Money

Question 1

The Functions of Money

(4 Functions)

Answer 1

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

Question 2

Characteristics of Money

(6 Characteristics)

Answer 2

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

Question 3

Forms of money in a modern economy

Answer 3

1. Cash
2. Central Bank Reserves
3. Money in Current Accounts
4. Near Money
5. Non-money Financial Assets

Question 4

Money in current accounts

Answer 4

When firms and consumers save money with commercial banks and building societies that can be withdrawn at request from an ATM

Question 5

Building societies

Answer 5

Mutual institutions
- part ownership of the company

Question 6

Near money

Answer 6

Assets that fill some but not all functions of money

Question 7

Non money financial assets

Answer 7

Assets that can be converted into cash but at a considerable cost and at a long period of time

Question 8

Liquidity

Answer 8

When you can turn an asset into cash easily asnd quickly without losing its value

Question 9

Narrow Money

Answer 9

Contains:
- notes and cash
- commercial bank deposits held at the central bank which are easily convertable to cash and are liquid

Question 10

Broad Money

Answer 10

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

Question 11

The Credit Creation Multiplier

Answer 11

A process by which an increase in money supply can have a multiplied effect on the amount of credit available in the economy

Question 12

What does the credit creation multiplier explain?

Answer 12

• how money is created
• why it is difficult for the Central Bank to really control the money supply

Question 13

The role of Banks

Answer 13

Accept deposits from consumers and lend it out to investors so that they can get a return on the deposit and pay interest

Question 14

How can the credit creation multiplier be calculated?

Answer 14

1 / liquidity ratio

Question 15

What happens the higher the liquidity ratio?

Answer 15

The lower the credit creation multiplier

Question 16

What will be the final increase in money supply?

Answer 16

Initial deposit x credit creation multiplier

Question 17

How can the Central Bank attempt to have more control over money supply?

Answer 17

Requiring commercial banks to have a high liquidity ratio

Question 18

Why might this not give them for control?

Answer 18

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

Question 19

What is the price of money?

Answer 19

Interest
- this is because it is the price that has to be paid to borrow money
- the interest is paid to the lender

Question 20

What does the liquidity preference theory explain?

Answer 20

Explains how interest rates are determined and is based on the demand for holding money as opposed to other financial assets

Question 21

What does it mean when it is assumed that individuals have a liquidity preference?

Answer 21

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

Question 22

The three primary reasons for holding money

Answer 22

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

Question 23

The demand curve for money

Answer 23

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

Question 24

The supply curve for money

Answer 24

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

Question 25

According to the Loanable Funds Theory, where does the demand for loanable funds come from?

Answer 25

• Purely from investments as firms take out loans to fund their investments
  (ceteris paribus)

Question 26

What does this mean about the demand of loanable funds?

Answer 26

• Downwards sloping at lower interest rates, more firms want to take out loans and invest as the cost of borrowing is lower

Question 27

According to the Loanable Funds Theory, where does the supply for loanable funds come from?

Answer 27

• Purely from savings as most people save their money in banks
  (ceteris paribus)

Question 28

What does this mean about the supply of loanable funds?

Answer 28

• Upwards sloping because at high interest rates, more people are saving as the reward for saving is higher

Question 29

Equilibrium in the loanable funds theory

Answer 29

Savings = Investments

Question 30

How can loanable funds theory be used to explain low interest rates during a recession?

Answer 30

• 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