Money and Banking Flashcards
What is money
Item which is generally acceptable as a form of payment
What are the functions of money?
Medium of exchange
Store of value
Unit of account
Standard of deferred payment - ability to borrow and lend money or buy and sell in the future.
What is the characteristic of money?
Generally acceptable
Portable
Recognizable
Divisible
Homogenous
Limited in supply
Not easy to counterfeit
Money supply
The total amount of money in an economy.
Governments measure the money supply to obtain information about trends in aggregate demand and the state of financial markets and to help them determine the direction of monetary policy.
Why is the money supply difficult to measure?
This is because it is difficult to decide what to include in any measure of the money supply.
The extent to which items carry out the functions of money varies and changes over time. Therefore, governments use a variety of measures of the money supply, which are occasionally altered to reflect developments in the roles carried out by particular items.
What are the two main measures of money?
The 2 main measures of money are narrow money and broad money.
Narrow money is money that can be spent directly. It consists of notes in circulation, cash held in banks, and balances held by commercial banks at the central bank. This is sometimes referred to as the monetary base.
Broad Money consists of narrow money plus a range of items concerned with money’s function as a store of value. An example is money in a savings account.
Quantity theory of money
It is based on the Fisher equation. P x Y is the total value of the GDP. To use it as a theory, Velocity of circulation and the transactions or output of the economy is taken as constant. This is so that a change in the money supply causes an equal percentage change in the price level.
The monetarist view is that inflation is a monetary phenomenon. However, Keynesians argue that the equation cannot be turned into a theory since V and T can change with a change in the money supply and so no predictions can be made about what effect a change in M will have on P
Keynesians believe that if left to market forces, there is no guarantee the market will reach full employment of GDP. In this case, they favor government intervention. They argue that if there is high unemployment, the government should use a budget deficit to increase aggregate demand. They believe the government can assess the appropriate amount of extra spending to inject into the economy. The avoidance of unemployment is a key priority.
Functions of commercial banks
They provide deposit accounts for their customers; They hold a range of other assets as well. These include cash, government securities and equities.
Commercial banks make most of their profits from lending. They allow for overdrafts, where consumers are allowed to spend more than what they have. Likewise, they give out loans as well and make profit from the interest.
Demand Deposit account
A bank account that allows the holder to make and receive payments. This type of account provides easy and quick access to the money in the account. It is mainly used to receive and make payments.
It is also known as a sight account or current account.
Savings deposit account
A type of account mainly used for saving.
Reserve ratio
The proportion of liquid assets to total liabilities
Capital ratio
A banks available financial capital as a percentage of its riskier assets
Three main objectives of commercial banks
Liquidity, profitability and security
Causes of changes in the money supply
- An increase in commercial bank lending
- An increase in government spending financed by borrowing from
commercial banks - An increase in government spending financed by borrowing from the central bank.
-The sale of government bonds to private sector financial institutions(quantitative easing) - More money entering than leaving the country
Commercial banks and credit creation
Money is created when banks lend. This is because when a bank gives a loan, the borrowers account is credited with the amount borrowed. They can create money because they can create more deposits than they have cash and other liquid assets(items that can be converted to cash). Because only few deposits are cashed on, the tracking of transfer of money is done through entries in the records of customers deposits rather paying out cash.
They have to careful when calculating liquidity ratios. The lower the proportion of liquid assets kept, the more they can lend. However, they have to be able to meet their customers’ demands for cash. If they miscalculate and keep too low a ratio, or if people suddenly start to cash more of their deposits, there is a risk of a run on the banking system.
