Money Flashcards
The Functions of Money
(4 Functions)
1. Medium of Exchange
- facilitates transactions between consumers and producers as avoids a barter economy
- no need for double coincidence of wants
2. Unit of Account
- money helps establish the measure of goods
- adds a monetary value to goods
3. Store of Value
- retains its value in order to save
- in the long run the value of money loses its value so savings erode over time as as real IR become negative
4. Means of Deferred Payments
- when people take out loans
- have to pay back interest to lenders
Characteristics of Money
(6 Characteristics)
1. Portability
- carry money and allow everyday use
2. Divisibility
- can be broken down to smaller amounts
3. Exceptability
- must trust the money
4. Durability
- doesnt rip or fall apart
5. Scarcity
- limited in supply so remains its value
6. Stability
Forms of money in a modern economy
- Cash
- Central Bank Reserves
- Money in Current Accounts
- Near Money
- Non-money Financial Assets
Money in current accounts
When firms and consumers save money with commercial banks and building societies that can be withdrawn at request from an ATM
Building societies
Mutual institutions
- part ownership of the company
Near money
Assets that fill some but not all functions of money
Non money financial assets
Assets that can be converted into cash but at a considerable cost and at a long period of time
Liquidity
When you can turn an asset into cash easily asnd quickly without losing its value
Narrow Money
Contains:
- notes and cash
- commercial bank deposits held at the central bank which are easily convertable to cash and are liquid
Broad Money
Contains:
- notes and coins
- commercial bank deposits held at the central bank
- Wholesale deposits (made by large institutions)
- Retail deposits (made by individuals) that are with financial institutions
The Credit Creation Multiplier
A process by which an increase in money supply can have a multiplied effect on the amount of credit available in the economy
What does the credit creation multiplier explain?
- how money is created
- why it is difficult for the Central Bank to really control the money supply
The role of Banks
Accept deposits from consumers and lend it out to investors so that they can get a return on the deposit and pay interest
How can the credit creation multiplier be calculated?
1 / liquidity ratio
What happens the higher the liquidity ratio?
The lower the credit creation multiplier
What will be the final increase in money supply?
Initial deposit x credit creation multiplier
How can the Central Bank attempt to have more control over money supply?
Requiring commercial banks to have a high liquidity ratio
Why might this not give them for control?
Commercial banks will set themselves an even higher liquidity ratio than the Central Bank tells them to retain more money especially during a recession as have low confidence
- this is because consumers may default and firms may not be able to pay back loans
What is the price of money?
Interest
- this is because it is the price that has to be paid to borrow money
- the interest is paid to the lender
What does the liquidity preference theory explain?
Explains how interest rates are determined and is based on the demand for holding money as opposed to other financial assets
What does it mean when it is assumed that individuals have a liquidity preference?
Want people want to hold liquid assets as opposed to illiquid assets as it is easier to change into money such as cash
- many illiquid assets are risky as they are quite volatile in price
The three primary reasons for holding money
1. Transactional demand for money
- the first motive for holding money as people use money to buy goods and services for everyday use
2. Precautionary demand for money
- negative output gaps increase the demand for precautionary demand of money in case of emergency
- includes target savers
- people may save during a boom
3. Speculative demand for money
- when the equity market is very high people hold their money in anticipation of prices decreasing
- people won’t buy shares until it is of high value as gain more money
- people may buy when of low value and wait till it appreciates
The demand curve for money
It is downwards sloping
- at lower interest rates less people want to save
- at higher interest rates more people want to save
- the opportunity cost of not saving money is greater when interest rates are high
The supply curve for money
The supply of money is fixed
- the Central Bank aims to control the money supply of the economy
- money supply is not affected by interest rates so it is perfectly inelastic
According to the Loanable Funds Theory, where does the demand for loanable funds come from?
- Purely from investments as firms take out loans to fund their investments
(ceteris paribus)
What does this mean about the demand of loanable funds?
- Downwards sloping at lower interest rates, more firms want to take out loans and invest as the cost of borrowing is lower
According to the Loanable Funds Theory, where does the supply for loanable funds come from?
- Purely from savings as most people save their money in banks
(ceteris paribus)
What does this mean about the supply of loanable funds?
- Upwards sloping because at high interest rates, more people are saving as the reward for saving is higher
Equilibrium in the loanable funds theory
Savings = Investments
How can loanable funds theory be used to explain low interest rates during a recession?
- animal spirits are not aroused and so investments decreases and shifts to the left so IR decreases (as borrowing less money to invest)
- individuals are less confident and so are more likely to save more for precautionary reasons
