Chapter 4: The monetary system Flashcards
What are the 3 purposes of money? And what does it mean?
Three purposes of money: a store of value, a unit of account and a medium of exchange
A store of value: transfer purchasing power from the present to the future
Unit of account: provides the terms in which prices are quoted and debts are recorded
What is fiat money?
And what is commodity money?
Fiat money: money with no intrinsic value, established as money by government decree or fiat
Commodity money: a commodity with some intrinsic value, e.g. gold
What is the primary way of controlling money?
Primary way of controlling money : open-market operations - the purchase and sale of government bonds
When the central bank wants to increase money supply - creates money and uses it to buy government bonds from the public
What is the quantity of money (and what is included)?
Because money is the stock of assets used for transactions, the quantity of money is the quantity of those assets
The most obvious assets to include in the quantity of money - currency
Also include demand deposits
Include other bank accounts, e.g. savings, and depositors in money market funds
Are debit- and credit cards money?
Debit- and credit cards and cheques are not money - they are a method of transferring money between bank accounts
What is 100 per cent-reserve banking and what does it imply?
100 per cent-reserve banking - a system where all money in the bank is held as reserves
If banks hold 100% of the deposits in reserve, the banking system does not affect the supply of money
What is fractional reserve banking and what does it imply?
Fractional reserve banking - the bank keeps a fraction of their deposits in reserve
In a system of fractional reserve banking, banks create money. Loaning out money increases the supply of money. –> The depositors still have a demand deposit but now the borrower has more money. With each deposit and loan, more money is created.
Note: the banking system increases the economy’s liquidity, not its wealth.
What is the primary difference between banks and other financial institutions?
The banking system’s ability to create money is the primary difference between banks and other financial institutions.
What are 3 ways the bank uses its resources?
Three ways the bank uses resources: reserves, loans, buying financial securities
What is leverage and what is the leverage ratio?
Leverage - the use of borrowed money to supplement existing funds for purposes of investment
Leverage ratio, the ratio of the bank’s total assets to bank capital
(Bank capital or the equity of the bank owners - starting a bank requires resources)
What is an implication of leverage and how can it be mitigated?
An implication of leverage: in bad times a bank can lose much of its capital quickly. A high leverage ratio indicates that a lot of bank assets are not financed through capital owner’s equity but through deposits and debt.
Goal of capital requirement: the bank can pay off depositors. The capital requirement depends on the risks of the assets held by the bank
What are the 3 exogenous variables in the model of money supply?
- The monetary base B - the total number of euros held by public as currency, C, and by banks as reserves, R.
- Reserve-deposit ratio rr
- Currency-deposit ratio cr
- Who controls B (the monetary base) and what is 2. the reserve-deposit ratio rr and 3. the currency-deposit ratio cr?
- Directly controlled by the central bank
- The proportion of deposits the bank holds in reserve
- The amount of currency C people hold as a proportion of their holdings of demand deposits D
What is the money supply a function of?
The money supply is a function of B, rr and cr
M=(cr+1)/(cr+rr)·B
The money supply is proportional to the monetary base. What is the factor of proportionality ?
m=(cr+1)/(cr+rr)
m = the money multiplier
Because the monetary base has a multiplied effect on the money supply, the monetary base is sometimes called high-powered money
The money supply is proportional to the monetary base
What happens if there is an increase in B?
An increase in monetary base increases money supply by the same percentage
If monetary base changes by ΔB, then ΔM= m×ΔB
What happens if there is a decrease in rr (reserve-deposit ratio)?
The lower the rr, the more loans banks make, and the more money banks create
A decrease in rr raises money multiplier and money supply
What happens if there is a decrease in cr (currency-deposit ratio)?
A decrease in cr raises the money multiplier and the money supply
The lower the cr, the fewer euros of the monetary base the public holds as currency, the more base euros banks hold as reserves and the more money banks can create
How does the central bank control the money supply?
The central bank controls money supply indirectly by altering the monetary base or rr
What are the 3 instruments central banks use to control money supply?
Three instruments: open-market operations, refinancing rate and reserve requirements
More sophisticated form of open-market operations - buying bonds or other assets from banks and at the same time agreeing to sell them back later - often called repurchase agreement or repo
What are outright open-market operations?
Outright open-market operations - involve an outright sale or purchase of non-monetary assets to or from the banking sector
What is the refinancing rate?
Refinancing rate - an interest rate at which the central bank is willing to lend to commercial banks on a short-term basis
OR
Repurchase or repo rate - the difference between the price at which the bank sells the assets to the central bank and the price the bank has agreed to repurchase the assets for
The central bank has thus effectively made a loan and taken the bonds or other assets as collateral. The interest rate the central bank charges on the loan is the refinancing rate.
What is the money market and what is the rate in the market?
Most banks have a minimum reserve ratio, if they are above or below, the might short-term lend out or borrow money from other banks - this market is called the money market
What happens if the central bank increases the refinancing rate?
If the central bank increases refinancing rate - commercial banks will try to rein in their lending rather than borrow reserves from the central bank - decrease in money supply
If there is general shortage of liquidity - the short-term interest rate at which they lend to each other will rise, and vice versa
The central bank closely monitors the money market and may intervene to affect liquidity supply which affect the lending and thus money supply
What are reserve requirements and how can they affect the money supply?
Reserve requirements - regulations on the minimum amount of reserves that banks must hold against deposits
Reserve requirements influence how much money the banking system can create with each euro
Increase in reserve requirements - banks must hold more reserves and therefore can lend out less money and create less money - the money multiplier is lowered
How does the ECB use reserve requirements?
The ECB applies reserve requirements to an average reserve ratio over a specified period of time
Uses the reserve ratio to maintain stability in the money market rather than instrument policy
Reserve requirements only used rarely - would disrupt the business of banks
What are 2 problems the central bank has in regards to controlling money supply?
(1) No control over households
(2) No control over amount bankers choose to lend
Each arises because of the fractional reserve banking system
What is the money multiplier?
The increase in the money supply resulting from a one-euro increase in the monetary base.
m=(cr+1)/(cr+rr)
