Lecture 11 - Monetary System Flashcards
Define the inflation rate
the percentage increase in the average level of prices (over a given period of time)
Define price
the amount of money required to buy a good
What are the 4 functions of money?
- medium of exchange
- store of value
- unit of account
- liquidity
What is meant by money being a medium of exchange?
it is used to purchase goods and services
What is meant by money being a store of value?
transfers purchasing power from the present to the future
What is meant by money being a unit of account?
the common unit by which everyone measures prices and values
What is meant by money having the function of liquidity?
easy access to funds, facilitates markets
What are the 2 types of money?
- commodity money
- fiat money
What is meant by commodity money? Give an example
- has intrinsic value
- e.g. gold coins
What is meant by fiat money? Give an example
- has no intrinsic value
- e.g. the paper currency we use
What is fiat money based on?
based on all of us coordinating that we will honour the “agreement” of accepting paper bills
What do M0 mean?
- M0 = currency (notes and coins) + reserves
- called monetary base or legal tender
What does M1 mean?
M1 = M0 + demand deposits, travellers’ cheques, other checkable deposits
What does M2 mean?
M2 = M1 + small time deposits, small savings deposits
What does M3 mean?
M3 = M2 + large time deposits
What does M4 mean?
M4 = M3 + least liquid assets, e.g., long term bonds
What does the central bank control? How do they control this?
- controls the money supply (though not entirely)
- done via monetary policy
What are the broad categories for how the central bank can control money supply?
- directly (open market operations)
- indirectly (controlling banks reserves, lending rates, etc.)
Why can’t the central bank fully control the money supply?
- they cannot control individual’s behaviour and preferences
- cannot control high street bank operations
What is the equation for the money supply?
- the money supply equals currency (C) plus demand deposits (D) (deposits in current accounts)
- M = C + D
Define Reserves (R)
the portion of deposits that banks have not lent
Define 100-percent-reserve banking
a system in which banks hold all deposits as reserves
Define fractional-reserve banking
a system in which banks hold a fraction of their deposits as reserves
Define assets
anything valuable owned by the institution
Define liabilities
anything valuable that the institution owes to others
What is the equation linking assets, liabilities, and equity?
equity = assets - liabilities
What does total money supply equal in relation to rr?
total money supply = C x 1/rr
What does rr equal?
rr = ratio of reserves to deposits
A fractional-reserve banking system creates money, but it doesn’t create…?
doesn’t create real wealth
Why doesn’t a fractional banking system create real wealth?
bank loans give borrowers some new money and an equal amount of debt
Define bank capital
the resources a bank’s owners have put into the bank
Define leverage
the use of borrowed funds to supplement existing funds for purposes of investment
What is the equation for the leverage ratio?
leverage ratio = assets or total liabilities / net worth
Being highly leverages makes banks…?
makes banks vulnerable
