2- Money and Central Banks Flashcards
Who are the 3 main parties in the banking system?
- Central banks
- Commercial banks
- Private sector
What are the 3 main functions of the central bank in the banking system?
- Issues currency
- Holds reserves which are the deposits of commercial banks
- Holds financial assets such as government bonds
What are 3 main functions of commercial banks in the banking system?
- Hold deposits owned by the private sector
- Hold other financial assets including government bonds
- Issue loans to the private sector
What is the main service of a commercial bank?
Act as an intermediary between households and firms that save and those that borrow
What are the 3 main functions of the private sector in the banking system?
- Owns deposits held at commercial banks
- Holds other financial assets including government bonds
- Holds loans issued by commercial banks
What are the 2 main definitions of the money supply we will consider?
- Narrow money (M0)
- Broad money (M4)
What is narrow money (M0) comprised of?
Currency and Bank reserves
M0 = C + R
What is broad money (M4) comprised of?
Currency and Bank deposits
M4 = C + D
What are the 4 main steps of money creation?
- Central banks print currency and issue reserves to commercial banks
- So the central bank creates M0
- Commercial banks issue loans to the private sector
- So commercial banks create M4
What are the 2 main ways central banks perform asset purchases, namely before and after 2008
- Prior to 2008, Central Banks mainly purchased assets from Commercial Banks; through Open Market Operations (OMO)
- Post-2008, Central Banks mainly purchased assets from the private sector; through Quantitative Easing (QE)
How can commercial banks independently create money?
If they issue loans to the private sector, this increases deposits held by the private sector at commercial banks increasing M4. But there is no change in currency or reserves so M0 does not increase
What is the Money Multiplier theory?
It is the ratio of M4 to M0
What is the flaw which makes the money multiplier theory incorrect?
The theory assumes the money multiplier is constant
Why can’t central banks control the money supply through the money multiplier?
Because the money multiplier theory assumes that commercial banks want to issue as many loans as possible whereas in reality banks are risk averse and don’t want to make risky loans
If someone buys a car off somebody else with their debit card, does M4 change?
No, money just shifts between bank accounts so total deposits are unchanged
