Banking and Interest Rates Flashcards
what do commercial banks create
money and credit.
How do banks increase the money supply in the economy
what does the customer then become
by granting loans, bank creates a deposit in the customers account. this is new money.
a debtor of the bank,
what is a loan to a bank
it is an asset
an asset to the bank is anything that is owned by or owned to the bank.
what is a liability for the bank
a customers deposit. anything the bank owes is a liability.
as if customer wants his money the bank has to pay.
what do banks do with each other
where do they do that and what is it called.
they lend each other money,
it is called inter-bank lending. and this occurs on the inter-bank lending market.
how long do loans usually last on the inter-bank lending market?
usually less than one week, and often only overnight.
why do banks need to lend money to each other?
on any day, some banks have excess liquidity others will have a shortage (because they received more or less than they expected in payments for example).
banks with a temporary shortage of liquidity can borrow to meet their customers’ needs. banks with extra liquidity earn interest on what they lend.
the rate charged for inter-lending between banks is called?
the inter-bank lending rate or the overnight rate.
banks have a balance sheet.
what is a balance sheet
what should happen on a balance sheet always
a snapshot in time of its assets and liabilities.
total assets should always equal total liabilities.
why is the banks capital a liability?
because if the bank ceased trading, this money would be returned to shareholders (once all the bank’s outstanding debts had been paid)
on a balance sheet how are assets organised
they go form top to being most liquid to bottom to being least liquid.
what is a banks capital?
it is the total of its share capital which is the money raised when its shares were first issued and its reserves made up from retained profits.
the amount of credit a bank can create depends on
what do banks want to keep?
its levels of capital.
banks want to keep the ratio of loans to capital within a certain limit.
what happens when the banks assets falls.
and why is that.
the banks capital is reduced by the same amount because total assets still equals total liabilities.
when does a bank become insolvent?
when the value of the banks assets becomes less than the value of its liabilities. insolvent banks usually have to close down as the central bank doesn’t usually lend to insolvent banks.
what does a bank try to achieve a balance of?
how do they do that?
the bank tries to achieve a balance of liquidity, security and profitability.
the bank will hold a variety of assets to do this. for example they will have unsecured loans which are more profitable and secured loans which are safer.
How are interest rates determined
they are determined by levels of supply and demand.
what does the loanable funds theory say
it says that interest rates are set by savers and borrowers.
it says the interest rate is determined by the supply of, and demand for, loanable funds.
what are loanable funds
the total amount of money available for borrowing.
at high interest rates the loanable theory says that
the supply of loanable funds will be higher since people save more. and demand will be lower since people borrow less.
when is the market for loanable funds at equilibrium
where the supply and demand curves cross.
the loanable funds theory works best for a
very simple economy.
what does the liquidity preference theory say.
what does it assume
that people balance risk and reward.
It assumes that people can either hold their wealth as liquid money (cash in your pocket) or illiquid bonds (bonds meaning any illiquid interest earning asset whose price can change).
when interest rates are high
bonds are more attractive
the reward of the interest outweighs the risk of a fall in price
when interest rates are low
bonds are less attractive
the risk of a price fall outweighs the reward of the interest.
what does demand for liquid money also depend on?
people’s expectations of future interest rates.
when interest rates are high people might expect
what will this lead to?
because of this what will speculators do?
the interest rates to fall
an increase in bond prices.
they will want to hold their wealth as bonds and will demand less liquid money.
if interest rates are low people might expect
What will this lead to?
interest rates to rise.
a decrease in bond prices.
therefore demand for liquid money will increase if interest rates are low.
what is the liquidity preference schedule LP?
how does it slope
draw it with MS which stands for?
the demand curve for money.
it slopes downwards. interest rate on Y axis.
money supply.
money supply is assumed to be
fixed.
the interest rate is at the
equilibrium between supply MS and demand LP.
interest rates can be expressed in
nominal terms and real terms.
what is a nominal rate of interest
is one that hasn’t been adjusted to allow for inflation.
what is the real rate of interest
one that has been adjusted with the rate of inflation.
= nominal rate of interest - rate of inflation.
market interest rates and bond prices have
an inverse relation.
the yield of a bond will approximately match the rate of interest on other investments with similar risk levels.
this means that as interest rates rise, bond prices fall, and vice versa.
equation to find the approximate market price of bond.
coupon / yield x 100
