Money Creation/Inflation bias/AS+MH

Question 1

What is Central Bank Money (CBM) equation?

Answer 1

CBM = CASH (C) + Reserves (R)

Question 2

What two reasons do COMBs have to hold central bank reserves (CBR)?

Answer 2

1. To undertake interbank transactions
2. COMBs can purchase cash from CB by running down CBR

Question 3

What is money supply equation?

Answer 3

Ms = Cash (C) + Deposits (D)

Question 4

Why doesn’t money multiplier approach to money creation not work in the real world?

Answer 4

• BoE does not determine the level of reserves or the reserve ratio

Money multiplier - Ms = (1/rr) x R

Question 5

How do COMBs create money?

Answer 5

• COMBs create money by lending to the private sector
• lending creates bank deposits which increases the money supply

Question 6

How does BoE set interest rates? (Normal times)

Answer 6

1. CB offers a rate on interest on CBR (bank rate)
2. Before GFC COMBs set their own targets for amount of CBR they wish to hold
3. As long as CBR deposited by an individual COMB is close to target BoE paid the bank rate on it
4. If the COMB held an excess or had a shortfall it was charged for this at the bank rate
5. BoE also provide OSF - allows COMBs to deposit any excess reserved at rate just below bank rate or to borrow any shortfall at rate just above the bank rate
6. BoE also made use of OMO as necessary- selling assets increases reserves

Question 7

How has setting of short-term interest rates changed since GFC?

Answer 7

• under QE the BoE has made large scale asset purchases
• bank rate is still paid in R but no more reserve targets
• payment of bank rates sets a floor on short term interest rates

Question 8

What did Walsh (1995) suggest was a way to reduce/eliminate inflation bias?

Answer 8

• a contract for the governor that penalised them if inflation is above target
• assumes governor’s preferences aligned with loss function (unlikely)
• inflation can deviate even if governor does good job (could be unfair)

Question 9

What is Rogoff’s ‘conservative’ banker?

Answer 9

• to reduce inflation bias society should appoint a conservative central banker
• central banker would be more inflation averse than society
• higher a flattens loss function (IC’s)
• equilibrium at lower inflation rate
• conservative central banker reduced elimination bias and in repeated game much more likely to achiever A

Question 10

Describe the adverse selection problem (AS)?

Answer 10

• banks don’t know probability of investments success (p)
• firms have incentive to take on riskier projects
• if unsuccessful they lose nothing
• if successful they receive much greater reward from riskier projects
• firms with low risk investments have less incentive to borrow as expected profit much lower

Question 11

Describe moral hazard (MH) problem?

Answer 11

• firms have an incentive to pursue riskier projects once they have borrowed funds

Question 12

How can AS and MH be reduced?

Answer 12

• collateral
• if banks increase collateral they require before lending, firms have more to lose if investment unsuccessful
• firms less likely to take in riskier investments
• aligns interests
• MH and AS become less of a problem