Chapter 4- Monetary System

Question 1

Define monetary policy

Answer 1

Policy made by the central bank about that nation’s:
- system of money
- banking
- currency

Question 2

Define money

Answer 2

Stock of assets that can be readily used to make transactions.

Question 3

What are the functions of money?

Answer 3

1. Store of value: used to transfer purchasing power from the present to the future. BUT it is not perfect because if prices rise, the amount you can buy with money you hold decreases
2. Unit of account: it provides the terms which prices are quoted and debts are recorded
3. Medium of exchange: we use it to buy goods and services.

Question 4

Define asset liquidity

Answer 4

The level of ease which an asset can be converted into the medium of exchange and used to buy other things.

Question 5

Define fiat money

Answer 5

Money that has NO intrinsic value. It is established as money by government decree or fist.

Question 6

Define commodity money

Answer 6

Using commodity (like gold) that had some intrinsic value.

Question 7

Define gold standard

Answer 7

Economy that uses gold as money.

Question 8

Why everyone values money?

Answer 8

Because they expect others to value it

Question 9

Define money supply

Answer 9

Quantity of money available in an economy

Question 10

Define monetary policy

Answer 10

Government control over the money supply

Question 11

Define open market operations

Answer 11

Purchases and sale of government bonds by the central bank in which it controls money supply.

Question 12

How the central bank increases money supply?

Answer 12

It uses some of the dollars it has to buy government bonds from the public.

Question 13

How the central bank decreases money supply?

Answer 13

It sells some government bonds from its own portfolio.

Question 14

How money is measured?

Answer 14

Money is the stock of assets for transactions, then its quantity = quantity of those assets

Question 15

What are the most used assets used for transactions? Define them and who holds them?

Answer 15

Currency: sum of outstanding paper money and coins. It is in the hands of the public.

Demand deposits: funds people hold in bank ready to withdraw. It is in the hands of the banks.

Question 16

Define reserves? What is the name of banking which focus solely on reserves?

Does it have effect on the money supply?

Answer 16

The deposits banks received but didn’t lent out.

100-percent-reserve banking

No it does not

Question 17

Define balance sheet

Answer 17

Accounting statement of assets and liabilities

Question 18

What we call the banking method in which bank does not store all of its reserves?

How does it effect the economy?

Answer 18

Fractional-reserve banking in which the banks keeps only a fraction of its deposits in reserve.

When the banks lends people, it increases the money supply.

Question 19

What we call the process of transferring funds from savers to borrowers?

Answer 19

Financial intermediation

Question 20

Define bank capital

How bank funds are used?

Answer 20

A capital required to open a bank.

1. Reserve
2. Loans
3. Buying securities

Question 21

Define leverage, leverage ratio

Answer 21

Leverage: use of borrowed money to supplement existing funds for purposes of investment

Leverage ratio: bank assets / bank capital

Question 22

When a bank becomes insolvent?

Answer 22

Bank assets < liabilities

Bank capital = 0

Question 23

What interactions affect money supply?

Answer 23

Central bank decision about how many dollars to create

Households decision about whether to hold their money in currency / demand deposits

Bank decision about whether to hold deposits as reserves / lend them out

Question 24

What 3 exogenous variable the model of money supply has?

Answer 24

Monetary base: controlled by central bank and it is the total number of dollars held by the public as currency, and by the banks as reserve.

Reserve-deposit ratio: the fraction of deposits that banks hold in reserve.

Currency-deposit ratio: the amount of currency people hold as fraction of their holdings of demand deposits.

Question 25

What the currency-deposit ratio reflects?

Answer 25

The preferences of households about the form of money they wish to hold.

Question 26

What happens to money supply when monetary base increases?

Answer 26

Increases because
Monetary base = currency + bank reserves

Question 27

What lower reserve-deposit ratio means? And how it affects money supply?

Answer 27

More loans banks make

It affects money supply by increasing it

Question 28

What lower currency-deposit ratio means? How it affects money supply?

Answer 28

Less money held as currency therefore higher deposits and as a result higher money supply

Question 29

How the central bank controls money supply indirectly?

Answer 29

Influence monetary base:
- buying and selling government bonds
- lending reserves to banks
- lower discount rate

Influence reserve-deposit ratio:
- increase in reserve-deposit minimum reduces money supply.
- higher interest on reserves reduces money supply

Question 30

Define discount rate

Answer 30

Interest rate central bank charges on loans lent to banks

Question 31

Define reserve requirements, excess reserves, and interest on reserves

Answer 31

1. Central bank regulation that impose a minimum reserve-deposit on banks
2. Reserves above the minimum required
3. Central bank pays interest for banks who deposit at it