Money and Banking Flashcards
When might money be valued and used as a means of payment?
What is fiat currency?
A money might be valued and used as a means of payment if
it has status as legal tender, if it is the medium by which taxes
must be paid or if there is general confidence that it will
continue to be used as a means of payment (of roughly equal
value).
Fiat currency is not convertible into anything other than the
currency itself (i.e. the currency-issuer is not obliged to
exchange any commodity for the currency).
Fiat money is a type of currency that is not backed by a precious metal, such as gold or silver.
If money is a means of payment and we can pay with a debit
card in a shop, does this mean that bank deposits are money?
However…?
Yes, arguably bank deposits (in current accounts, in UK
terms) are a form of money as they can be used for immediate
payment.
However, bank deposits aren’t as ‘moneysome’ as currency,
because currency is a liability of the central bank (or
government), whereas a bank deposit is a liability of a
commercial bank.
The ‘hierarchy’ of liabilities is recognized by different official
classifications of money.
What two types of money is there?
- Base money (or high-powered money) is defined as all liabilities of the central bank, i.e. notes and coins plus reserves of commercial banks. This is referred to as M0 in the UK official statistics.
- Broad money includes private-sector bank deposits and is typically much larger. (The exact definition of which deposits are included varies from country to country.
Are cryptocurrencies money?
Cryptocurrencies can be used as payment for some transactions, but mostly seem to be held for speculative purposes. To this extent they are financial assets (without a matching liability) rather than currencies.
The UK government is considering the feasibility of a ‘digital pound
Money Creation
What does the granting of the loan by the commercial bank do?
What happens when the loan/deposit is used?
What is narrow money?
Notice that the granting of the loan by the commercial bank creates a new bank deposit (liability) that would be counted as part of broad money.
Furthermore, when the loan/deposit is used it might necessitate the creation of new reserves by the central bank (if the bank does not have enough reserves and cannot borrow them from another commercial bank), which would increase narrow money as well.
narrow money represents the most liquid and easily accessible forms of money,
In the previous example, after creating the loan the commercial bank needed more reserves than it had available. It would therefore have to either (4 options)
- Sell an asset
- Borrow reserves from the interbank market
- Borrow reserves from the central bank
- Attract new non-loan deposits
The interbank market I
On a typical day, some banks will have _________ __________ (more than they need, given their balance sheets and transactions) and others will have a ________. Those with an excess will often lend to other banks (for a short-term and against collateral). This lending is usually close to being ‘risk-free’ and consequently the interest rate will be close to the Bank of England base rate. The actual transacted rates are observed and compiled into the _______ (________ ____________ _________ _________).
On a typical day, some banks will have excess reserves (more than they need, given their balance sheets and transactions) and others will have a deficit. Those with an excess will often lend to other banks (for a short-term and against collateral). This lending is usually close to being ‘risk-free’ and consequently the interest rate will be close to the Bank of England base rate. The actual transacted rates are observed and compiled into the SONIA (Sterling OverNight Index Average).
The interbank market II
Short-term lending between banks and financial institutions is usually very safe, but this is not always the case.
(2)
The ‘credit crunch’ in 2007 involved a loss of confidence amongst banks and a reluctance to lend to each other.
Northern Rock found that it was not able to sell assets (via loan securitization) at a good price or borrow reserves at an affordable rate, due to its exposure to the housing markets and fears of falling values.
Borrowing from the central bank
One of the main tools used by the Bank of England is ‘______-_______ _______________ ____________’. The BoE and a commercial bank will enter into a pair of contracts: firstly, the Bank of England purchases a very safe asset (such as a UK government bond) from the _____________ bank, then one week later the commercial bank buys back (repurchases) the same asset, at a slightly ________ price.
One of the main tools used by the Bank of England is ‘short-term repurchase agreements’. The BoE and a commercial bank will enter into a pair of contracts: firstly, the Bank of England purchases a very safe asset (such as a UK government bond) from the commercial bank, then one week later the commercial bank buys back (repurchases) the same asset, at a slightly higher price.
What limits bank lending?
If commercial banks do not need reserves in advance of making loans, what determines the amount which they lend?
- Banks can’t supply more loans than people want, i.e. there has to be demand for loans from households and businesses.
- Banks will assess the creditworthiness of potential customers and will aim to limit the default rate.
- Banks want their lending to be profitable - if reserves are increasingly costly relative to the rate which can be charged on loans then it might not be worthwhile to increase lending.
