4.2 Monetary System and Monetary Control Flashcards
What are the functions and roles of money?
Functions:
1. Medium of exchange
- Unit of account - records prices and debts
- Store of value - transfers purchasing power from present to future e.g. gold
Money is the most liquid of assets - ease at which it can be converted into the medium of exchange
- The more liquid, the lower its return - money has lowest return of an asset
What are the types of money
Commodity money - form of a commodity with intrinsic value (would have value even if not used for money)
Fiat money: without intrinsic value, used as money due to government decree
- Faith crucial here, if lost, money loses value
What is the money stock
Add up all the fiat money, get money stock
Split into 2 parts
M1 = Currency + Demand Deposits + Checkable Deposits
M2 = M1 + Savings deposits (short term) + money market mutual funds
What is the role of central banks? role of BofE and banks in Europe and US
Fiat money regulated by central banks. Have legal entity with authority to oversee banking system and regulate quantity of money in the economy
BofE: 1694 (independent in 1997)
- MPC sets interest rate to achieve 2% inflation rate of CPI
- New powers for financial regulation, abolish Financial Services Authority in aftermath of global financial crisis
US:
Federal reserve 1913 - policy aims to ensure health of nation banking system
ECB:
- Comprises EMU countries
- Goal to achieve price stability - below but close to 2% in medium run
What is monetary policy?
Controlling money supply to control inflation
- Printing too much causes inflation
- Interest rates/money supply affect activity and unemployment
Trade off between inflation and increasing production/unemployment when money supply increased
Quantitative easing:
- 2009 and 2010 MPC authorised purchase of £200bn worth of assets, mostly gilts
- Repeatedly renewed
This lowers interest rates, boosting activity and increases inflation all else equal - may be used to prevent deflation
What is a banks influence on money supply? What are reserves?
Reserves:
- Deposits banks have received but not loaned out
100% reserve banking:
- All deposits held as reserves - dont influence money supply
Fractional reserve banking:
- Hold only a fraction of deposits as reserves, rest used to make loans and make retursn
Reserve ratio: fraction of deposits banks hold as reserves - in case depositors wish to withdraw cash
Reserve requiremen: minimum amount of rserves banks must hold; set in some countries - by FED, ECB - but not imposed by law in UK
Excess reserve: may hold reserves above the legal minimum
Example: FNB has reserve ratio 10%
Deposit of $100, $10 is held, $90 loaned out
- $90 loan increases money supply by putting money into borrowers pockets, increases money supply from $100 to $190
- Does not create wealth as bank loans are debt for borrowers and so therefore not richer in long run
What is money creation
Suppose FNB use the $90 to buy goods, proceeds of which deposited in a second national bank
SNB then hold 10% in reserves ($9) and lends out a further ($81)
- The process repeats, creating the money multiplier
What is the money multiplier using the example?
Original deposit = $100
First lending = $90
Second lending = $81
Third lending = $81
Total money supply is the sum of above, equal to $1000
The money multiplier is the amount of money the banking system generates from each dollar of reserves
It is the reciprocol of the reserve ratio:
MM = 1/R
So in the example MM = 1/0.1 = 10, so $100 becomes $1000
The higher the reserve ratio, the smaller the money multipler
What are the 3 main tools of monetary control
- Open market operations
- Refinancing rate
- Reserve requirements
What is the effect of open market operations?
Outright purchases/sales of government bonds by central banks
Increases money supply:
- Central banks buy bonds from public, puts cash into public hands
- Public then pay interest
Reducing money supply:
- Central banks sell bonds to public, currency received now out of public hands
- Note unconventional OMOs exist, which is buying other types of assets such as private bonds
What is the effect of refinancing rates
Interest rate which CB lends to commercial bank on short term basis
Called repo rate in UK, discount rate in US
Banks lend money to eachother, borrow from the CB in the money market
The central bank can control the money market interest rates through the refinancing rate (as well as OMOs)
WHat is the effect of reserve requireements
Increase in reserve requirements reduces money supply, as multiplier falls
Reduction in RR increases money supply, as multiplier rises
BofE, FED, ECB prefer not to use since upsets banks business model
What are some problems with using monetary policy
CBs control of money supply not precise - money multiplier varying due to fracitonal reserve banking, hard to caclulate
CB cannot control amount of money households choose to hold as deposits in banks
- Also do not control amount bankers choose to lend rather than keep as reserves
What are bank runs and how do they affect money supply
When deposits suspect banks may go bankrupt, so rush to withdraw deposits e.g. Northern Rock bank run 2007
Problem for banks under fractional reserve banking is they cannot satisfy all withdrawal requests, bank forced to close doors until loans repaid
- Or until lender of last resort provides with currency needed to satisfy the deposits - in 2008 government took Northern rock into state ownership
Great depression 1930s:
- Wave of bank runs and closings
- Households and bankers became more cautious
- households withdrew deposits from banks
