block 11 Flashcards
what are the functions of money
- medium of exchange - used to facilitate transactions
- unit of account - common measure of the value of goods and services
- store of value - can be used to hold wealth
- standard of deferred payment - money acts as a ‘standard’ for making future payments
what are the 2 key roles of the central bank
- banker to the government - custodian of the gov’s reserves, carries out the country’s monetary policy and manages the country’s currency
- banker to the commercial banks - regulates the banking and financial system, lender of the last resort - provide them money in times of time crunch
what is a liquidity crisis
an institute is temporarily unable to meet immediate requests for payment even though its underlying assets exceed its liabilities
what is solvency crisis
an institutes assets have become less than its liabilities. it is bankrupt without a rapid new injection of assets from government/ shareholders
what are the differences between liquidity crisis and solvency crisis
- liquidity crisis:
- assets > liabilities
- cash flow problem, therefore it needs time to convert assets to cash
- central bank intervention can help them - solvency crisis
- assets < liabilities = cannot pay off debts
- central bank intervention wont help
why is the money supply greater than the monetary base
- money supply comprises currency in circulation and deposits at the bank
- the monetary base is the quantity of notes and coins in private circulation plus the quantity of reserves held by commercial banks (deposits + vault cash)
since deposits are a multiple of banks’ cash reserves, the money multiplier exceeds 1
- the monetary base is ‘high powered’ because part of it is multiplied up as the banking system creates additional deposits, the major component of the money supply
why is there a multiplier effect for money supply
under the fractional reserve banking system, commercial banks are required by law to keep a fraction of their deposits as cash reserves - fractional depends on the reserve ratio set by the central bank
- purpose of cash reserves is to ensure that commercial banks have enough money to meet customers withdrawals
- the rest of deposits can be loaned out
what is the credit creation process
when commercial banks use a part of customers’ deposits to make loans to individuals and businesses, new deposits are created = money supply increases
how does the central bank control the money supply in an economy thru open market operations
- the buying and selling of government bonds in the open market
- if the gov buys 10k work to of govt bonds from banks
= 10k cash is added to the bank’s cash reserves
= commercial banks loan out the entire 10k
= increase in money supply
how does the central bank control the money supply in an economy by controlling the monetary base thru reserve requirements
reserve requirement;
- the percentage of deposits the commercial banks are required to keep as cash according to directors of the central bank
- by adjusting this, central banks can influence the amount of money that banks can lend and hence the money supply
- if reserve is reduced, banks have more money to lend, money supply increases
- if reserve is raised, commercial banks have less money to lend and= money supply falls
how does the central bank control the money supply thru controlling the monetary base via discount rate
discount rate = interest rate that central banks are required charges on its loans to commercial banks
- when central bank lowers the discount rate - induces the commercial banks to borrow from the central bank = increase in reserves so commercial banks are encouraged to lend, money supply increases
if the discount rate is raised, money supply falls
what is quantitative easing
an unconventional form of monetary policy used to increase monetary base to stimulate the economy
- involves the central bank buying large quantities of financial instruments (bonds) from the market in exchange for newly created cash
- usually used when interest rates have been cut to almost 0 and traditional tools cant be used to lower interest rates further
- purchase of bonds by the government will push up bond prices and hence lower long-tun interest rate = encourage investment and consumption
- may not work if economic outlook is gloomy
what is understood as demand for money
it looks at how much of our wealth we want to hold in the form of money at any point in time
wealth consists of money (cash deposits) and bonds (interest earning assets)
money is demanded because it is a medium of exchange and store of value
what are the motives for holding money
- transactions and precautionary demand for money
- money is essential to pay for expected expenses and contingencies
- money is kept on hand cuz receipts and payments are not coordinated
- transaction and precautionary motives for holding money is positively related to income - speculative demand for money
- money is set aside to take advantage of future investment opportunities
- asset notice is inversely related to interest rate
- low interest rate = people wanna hold more money cuz bonds are expensive and opportunity cost of holding money is low
what is money supply targeting
the central bank sets the growth rate of money supply with interest rate then adjusting to bring the money market into equilibrium
under money supply targeting
- when the central bank increases MS ( adopting an expansionary MP) interest rates decrease
- when the central bank decreases MS (tight MP), interest rate increases
why is money supply targeting difficult to achieve
it is difficult to control the money supply
demand for money tends to be volatile cuz of innovations in the financial market and the increase in financial integration
it depends on the economic environment and MS also depends on external factors
what is interest rate targeting
the central bank sets its target interest rate with money supply adjusting to achieve the target interest rate
how does monetary affect the real economy )the transmission mechanism)
monetary policy affects interest rates = affecting C and I
C: interest rates affect consumer wealth, consumer credit and consumers’ stream of expected future income - affecting autonomous consumption
I : inversely related to interest rate, fall in interest rate increases investment, AD and output
