MONEY

Question 1

Define “money”

Answer 1

Assets, serving as a medium of exchange, that people regularly use to buy goods and services.

Question 2

What is meant by “commodity money”

Answer 2

The use of a specific commodity as a form of money. Commodities such as gold and silver have been used for years as a method of payment.

Question 3

What is meant by “fiat money”

Answer 3

Fiat money is currency that a government has declared to be legal tender, but it is not backed by a physical commodity.

The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of.

Question 4

What is the function of the central bank?

Answer 4

A central bank is an institution designed to oversee the banking system and regulate the quantity of money in the economy.

The main functions of the central bank are to maintain low inflation and a low level of unemployment.

Since the economy relies on fiat money, there must be some agency that regulates the system, the central bank.

Question 5

What is the money supply?

Answer 5

The money supply is the quantity of money available in the economy.

Question 6

What are the five general roles of a nation’s central bank?

Answer 6

• To regulate the MONEY SUPPLY, since prices rise when too much money is produced
• MONETARY POLICY is the set of actions taken by the central bank in order to affect the money supply.
• BANKER TO THE GOVERNMENT - the government of a nation usually has an account with central bank where all tax revenue and current government expenditure are passed
• LENDER OF LAST RESORT if the banking system is short of liquidity (liquid assets such as cash), the central bank will always be prepared to lend to it
• MANAGEMENT OF THE FOREIGN EXCHANGE RESERVES The account holds the country’s reserves of gold and foreign currency which are used to influence the external value of the nation’s currency.
  A reserve currency acts as a global pricing currency for many commodities such as gold, oil, wheat and copper.

Question 7

What are the three ways that the central bank can control the supply of money?

Answer 7

• Open-market operations: The central bank buys and sells government bonds to control the supply of money. When the central bank buys the government bonds the supply of money increases, when they sell the bonds the supply of money decreases.
  For example, in an open market purchase of £100 million the bank gains reserves (increase in assets)
  In an open market sale of £100 million the bank reserves decline (negative)
• By changing the reserve requirement: The reserve requirements are regulations on the minimum amount of reserves banks must hold against deposits
  Increasing the reserve requirements the money supply will decrease since the banks will be holding more money
• By changing the refinancing rate: The refinancing rate is the interest rate which banks have to pay when they borrow money from the European CB. Banks need to borrow money from the central bank when they are short on liquidity (i.e. cash)
  Increasing the refinancing rate decreases the money supply since not as many banks will borrow

Question 8

What problems does the central bank have when it comes to monitoring the money supply?

Answer 8

A central bank’s control of the money supply is not precise since the central banks do not control the amount of money that households choose to hold as deposits in banks or also does not control the amount of money that banks choose to lend.