money and banking Flashcards
what are the functions of money
- medium of exchange We sell goods and services for money. no need of double coincidence of wants where two people each have something other one wants
- Store of value. Money enables people to save. They can keep any
money for future use - Unit of account. This a measure of value.
Money enables the value of different items to be compared as
prices are expressed in money terms. - Standard of deferred payment. Money enables people, firms and
the government to borrow and lend and to buy and sell in the future
characteristic of money
-Generally acceptable.. If
people are not prepared to accept an item in exchange for products,
as a store of value and standard of deferred payments, if it will not
act as money. In Zimbabwe, people lost confidence in the
Zimbabwean dollar in 2009 due to hyperinflation People used US dollars instead. The Zimbabwean central bank stopped printing the Zimbabwean dollar in 2009 and did not
issue a new version until 2019.
-Recognisable
-Portable.
-Divisible. Any form of money must be divisible into units of
different value
-Homogeneous every unit of money identical
Limited in supply. If there is an unlimited supply of money, it
would have no value
-Not easy to counterfeit
what is money supply why is it imp
The money supply is the total amount of money in an economy.
1. trends in aggregate demand
2. the state of financial markets
3. determining the direction of monetary policy
types of money supply
Narrow money: as a medium of exchange and notes and cash held in
banks and in balances held by commercial banks at the central bank. This is the monetary base.
2 Broad money: narrow money plus money’s functions as a store
of value. money in savings accounts.
explain the quantity theory of money
-quantity theory of money links inflation in economy to changes in money supply
-This theory is based on the Fisher
equation: MV = PT
-Both sides of the equation have to equal each other since both sides
represent total expenditure in the economy
- monetarists assume that V and T are constant,so that a change in the money supply causes an equal percentage change in the price level.
805=1004 50% rise MS
1205=1504 50 % rises P
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
keyns belief
- They believe
that if left to market forces, there is no guarantee that the economy will achieve a full employment level of GDP. . -In such cases, they favour government intervention to influence the level of economic activity. - They argue that
if there is high unemployment, the government should use a budget deficit to increase aggregate demand. - They believe that a government can assess the appropriate amount of extra spending to inject into the economy in such a situation.
-For most Keynesians, the avoidance of unemployment is a key priority - ideas based on john maynard keyns
monetarists view
- for monetarists, the control of inflation is seen as the top priority for a government.
-Milton Friedman
-argue that inflation is the result of an excessive growth of the money
supply, so they believe that the main role of a government is to control
the money supply. - They also maintain that attempts to reduce
unemployment by increasing government spending will only succeed in raising inflation in the long run.
-They think that the economy is inherently stable
functions of commercial banks
-demand deposit account easy and quick access to the money in the account. It is used mainly to receive and make payments.
- savings deposit account. This type of account is used mainly as a way of saving notice before withdrawal
-cash, government securities and equities.
-overdraft. An
overdraft allows customers to spend more than is in their deposit
accounts. It is often used for unexpected differences in spending and
income.
-loan
-reserve ratio proportion liquid assets to total liabilities
-capital ratio banks available financial capital as percentage of riskier assets
objectives of commercial banks
-PROFITABILITY: Commercial banks aim to achieve high profits for their shareholders mainly by lending. This objective conflicts with its two
other objectives and a balance has to be achieved between the three
objectives.
-LIQUID: They need to have enough liquid assets, such as cash and short-term securities that will soon be turned into cash, to meet
the expected request by their customers to withdraw their money in
cash. These liquid assets are, however, not very profitable. Indeed, no
money is earned on holding cash.
-SECURITY They do not want to go out of business and they have to
convince their customers that they are financially sound. To achieve this
aim they try to ensure they have sufficient financial capital to cover their risker loans.
credit creation by banks
-When commercial banks lend, they create money. This is because when
a bank gives a loan (also called an advance by bankers), the borrower’s
account is credited with the amount borrowed. create money because they can create more deposits than
they have cash and other liquid assets
- banks have found that only a small proportion of deposits are cashed. When people make payments, they tend to make
use of credit cards, debit cards and online transfers. These means of
payment involve a transfer of money using entries in the records rather than by paying out cash.
-reserve ratio (the proportion of liquid assets to total liabilities) to keep. . The
lower the proportion of liquid assets commercial banks keep, 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. This was evidenced in 2008 when there
were fears over the liquidity of some US and European banks
-Indeed, banking is based on
confidence. Customers have to believe there is enough cash and liquid
assets to pay out all their deposits even though,
bank credit multiplier
its process to make more loans than deposits available
after loan =value new asset /value of change in liquid assets
advance =100/reserve ratio
explain reserve ratio
-helps to know how much to lend work out possible increase in its total liabilities. This is found by multiplying the change in liquid assets by the bank credit multiplier.
-Not lend credit multiplier implies This is because there may be a lack of
households and firms wanting to borrow or a lack of credit-worthy
borrowers. If banks persist in lending to borrowers with poor credit
ratings, as was the case in the US sub-prime market in 2008, the risk of
default is high and lowers bank’s liquidity.
-A bank is likely to change its reserve ratio if people alter the proportion
of their deposits they require in cash, if other banks alter their lending
policies or if the country’s central bank requires banks to keep a set
reserve ratio.
- central bank may seek to influence commercial banks’ ability to lend.
For example, the bank may engage in open market operations. These
involve the central bank buying or selling government securities to
change bank lending. If the central bank wants to reduce money supply, it
will sell government securities. The purchasers will pay by drawing on
their deposits in commercial banks and so cause the commercial banks’
liquid assets to fall
capital ratio
The capital ratio is a commercial bank’s available financial capital
expressed as a percentage of its riskier assets. The available financial
capital includes its retained profits and newly issued shares.some
loans may be considered risky if the economy got into difficulties. For
example, if a commercial bank had a capital ratio of 8%, this would
mean that 8% of its risker assets are covered by readily available
financial capital. The higher the capital ratio a commercial bank has, the
more unexpected losses it can experience without going out of business.
The capital ratio is designed to protect the bank’s customers in the event
of a financial crisis and to promote the stability of the banking sector by
discouraging excessive risk taking.
role of central banks
-It issues bank notes and authorises the minting of coins.
- It is the bank of the commercial banks. Commercial banks keep deposits in the central bank. This enables the commercial banks to make and receive payments from
other commercial banks and to withdraw money when needed. Their
deposits at the central bank are considered to be liquid assets. The
central bank will also usually lend to commercial banks if they get into
financial difficulty.
-act as the banker to the government
-to implement the government’s monetary policy
govt defecit financing
- If the government spends more than it raises in taxation, it will have to
borrow. This is organised by the central bank. If the central bank
borrows, on behalf of the government, by selling government securities,
including National Savings certificates, to the non-bank private sector
(non-bank firms and the general public), it will be using existing money.
The purchasers will be likely to draw money out of their bank deposits.
So, the rise in liquid assets resulting from increased government
spending will be matched by an equal fall in liquid assets as money is
withdrawn. - budget deficit is financed by borrowing from commercial
banks or the central bank itself, the money supply will increase monetizaton of debts contractors deposits in commercial banks rises. . With
more liquid assets, they will be able to lend more. Commercial banks
will also be able to lend more if the government borrows from them by
selling them short-term government securities. This is because these
securities count as liquid assets and so can be used as the basis for
loans
quantitative easing
When the rate of interest is very low, a central bank may decide to try to
increase aggregate demand by in the use of quantitative easing. This
involves a central bank buying both government and private securities,
from financial institutions, including commercial banks. In return for the securities, the central bank credits the accounts of the commercial banks. With more liquid assets, it is hoped that the
commercial banks will lend more. This should increase the money
supply and reduce the short-term and long-term interest rate. These
changes may, in turn, increase investment and consumer expenditure
and so aggregate demand and economic activity. For example, the
Federal Reserve Bank of the USA has purchased mortgage-based
securities to help the US housing market.
banks’ ability to stimulate economic activity by reducing the rate of
interest it sets
total currency flow
The total currency flow refers to the total net outflow or inflow of
money resulting from international transactions, as recorded in the
different sections of the balance of payments. If, for example, export
revenue exceeds import expenditure, money will flow into the country
on the trade balance. Exporters will deposit the money into the
country’s commercial banks, which will lead to a multiple increase in
the money supply
how to reduce inflation
-contractionary monetary and/or
-contractionary fiscal policy can be used to reduce inflation.
-Supply-side policy can also be used in the case of cost-push inflation. For example,
increased spending on training can raise labour productivity and so
reduce labour costs or at least reduce the upward pressure on labour
costs.
- Lower corporate tax may encourage firms to buy more efficient capital equipment, which can also put downward pressure on price rises.
effectiveness of policies to reduce inflation
- Inflation may be of a cost-push type, arising when the economy is operating at less than full employment. If a government then introduces contractionary monetary and fiscal policies, the fall in
aggregate demand may not have much impact on the price level but could increase unemployment
-it is usually a mixture of cost-push
and demand-pull inflation. Also, some policy tools can help to reduce both types of inflation, at least in the long run. For example, an increase
in government spending on education and training may increase demand-pull inflation in the short run. However, in the long run it may reduce cost-push inflation by raising productivity and lowering costs of
production, It could also allow the economy to sustain larger increases in aggregate demand without experiencing inflation. - Governments and central banks make estimates of future inflation rates– the further they are into the future, the more uncertain these forecasts
are. There is no guarantee that such a forecast is right and even if it is, it will take time to decide on the appropriate policy
tool, implement it and for households and firms to react. - There may be limits on the policy tools a government can use. If it is a
member of an economic and monetary union, it will not be able to set
its own interest rate.
-Any country may be reluctant to raise its income tax rate if it thinks this will encourage some of its skilled workers to
emigrate and will discourage multinational companies from setting up
in the country. A government may also want to spend more on
infrastructure to reduce cost-push inflation, but may be reluctant to raise
tax rates and may lack willing lenders. - A government may decide that inflation is the result of the money supply growing faster than output, but it can be difficult to control the growth of the money supply. This is because commercial banks have a
profit incentive to increase their loans and they are inventive in getting
around any limits on bank lending. - how households and firms react. Contractionary monetary
and/or fiscal policies may be introduced to lower demand-pull inflation.
This will occur at a time when households and firms are likely to be
optimistic about the future. In such a situation, a rise in the rate of
interest, for example, may not reduce consumption and investment.
-A rise in income tax rates may cause people to work more hours to
maintain their living standards rather than reduce their spending. - There is also no guarantee that if a government trains or provides subsidies for
firms to train workers, that firms will have the capital equipment that
can take full advantage of the workers’ new skills. If productivity of
workers rises by less than their wage rates, costs of production will still
rise
monetary transmission mechanism
This is the process by which a change in monetary policy works through
the economy via a change in aggregate demand to the price level and
the real GDP.. For example,
an increase in the money supply may lower the interest rate, which in
turn may increase aggregate demand. Higher aggregate demand may
increase output and/or the price level
liquidity preference theory
The demand for money is explained by keyns concept liquidity preference.
There are three main motives for households and firms to hold part of their wealth in a money form.
1. transactions motive This is the desire to hold money to make everyday purchases
and meet everyday payments.. Generally, the more income received and the more
infrequently the payments are received, the higher the amount that will
be held.
2. precautionary motive Usually, firms and households hold rather more of their wealth in money form than they anticipate they will spend. This is so that they
can meet unexpected expenses, and take advantage of unforeseen
bargains.. Money resources
held for the transactions and precautionary motives are sometimes
referred to as active balances as they are likely to be spent in the near
future. They are relatively interest inelastic so that, for example, a rise
in the rate of interest will not result in households and firms
significantly cutting back on their holdings of money for transactions
and precautionary reasons.
3. the speculative motive, is interest elastic. Households and firms will hold
what are sometimes called idle balances when they believe that the
returns from holding financial assets are low. One financial asset is government bonds. These are government securities that represent loans to the government. The price of government bonds and the rate of interest move in opposite directions. For example, a government bond with a
face value of $500 may carry a fixed interest rate of 5% of its issue
price. If the price of the bond rises to $1000, the interest paid will now
represent 2.5% of the price of the bond. Households and firms are likely
to hold money when the price of bonds is high and expected to fall not forgo intrest as its low . This is because they will not be forgoing much interest and because they will be afraid of making a capital loss. The speculative demand for money
will be low when the price of bonds is low and the rate of interest is
high.
intrest rate determniation keyns
- Keynesians argue that the rate of interest is determined by the demand
for and supply of money. - They assume that the supply of money is
determined by the monetary authorities and is fixed in the short run. - The rate of interest is at R, since this
is where the liquidity preference curve intersects the supply of money
curve
-An increase in the money supply will cause a fall in the rate of interest. The rate of interest falls because the rise
in the money supply will result in some households and firms having
higher money balances than they want to hold. As a result, they use
some to buy financial assets. A rise in demand for government bonds
will cause the price of bonds to rise and so the rate of interest to fall
liquidity trap
- liquidity trap situation here intrest rate cannot be reduced any more to stimulate upturn in economic activity.
- He thought it could occur when the rate of interest is very low and the price
of bonds is very high. In this case, he thought that speculators would
expect the price of bonds to fall in the future, so if the money supply
was to be increased they would hold all the extra money. They would
not buy bonds for fear of making a capital loss, and because the return
from holding such securities would be low. that at a rate of interest R, demand for money becomes perfectly elastic and the
increase in the money supply has no effect on the rate of interest
loanable funds theory
- The demand for loanable funds is the demand for money to borrow. For
example, households borrow money to purchase cars and houses. Firms
may demand loanable funds because they are in financial difficulties or
more commonly because they want to invest. The government may also
want to borrow if it has a budget deficit. The demand for loanable funds
slopes down from left to right as borrowing and the rate of interest are
inversely related. The lower the rate of interest, the more likely that
economic agents will borrow more. - The supply of loanable funds comes from savings. The more money that is saved, the more money there will be available to lend. The supply of loanable funds curve slopes up from left to right as savings and the rate
of interest are directly related. The higher the rate of interest, the more
likely economic agents will save as they will gain a higher return.
The theory suggests that an increase in savings will result in a rise in the
supply of loanable funds and a fall in the rate of interest
