Money and interest rates

Question 1

Prior knowledge

Answer 1

Money is essential to make a modern economy work. It’s main function is to act as medium of exchange, facilitating the buying and selling of goods and services between different economic agents. Without money we would be forced to rely on barter (goods exchanged for other goods) requiring a double coincidence of wants.

Question 2

What is money

Answer 2

In the modern age, money in most economies has been “fiat money”. Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it.

In other words, a UK £10 note is not physically worth £10- the value of the actual printed bit of paper might be 1p or less. However, the government decrees that a £10 note entitles you to goods and services valued at £10.

Question 3

legal tender

Answer 3

The £10 note is legal tender in the UK, as is the 50p piece, £1 coin etc. Legal tender means that a seller is obliged to accept that in payment for the good or service they are selling.

On the other hand, a 10 Euro note is not legal tender in the UK, sellers are not obliged to accept Euros. Obviously, the historic concept of legal tender is now evolving due to the emergence of a “cashless” society; in reality the payee may choose to refuse or accept any specific type of payment, whether legal tender or not.

Question 4

3 main functions of money

Answer 4

1. Medium of exchange- it enables us to easily purchase goods and services
2. Store of value- it can be stored, invested kept safe for future use
3. Measure of value (Unit of account)- can be used to value goods and services, record debts, make calculations.

Question 5

4th function of money

Answer 5

Standard of deferred payment- some sources use this as a 4th function of money- i.e. the existence of money allows us to receive and award credit as well as borrowing and lending facilities

Question 6

6 characteristics of money

Answer 6

1. Durability- money must nor rot, or wither away. It has to physically last a decent period of time. If it didn’t it would not be useful as a store of value and not always acceptable as a medium exchange. Perishable products are not suitable as money
2. Portability- money must be easy to carry and move around, essential for it to be a good medium of exchange. Portable means able to carry
3. Divisibility- it should be possible to divide units of money down into smaller portions. Otherwise, it would not be possible to exchange money for smaller items- lack of divisibility is a big disadvantage of many physical commodities as money
4. Uniformity- each £10 notes, each £1 coin, should be the same as the next. Otherwise its functions as a medium of exchange and measure of value are completely undermined. Again this is a big disadvantage of many physical commodities as money
5. Relatively scarce- money needs to be limited in supply. If it wasn’t then it would not hold its value and none of the above functions would be met.
6. Acceptable to all- Money must be widely accepted as a payment for debts or for purchasing goods and services- this is what gives money its value. Cryptocurrency has not overcome this hurdle as yet.

Question 7

Where does money come from

and money supply

Answer 7

In the UK, coins are made by the Royal Mint, bank notes printed by the Bank of England. However, notes and coins are only a tiny % of actual money in the UK- most money is made up by the banks. Banks are able to do this due to the rule that they only ever need to hold about 3% of their deposits in cash. Therefore, if person X deposits £100 in a bank that enables the bank to lend £97 that did not previously exist.

This £97 has increased the money supply in the economy and thereby facilitated more economic activity. It should be obvious from this that increasing the money supply is intrinsically related to higher AD and economic growth. Of course, this only works if there is spare capacity in the economy- if we’re at Yfe and no new goods or services can be made then the new money is just going to inflate prices. Inflation therefore is often defined as too much money chasing too few goods.

Question 8

Prior knowledge 2

Answer 8

Money serves as medium of exchange, store of value and a measure of value. Its main characteristics are that it must be acceptable, scarce and relatively stable in value. In addition, is should be durable, divisible and portable. Most money is created by the banks. When they issue loans to households to businesses they are creating new money, thereby increasing the money supply of the country. They can do this as the only need to keep about 3% of their deposits as cash.

Question 9

why do economies reply on money to function

Answer 9

All economies rely on money to function. The supply of money in an economy is central to the value and acceptability of money- if too much money is supplied (e.g. if the banks lend out too much) inflation occurs and all of the functions of money gets undermined. A key role of the Bank of England is to manage the supply of money in the UK.

Question 10

what does money supply measure

Answer 10

The money supply measures the total amount of money in the economy at a particular time. It includes actual notes and coins and also any deposits which can be quickly converted into cash.

Question 11

liquidity

Answer 11

Assets that are easily converted into cash are Liquid Assets.

Examples of liquid assets include bank current accounts, saving accounts, money market accounts.

An asset is liquid if you can quickly turn it into spendable cash without a significant penalty or loss in the underlying value.

A good example of an asset that is not liquid is property

Question 12

narrow money

Answer 12

This is the level of notes and coins in circulation + banks operational balances at the Bank of England. These are overnight balances that banks hold in an account at the central bank-they are used for settling payments between the banks.

Question 13

broad money

Answer 13

e.g. M4 money supply is defined as a measure of notes and coins in circulation (M0) + bank accounts. It is a broader definition because it includes bank accounts, and not just notes and coins in circulation. M4 also includes near money; i.e. non-cash assets which can be changed into cash within a relatively short period.

Question 14

near money

Answer 14

broad money can also includeTreasury Billsand gilts. These financial securities are seen as ‘near money’ because they are more illiquid than cash and instant saving accounts.M4 is a key statistic because it can illustrate the underlying strength of economic activity. When the economy went into recession, we see a sharp fall in M4 growth from 15% a year to negative growth in mid-2008.

Question 15

quantity theory of money

Answer 15

A fundamentally important relationship exists between the money supply and price level. This relationship is a positive one, i.e. increases in the money supply increase price level and decreases in the money supply should lower PL. This relationship is explained by the Fisher Equation of Exchange, which lies at the heart of the Quantity Theory of Money.

Question 16

fisher equation

Answer 16

MV=PT, where:

M = Money Supply,
V= Velocity of circulation: (the number of times that money moves from one economic agent to another)
P= Price Level
T = Transactions (sometimes referred to as Q (quantity of goods sold) or Y (national output)

MV= the amount of goods + services bought in the economy, PT (PQ) is the amount of goods sold the economy. As what is bought = what is sold, MV must =PT.

Question 17

importance of fisher equation

Answer 17

The importance of this equation is its use as an explanation for inflation. Some economists (called monetarists) argue passionately that V and Q are relatively fixed and will certainly even out over time.

Their conclusion therefore is that the only way that P/PL can increase is due to increased M, i.e. higher money supply.

This leads monetarists to argue that inflation, always and everywhere is a monetary phenomenon, i.e. caused by increased money supply. To solve inflation, you need to reduce money supply.
Keynesians completely disagree (more later on that).

Question 18

prior knowledge 3

Answer 18

Interest is the reward for the factor of production capital. If a lender allows another economic agent to borrow their capital or money, they charge interest on that loan. The amount of interest charged is determined by the interest rate. The lowest rate of interest in the economy, called the base rate, is the rate at which the Bank of England make short-term loans to commercial banks. The level of interest rates is a major determinant of economic activity; high rates tend to slow down the economy, low rates to boost it.

Question 19

interest rate

Answer 19

the price of borrowed money.

Because it’s a price, its level will be determined by demand and supply, in this case the demand and supply of money.

Question 20

demand for money

Answer 20

demand for money in an economy comes from all economic agents.

Households demand money to fund consumer expenditure, firms demand money to fund investment, government to fund government expenditure etc.

As with all other “demands” you’ve met (demand for goods & services, aggregate demand, demand for labour), the demand curve for money is downward sloping, left to right. The vertical (P) axis here is Interest Rate whilst the horizontal axis represents the quantity of money.

Question 21

supply of money determined by

Answer 21

determined independently of the interest rate and is controlled by the central bank. Therefore, we assume that the supply of money line is vertical at a particular quantity of money set by the central bank.

Question 22

market for money

Answer 22

Money is traded (demanded/supplied), on money markets. As with all other markets we’ve looked at, the equilibrium price (interest rate) will be where the demand for money (Dm)= the supply of money (Ms).

At high rates of interest there is little incentive to keep your money in liquid form (e.g. cash or current accounts). This is because other assets are more attractive.

For example, long-term savings accounts will pay much higher rates of interest. If interest rates are low these alternatives are unattractive, so consumers want money to spend, businesses want money to invest etc.