed when referring to the 'interest rate'

Back 12

TRUE.

Front 13

What is the Money Supply?

Back 13

The total amount of money in circulation or in existence inside a country.

Front 14

Which 2 factors does Money Demand depend upon?

Back 14

1. The interest rate (money doesn't pay interest but other assets do; equates to the opportunity cost of holding money)

2. The dollar amount of transactions (P x Y)

Front 15

Fill in the blank:

"The higher the interest rate, the ________ is Money Demand"

Back 15

Ans:

Lower

Front 16

What is a liquidity trap?

Back 16

A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective

Front 17

Does a rising money supply mean falling interest rates (or rising inflation)?

Explain.

Back 17

Not necessarily: it may simply be keeping up with the growth of the economy and resulting in additional transactions.

Front 18

What is the Equilibrium for Money?

Back 18

When the short term interest rate moves up to equalize money demand and the money supply (now usually set by the central bank)

Front 19

Who sets the supply of money?

Back 19

The Central bank

Front 20

What is the "yield curve"?

Back 20

- The array of yields (interest rates) with different maturities, from short to long.

- Different maturities are connected by expectations of future short rates using a PV calculation

Front 21

What does an inverted yield curve signify?

Back 21

- A recession is coming/ rates will not stay as high as they are.

- short rates and/or inflation is expected to fall in the future; this would only likely occur after economic downturn or a period of weakness

- Expected trouble in the future.

Front 22

Should a yield curve slope up or down? Why?

Back 22

It should slope up due to the risk premium.

Front 23

What is a longer term yield?

Back 23

The average of the current short yield and the expected short rates through the longer term + a risk premium for committing to a longer span of borrowing or lending

Front 24

Why might changes in short term rates effect longer term rates?

Back 24

There will be some borrowers or lenders who will switch between long term and short term lending/ borrowing to take advantage or interest rate differences.

Front 25

What does the slope of a yield curve indicate?

Back 25

Expected future short rates

Front 26

What is a risk premium?

Back 26

The additional interest one gets for locking money in at a specific rate, as interest rates could be different in the future.

For some countries, the risk premium may also include probability of default.

Front 27

What does a steeply rising risk curve indicate?

Back 27

- nominal short rates are expected to rise in the future (the real rate or inflation or both)

- could indicate economic recovery and/or higher inflation

*It may possibly indicate higher default risk further into the future.

Front 28

Why are longer rates less volatile than short interest rates?

Back 28

Longer rates are anchored by expectations of long run inflation

The long run real rate is usually more steady

Front 29

What is the total money suppy?

Back 29

The currency and/ or coinage in circulation, sitting at home or sitting in the bank

Front 30

What are fractional reserves and what do they do?

Back 30

Fractional reserves are the portion of deposits a bank keeps on hand to cover withdrawals.

Fractional reserves enable banks to increase the money supply; All the depositors still 'have' their deposits in the bank, but those getting loans also have the money.

Front 31

What is the monetary base?

Back 31

In Modern Canadian banks:

- includes 'vault cash' (currency on hand)

- deposits at the Bank of Canada

Front 32

Describe the money multiplier?

Back 32

- How much an original deposit gets translated into a change in the money supply (say M1).

- roughly the reciprocal of the 'reserve ratio'

- a reserve ratio of 2% is a money multiplier of 50

- also depends on how much currency the economy wishes to hold

- usually stable; control of the monetary base= control of the whole money supply

Front 33

What are the Bank of Canada's assets and liabilities?

Back 33

Assets: Gov't bonds

Liabilities: Currency outstanding, deposits of commercial banks, deposits of federal goverments

Front 34

Why do commercial banks hold 'deposits' at the Bank of Canada?

Back 34

1. Formerly, required by law- legal reserve ratios; most nations incl US still use these

2. As reserves against possible depositor demand for withdrawal that earns (modest) interest- vault cash does not

3. Most important: to settle cheque-clearing balances at end of each day with other banks and financial institutions

**Must be a way for banks to transfer ownership from 1 bank to another; all have deposits at the Bank of Canada

Front 35

Where do commercial bank 'deposits' at the Bank of Canada come from?

Back 35

- NOT the same as individual deposits at commercial banks

- commercial banks cannot take 'money' and deposit it at the Bank of Canada- other than their own cash which counts as reserves anyway

- the Bank of Canada creates or destroys these deposits/ reserves

Front 36

Which 3 main tools does the central bank have to adjust their reserves?

Back 36

1. Open market operations for long- run, major adjustments (not usually used in Canada)

2. The Overnight Market

3. Shifts in fed gov't deposits between the central bank and commercial bank

**Some central banks will alter the required ratios to change the money multiplier and therefore the MS

**Foreign-exchange intervention can also change the monetary base

Front 37

Describe Open Market Operations

Back 37

To Expand the Money Supply

- the Bank buys gov't bonds on the 'open market', buying them from a commercial bank and paying for them by crediting the commercial bank's account at the Bank with additional reserves

-the commercial bank has extra reserves and can expand its loans and deposits, leading to a multiplier expansion of the money supply

- by offering new loans, the commercial banks may end up driving short term interest rates lower; thus an expansion of the MS should usually reduce interest rates

*Money has been created, but everyone's books balance

** The commercial bank has exchanged one asset (gov't bond) for another (deposit at the BOC)

Front 38

How does a central bank contract the money supply via Open Market Operations?

Back 38

1. Sell a bond from its assets on the open market (usually to a commercial bank)

2. Reduces the commercial banks' reserves by the cost of the bonds

3. with lower reserves, the commercial banks (as a group), must reduce their loans and deposits

*The money supply falls, and interest rates rise

Front 39

What happened in the US in 2008?

Back 39

- Fannie May and Freddie Mac created to extend mortgages to people who couldn't get them

- highly risky mortgage debt was issued

- increased demand for housing; prices went up, speculators entered market

- mortgage approval was split from mortgage holding (incentives increased for risky mortgages)

- mortgages were securitized (packaged into securities which hid their true riskiness)

- purchased by tons of banks who became insolvent when mortgage backed assets went to 0

Front 40

Explain how billions could be supplied to banks without causing massive inflation

Back 40

- US Fed Reserve supplied billions of new reserves to the system but banks hoarded reserves

- billions added to reserves, but money multiplier reduced significantly; therefore little growth in true money supply

*Reserves have exploded, money multiplier has imploded

Front 41

Why was Canada different than the US in 2008

Back 41

- Canadian mortgage mechanisms generated relatively few risky mortgages

- Canadian banks are large, diversified and more heavily regulated; took on relatively little 'toxic' debt

- Canadian banks have higher 'capital' ratios (share of assets against deposits)- they were not as leveraged

- the Bank of Canada didn't have to intervene to the same degree

Front 42

What is Quantitative Easing?

Back 42

- trying to increase the money supply further even though there will be no additional effect on short term rates

- intro of new money into the money supply by the central bank

--> Fed bought a large # of longer term bonds to reduce longer term rates, affecting longer term investment decisions

--> increased reserves of banks to encourage more lending and increase the money multiplier

--> may increase expectations of inflation which works to reduce the real rate of interest (both short and long)

Front 43

What are other new tools for monetary policy?

Back 43

Forward Guidance:

Letting the market know more concretely what the central bank intends to do; this can help influence longer rates as they should respond to plans for future short rates

other: Selling off assets acquired under QE when the monetary conditions and interest rates become more normal

Front 44

What other tools could be used to attack asset bubbles without forcing restrictive monetary policy on the non-financial side of the economy?

Back 44

Macro-Prudential policies including:

- regulations limiting risk taking

- forcing higher equity ratios

- reducing margins

etc

Front 45

What is real output determined by in the long run?

Back 45

Input factors from Section 2-4:

- labour

- physical and human capital

- resources

- TFP

and NOT money

**The money supply determines the Price level, but NOT real output in the long run. And thus of course, money growth determines inflation.

Front 46

What is the Quantity Theory of Money?

Back 46

Says the amount of Money (it's 'quantity') determines the price level int he long run.

Front 47

Explain how the Quantity Equation differs in the long run vs. the short run:

M x V = P x Y

Back 47

In the short run, V and Y are both flexible, so the relationship between M and P are much loser (money isn't inflationary).

In the long run, V and Y are fixed, so M determines P

Where:

M= money supply (in currency units)

V= Velocity (avg # of times 1 unit of currency is used to do transactions in a year

P= Average price of real output (eg: GDP Deflator)

Y= Real output or GDP (determined by L, K, H, etc in the long run)

Front 48

What does velocity depend on in the long run?

Back 48

Monetary institutions and money 'technology'

ex: # and types of banks, internet banking, etc

But in the long run, it is fairly stable and predictable

Front 49

In the labour market, what is the equilibrium?

Back 49

The average wage/ 'price' that equates demand with supply

Front 50

How do you know when the labour market has 'cleared'?

Back 50

The 'price' stops changing.

ie: there is neither upward nor downward pressure on real wages

**Does NOT mean there is no unemployment; some people will still not be employed. This is the "Natural Unemployment Rate" which can be influenced by policy

Front 51

What are other names for the "Natural" unemployment rate?

Back 51

- Full employment unemployment rate

the NAIRU- Non-Accelerating Inflation Rate of Unemployment

Front 52

Is the 'natural rate' of employment fixed?

Back 52

No; it varies with demographics and the labour market's structure an policies.

Front 53

Is real wage constant at the natural rate?

Back 53

Probably not: in the long term, real wages can grow at the same rate as labour productivity growth and there is still no pressure on price inflation (eg: wages up 2%; productivity up 2%= no need to change prices)

Front 54

Explain the relationship between unemployment rates and inflation

Back 54

- Unemployment rate is above the natural rate (low employment and economic output), real wages rise less than productivity growth and inflation decreases.

- Unemployment rate is below the natural rate (high employment and output), real wages increase more than productivity growth and eventually inflation rises

Front 55

What is the Phillips Curve?

Back 55

- high employment= lower inflation

- low unemployment= higher inflation than expected

- the natural rate= unchanging inflation

**The same unemployment rate can be associated with different levels of inflation depending on the underlying expected inflation rate

Front 56

What are the two major components of the 'natural rate'?

Back 56

1) Frictional unemployment (voluntary & short)

- workers in job search process

- affected by age/ sex comp

- existence and amount of EI

2) Structural unemployment

- incl mismatch of available jobs and workers (skills/ regions)

- barriers to the real wage clearing the market (eg: minimum wage)

Front 57

How can an economy 'cure' structural employment?

Back 57

Through policy changes (ex: improving re-training and inter- regional mobility)

**Incorrect cures incl:

- lower taxes/ interest rates (jobs created cannot be filled; inflation results)

- generous EI (slows down new training)

Front 58

Which barriers keep the wage rate from moving to obtain full employment?

Back 58

1) Minimum wages (may prevent wages from falling low enough to employ all low-wage workers)

2) Labour market regulation (European restrictions on terminating employment; you don't hire b/c you can't easily fire)

Front 59

Why do minimum wages exist?

Back 59

- better for politicians b/c they don't have to pay wage subsidies

- may not cost jobs (costs get passed along to consumers for small raises)

Front 60

Which factors may have contributed to a rise in the natural unemployment rate in the US?

Back 60

- mortgage crisis and low house prices significantly reduced geo mobility

- high structural unemployment based on skill (fewer construction workers and middle managers needed)

Front 61

What are the major categories for the Balance of Payments?

Back 61

1. Current Accounts Balance

2. Capital Balance

3. Financial Account

4. Net Errors and Omissions

5. Change in Official Reserves

Front 62

What is the rule for determining signs of a transaction on the Current Account, Capital Account, and Errors and Omissions?

Back 62

If Canadians receive the funds, it is a + (ex: sell exports, get interest)

If Canadians give the funds, it is a - (money going out. Buy imports, pay interest)

Front 63

For the Financial Account, are outflows a '+' or a '-' ?

Back 63

Outflows are a '+'

They go to assets abroad which makes us richer

Net Capital Outflows, NCO

Front 64

For Reserves, is adding to Foreign Exchange Reserves a '+' or a '-'?

Back 64

It's a +

Front 65

What are the components of the Current Account balance?

Back 65

a) Goods and Service Balance (ex: Net Exports)

b) Investment Income (interest, remittances, dividends, earnings on PAST lending and borrowing)*

c) Current Transfers Balance ("Secondary Income"; funds crossing the border with no strings attached. Ex: OXFAM, gov't aid, immigrants bringing $ in/ out)

*Actual lending and borrowing is in the Capital and Financial Account

Front 66

What does a negative Current Accounts balance signify?

Back 66

That we bought more from the rest of the world than we sold to them

Front 67

What are 3 reasons as to why Canada would have a service deficit for its Current Accounts?

Back 67

1. Travel & Tourism (more CNDs leave in the winter than foreigners coming to visit)

2. Shipping (we rent them from other countries)

3. Insuring cargoes

Front 68

Which component of the Current Account is part of GNP, not GDP?

Back 68

Investment Income.

GDP- production and income earned in Canada by whomever

GNP- production and income earned by Canadians, wherever

Front 69

What are remittances?

Back 69

A remittance is a transfer of money by a foreign worker to an individual in his or her home country. Money sent home by migrants competes with international aid as one of the largest financial inflows to developing countries.

Front 70

What comprises the capital account?

Back 70

Real property owned by individuals (ex: a Hollywood star buys a cottage in Muskoka)

Front 71

What comprises the financial account?

Back 71

Actual borrowing and lending

Front 72

How is the Official Reserve Change calculated?

Back 72

Current Account + Capital Account - Financial Account (NCO) + Stat Discount

*If this doesn't hold, you missed something

Front 73

How are financial inflows and outflows generally divided?

Back 73

1. Direct investment (buy > 10% ownership or start a branch plant/ subsidiary (often more controversial b/c it carries some 'control')

2. Portfolio investment (buy equities, bonds, or simply put funds in a foreign bank; sometimes further divided into long term and short term

Front 74

When a country adds to its foreign reserves, the sign is a + or a -? Why?

Back 74

The money is coming in, just as in payments for exports, hence a +

Front 75

What are Official Reserves?

Back 75

Government holdings of foreign currency to support or smooth out changes in the exchange rate.

*They have NOTHING to do with 'commercial bank reserves'

*In Canada, they are owned by the Fed Gov't; the Bank of Canada only manages them

Front 76

How are Errors and Omissions calculated?

Back 76

They are residuals to make the identity below hold true:

Current Accounts + Capital Accounts- Financial Account + Errors and Omissions= Change in Reserves

Front 77

Why does NX= NCO?

Back 77

NX= Current Account (ignoring non-trade items)

NCO= The Financial Account

Capital Account is usually ignored (too small!)

Stat Disc and Official Reserve Change are set to 0

Front 78

If Canada has a net trade deficit, what must be true about it's capital outflow?

Back 78

NCO < 0.

Canada must be borrowing from other nations to buy the excess of what we import over what we export

Front 79

Is a Current Account (Net Trade) Deficit bad or good? Explain.

Back 79

It depends on what it's being used for.

Good deficit- when funds are used for investment (eg: develop auto plans, mining, capital stock, natural resources, human capital, TFP).

Bad Deficit- when funds are borrowed to fund current consumption, the interest on the borrowing, debt repayment (ex: financing public services like the gov't did in the 1980s and first half of the 1990s

Front 80

In the long run, for a closed economy,

Y= C + I + G and

Private Savings (Y- T - C) + Gov't Saving= I= S

What happens when the economy is an open economy?

Back 80

Y= C + I + G + NX

Private Saving (Y - T - C) + Gov't Saving (T- G)= I + Net Capital Outflow

(S= I+ NCO)

Front 81

If total saving is > I, how is money moving abroad?

Back 81

The rest is loaned abroad (NCO >0, NX > 0)

Front 82

If total saving is < I, how is money moving abroad?

Back 82

There is borrowing from abroad to fund I and NCO < 0, NX < 0

Front 83

Is the following a trade deficit, balanced trade, or a trade surplus?

Exports < Imports

Net Exports < 0

Y < C + I + G

Savings < Investment

Net capital outflow < 0

Back 83

Trade Deficit

Front 84

Is the following a trade deficit, balanced trade, or a trade surplus?

Exports = Imports

Net Exports = 0

Y = C + I + G

Savings = Investment

Net capital outflow = 0

Back 84

Balanced Trade

Front 85

Is the following a trade deficit, balanced trade, or a trade surplus?

Exports > Imports

Net Exports > 0

Y > C + I + G

Savings > Investment

Net capital outflow > 0

Back 85

Trade Surplus

Front 86

Suppose domestic savings (S) increases. What must follow?

Back 86

I or NCO must rise. Extra savings goes into domestic I or is loaned abroad.

If NCO increases, so does NX

Front 87

Suppose domestic Investment (I) increases. What must be true?

Back 87

Either domestic S must rise or NCO falls. Less capital outflow or more borrowing from abroad.

If NCO is down, so is NX.

Front 88

What is the nominal exchange rate (E)?

Back 88

The number of units of foreign currency you get for one unit of domestic currency.

Eg: $1 CND= $0.70 USD

Front 89

What does it mean for a currency (like the CND$) to have appreciated?

Back 89

It means you get more of a foreign currency.

Front 90

What does the Real Exchange Rate (RER) take into account?

Back 90

It takes the price levels of the two nations into account

Ex: RER= E x Price (CND)/ Price (US)

Front 91

What are 3 ways in which real appreciation can occur?

Back 91

1. E (Exchange Rate) goes up

2. P(CND) goes up

3. P(US) goes down

Front 92

What is the Purchasing Power Parity (PPP) Theory of Long Run Exchange Rates?

Back 92

Over time, the nominal exchange rate will move to equalize the 'prices' of similar goods in two countries.

Each currency has equal (parity) purchasing power.

Front 93

What are 3 problems with PPP?

Back 93

*PPP= Purchasing Power Parity

1. Non-traded goods are not directly subject to int'l competition and price pressures (ex: haircuts in Buffalo don't compete w/ haircuts in Toronto)

2. Barriers to traded goods (incl: transportation costs, tariffs and other trade barriers, home bias)

3. Capital- flow pressures on exchange rates when S and I are unbalanced across countries (eg: C$ may have become overvalued as foreigners attempt to buy CND resource assets

Front 94

What affects the 'world' real interest rate?

Back 94

'World' supply and demand; we assume it is not affected by what happens in our country (the 'small country' assumption)

Front 95

What must happen for the 'world' rate to hold in a small country?

Back 95

There must be 'perfect capital mobility'

ie: financial capital must be free to cross boarders in order to seek the best rate of return.

Front 96

What are the limitations to Perfect Capital Mobility?

Back 96

- Default risk (countries with higher risks would pay the world rate plus a premium)

- Tax treatment and regulations- many countries tax domestic and foreign earnings differently or have different rules on prudent portfolio holdings that limit perfect capital mobility. Some countries like China also have outright capital controls

- In the short term, interest rates may deviate from a world rate more than in the long term

- nominal interest rates will differ across countries depending on expected changes in inflation (via the "real exchange rate")