Chapter 4: The monetary system

Question 1

What are the 3 purposes of money? And what does it mean?

Answer 1

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

Question 2

What is fiat money?

And what is commodity money?

Answer 2

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

Question 3

What is the primary way of controlling money?

Answer 3

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

Question 4

What is the quantity of money (and what is included)?

Answer 4

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

Question 5

Are debit- and credit cards money?

Answer 5

Debit- and credit cards and cheques are not money - they are a method of transferring money between bank accounts

Question 6

What is 100 per cent-reserve banking and what does it imply?

Answer 6

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

Question 7

What is fractional reserve banking and what does it imply?

Answer 7

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.

Question 8

What is the primary difference between banks and other financial institutions?

Answer 8

The banking system’s ability to create money is the primary difference between banks and other financial institutions.

Question 9

What are 3 ways the bank uses its resources?

Answer 9

Three ways the bank uses resources: reserves, loans, buying financial securities

Question 10

What is leverage and what is the leverage ratio?

Answer 10

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)

Question 11

What is an implication of leverage and how can it be mitigated?

Answer 11

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

Question 12

What are the 3 exogenous variables in the model of money supply?

Answer 12

1. The monetary base B - the total number of euros held by public as currency, C, and by banks as reserves, R.
2. Reserve-deposit ratio rr
3. Currency-deposit ratio cr

Question 13

1. Who controls B (the monetary base) and what is 2. the reserve-deposit ratio rr and 3. the currency-deposit ratio cr?

Answer 13

1. Directly controlled by the central bank
2. The proportion of deposits the bank holds in reserve
3. The amount of currency C people hold as a proportion of their holdings of demand deposits D

Question 14

What is the money supply a function of?

Answer 14

The money supply is a function of B, rr and cr

M=(cr+1)/(cr+rr)·B

Question 15

The money supply is proportional to the monetary base. What is the factor of proportionality ?

Answer 15

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

Question 16

What happens if there is an increase in B?

Answer 16

An increase in monetary base increases money supply by the same percentage

If monetary base changes by ΔB, then ΔM= m×ΔB

Question 17

What happens if there is a decrease in rr (reserve-deposit ratio)?

Answer 17

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

Question 18

What happens if there is a decrease in cr (currency-deposit ratio)?

Answer 18

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

Question 19

How does the central bank control the money supply?

Answer 19

The central bank controls money supply indirectly by altering the monetary base or rr

Question 20

What are the 3 instruments central banks use to control money supply?

Answer 20

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

Question 21

What are outright open-market operations?

Answer 21

Outright open-market operations - involve an outright sale or purchase of non-monetary assets to or from the banking sector

Question 22

What is the refinancing rate?

Answer 22

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.

Question 23

What is the money market and what is the rate in the market?

Answer 23

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

Question 24

What happens if the central bank increases the refinancing rate?

Answer 24

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

Question 25

What are reserve requirements and how can they affect the money supply?

Answer 25

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

Question 26

How does the ECB use reserve requirements?

Answer 26

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

Question 27

What are 2 problems the central bank has in regards to controlling money supply?

Answer 27

(1) No control over households
(2) No control over amount bankers choose to lend

Each arises because of the fractional reserve banking system

Question 28

What is the money multiplier?

Answer 28

The increase in the money supply resulting from a one-euro increase in the monetary base.

m=(cr+1)/(cr+rr)