Lecture 11 - Monetary System

Question 1

Define the inflation rate

Answer 1

the percentage increase in the average level of prices (over a given period of time)

Question 2

Define price

Answer 2

the amount of money required to buy a good

Question 3

What are the 4 functions of money?

Answer 3

• medium of exchange
• store of value
• unit of account
• liquidity

Question 4

What is meant by money being a medium of exchange?

Answer 4

it is used to purchase goods and services

Question 5

What is meant by money being a store of value?

Answer 5

transfers purchasing power from the present to the future

Question 6

What is meant by money being a unit of account?

Answer 6

the common unit by which everyone measures prices and values

Question 7

What is meant by money having the function of liquidity?

Answer 7

easy access to funds, facilitates markets

Question 8

What are the 2 types of money?

Answer 8

• commodity money
• fiat money

Question 9

What is meant by commodity money? Give an example

Answer 9

• has intrinsic value
• e.g. gold coins

Question 10

What is meant by fiat money? Give an example

Answer 10

• has no intrinsic value
• e.g. the paper currency we use

Question 11

What is fiat money based on?

Answer 11

based on all of us coordinating that we will honour the “agreement” of accepting paper bills

Question 12

What do M0 mean?

Answer 12

• M0 = currency (notes and coins) + reserves
• called monetary base or legal tender

Question 13

What does M1 mean?

Answer 13

M1 = M0 + demand deposits, travellers’ cheques, other checkable deposits

Question 14

What does M2 mean?

Answer 14

M2 = M1 + small time deposits, small savings deposits

Question 15

What does M3 mean?

Answer 15

M3 = M2 + large time deposits

Question 16

What does M4 mean?

Answer 16

M4 = M3 + least liquid assets, e.g., long term bonds

Question 17

What does the central bank control? How do they control this?

Answer 17

• controls the money supply (though not entirely)
• done via monetary policy

Question 18

What are the broad categories for how the central bank can control money supply?

Answer 18

• directly (open market operations)
• indirectly (controlling banks reserves, lending rates, etc.)

Question 19

Why can’t the central bank fully control the money supply?

Answer 19

• they cannot control individual’s behaviour and preferences
• cannot control high street bank operations

Question 20

What is the equation for the money supply?

Answer 20

• the money supply equals currency (C) plus demand deposits (D) (deposits in current accounts)
• M = C + D

Question 21

Define Reserves (R)

Answer 21

the portion of deposits that banks have not lent

Question 22

Define 100-percent-reserve banking

Answer 22

a system in which banks hold all deposits as reserves

Question 23

Define fractional-reserve banking

Answer 23

a system in which banks hold a fraction of their deposits as reserves

Question 24

Define assets

Answer 24

anything valuable owned by the institution

Question 25

Define liabilities

Answer 25

anything valuable that the institution owes to others

Question 26

What is the equation linking assets, liabilities, and equity?

Answer 26

equity = assets - liabilities

Question 27

What does total money supply equal in relation to rr?

Answer 27

total money supply = C x 1/rr

Question 28

What does rr equal?

Answer 28

rr = ratio of reserves to deposits

Question 29

A fractional-reserve banking system creates money, but it doesn’t create…?

Answer 29

doesn’t create real wealth

Question 30

Why doesn’t a fractional banking system create real wealth?

Answer 30

bank loans give borrowers some new money and an equal amount of debt

Question 31

Define bank capital

Answer 31

the resources a bank’s owners have put into the bank

Question 32

Define leverage

Answer 32

the use of borrowed funds to supplement existing funds for purposes of investment

Question 33

What is the equation for the leverage ratio?

Answer 33

leverage ratio = assets or total liabilities / net worth

Question 34

Being highly leverages makes banks…?

Answer 34

makes banks vulnerable