Topic 3: Money, Banking and Interest Rates

Question 1

What is a barter economy?

Answer 1

Where there is no money and individuals trade by exchanging different goods and services.

Question 2

What is the double coincidence of wants problem?

Answer 2

. Occurs when two people trade goods and services without money. The first individual demands the good offered by the second individual and vice versa.
. Problem is this is unlikely for most goods
. Issues of transportation of goods for large transactions

Question 3

What are the basic functions of money?

Answer 3

. medium of exchange → facilitates transactions between buyers & sellers & overcomes double coincidence of wants

. unit of account: prices, assets, liabilities & debts are expressed in monetary terms allowing comparison n
. store of value: we postpone consumption by saving unlike in barter, e.g. to retire – but:
- where do we store it - what are the risks?
- price inflation erodes the real spending power of
our savings if we save cash
. fiat money: notes & coins guaranteed by central bank rather than gold deposits – does not take £20 of resources to make a £20 note

Question 4

What is the difference between money and cash?

Answer 4

implications: money is a broader concept than cash

cash is legal tender-something you can use to pay for something in a transaction

Question 5

What are virtual currencies or digital money?

Answer 5

Digital currencies controlled by software developers, not central banks & not legal tender e.g. Bitcoin and Litecoin

Question 6

What are the risks of using virtual currencies?

Answer 6

. not generally accepted
. Not regulated by Central Bank
- forgery through hacking-could effect value
- value compared to other currencies, e.g. UK £, US $, is highly volatile making it risky for a store of value
- increasing subject to regulation by governments

Question 7

What are the motivations for holding money?

Answer 7

. Transactions motive
-hold money for day-to-day transactions so less synchronisation between income and expenditure
. Precautionary motive: cash is liquid
-Hold money for unforeseen circumstances, e.g.
house repairs, healthcare

Question 8

What are the ways an individual can hold assets?

Answer 8

. savings accounts: interest on money so value grows
. equities/shares: receive a divided & capital gain (or loss!)
. UK government debt: gilts or ‘bonds’- holding UK debt is very low risk-very liquid but some return
. property, e.g. ‘buy to let’ -risk of depreciation

Question 9

What are interest rates?

Answer 9

The interest rate is the price that is paid by a borrower of money to a lender of money in return for those funds: the opportunity cost of holding money

Question 10

What is a central bank?

Answer 10

Acts as a banker to the commercial bank, taking deposits and extreme circumstances, making loans.

Question 11

Explain central banks

Answer 11

. Prudential Regulation Authority (PRA): regulates & supervises financial firms

. issues notes & coins

. banker to government & commercial banks
- banks can hold deposits with BoE
-lends to banks when short of liquidity → lender of
last resort to stop issue transferring to other banks

. implements monetary policy: for UK involves using the
policy tool of the official bank rate to meet a policy
target of 2% annual price inflation

Question 12

What is a retail bank?

Answer 12

Lends money for non-banks, including households and non-bank firms e.g. Halifax in the UK

Question 13

Explain the function of retail banks?

Answer 13

. takes deposits from households & offers basic banking services: financial intermediation

. sight deposits: customer has instant access to cash
time deposits: give notice to withdraw with higher interest rates but more money for banks to lend out

. lends to households & small sized firms, e.g. mortgages, personal loans, extension of credit via credit card, business loans

Question 14

Explain wholesale or investment banks

Answer 14

. Note: these perform both retail & wholesale services

. large cash deposits & loans to companies

. act as fund managers, e.g. pension funds

. banker for international transactions

. Investment banks: income is commission based

. manages ‘initial public offerings’ (IPOs) when the stock of a company is offered to the public for sale, e.g. Facebook in 2012 by Morgan Stanley

. managing mergers & acquisitions

. trading in foreign exchange & equities

Question 15

What are the key important services of banking to the economy?

Answer 15

. Provide liquidity
. Maturity transformation
. Risk Pooling
. reduce search and transaction cost for lenders
. reduced risk for depositors
. risk pricing

Question 16

Explain the role of banking in providing liquidity

Answer 16

. Provide the speed, price and ease of access to money
. Problem is they tend to borrow short and lend long so banks need to ensure they have enough liquidity to pay lenders
. This is done by having near liquid assets like gold or gov bonds but they offer low interest

Question 17

Explain the role of banking in maturity transformation

Answer 17

Maturity transformation: accept deposits for a given
aturity & ‘transforms’ them into loans of a different maturity

e.g. Halifax: accepts sight deposits (short term) & provides mortgages to house buyers who pay back over, say, 25 years (long term)

Question 18

Explain the role of banking in risk pooling

Answer 18

Having a large number of depositors & lenders make the proportion of defaulters predictable (similar to insurance)-diversification of risk leads to benefits

Question 19

Explain the role of banking in reducing search and transaction costs for lenders

Answer 19

. advertising-lenders don’t have to find borrower

. reduces the average cost of intermediation, e.g. standard contracts

Question 20

Explain the role of banking in reducing risk for depositors?

Answer 20

Specialist staff assess risk of borrowers and price the risk

Question 21

Explain the role of banking in risk pricing?

Answer 21

Riskier borrowers pay a high-interest rate on their loan

Question 22

What is an alternative to banking? and risks

Answer 22

. Peer to peer lending P2P-On-line matching of borrowers and lenders
. very risky as less regulation
. less of benefits banks offer consumers
. less backing for defaulted loans
. higher risk=higher reward as may be higher interest rates

Question 23

What are the measures of the money supply?

Answer 23

. Narrow money (M0): notes & coins in circulation: monetary base
. Broad money (M4): M0 plus sight & time deposits
. Reserve balances are funds held at the BoE-not included in measure of money supply as depsits into BoE are removed from the money supply

Question 24

How can banks use the reserve balance to alter the money supply?

Answer 24

BoE can reduce money supply by encouraging banks to deposit into them through higher interest rates

Question 25

What does the balance sheet tell of UK banks tell us about?

Answer 25

. Banks get most of their money (liabilities) from deposits

. Majority of loans funded by UK banks are funded for by savers-intermediation and little from shareholders

Question 26

How do banks create money?

Answer 26

. Money multiplier effect via credit creation
. Banks minimise cash holdings to facilitate profitable
lending

Question 27

What is credit creation?

Answer 27

Process of turning existing bank deposits into credit facilities for borrowers. The process can increase the money supply (deposits+ notes and coins(monetary base))

Question 28

What is the money multiplier?

Answer 28

The ratio of the money supply to the monetary base

Question 29

What determines the value of the money multiplier?

Answer 29

. willingness of individuals to deposit money in banks

. level of cash reserves held by banks
-determined by central bank, e.g. USA

 - determined by the risk/return trade-off by banks, 
    e. g. in UK it is supervised by BoE-test for banks to cope with extreme macroeconomic conditions

Question 30

What are examples of monetary policy used by central banks?

Answer 30

. Minimum reserve requirements

. Offical banks rates (base rate)

Question 31

Explain Minimum Reserve Requirements (MRS)

Answer 31

e.g. The People’s Bank of China

if a bank is required to hold 5% of its deposits with the central bank then it can create more credit if required to hold, say, 10%

interest rates for borrowers will increase the higher the MRS

Question 32

Explain Official Bank rates (base rates)

Answer 32

. BoE sets an official bank rate (or ‘base rate’) which is the interest rate that lends to commercial banks

. BoE is lender of last resort so the official rate can be thought of as the cost of short-term liquidity for commercial banks

. bank rate & commercial interest rates for business & household lending tend to move together e.g. mortgage SVR

Question 33

What has happened to the BoE base rate since 2008?

Answer 33

Fell after financial crash and only starting to increase now=less money supply in circulation
. got to historic low of 0.25%

Question 34

Explain the context before the financial crash 2008

Answer 34

Subprime mortgage market had been growing in 2000s-meant banks got higher interest from investing in other banks stock of mortgages. Bundled mortgage debt was bought by European investors
. soon prices sored and demand was far less than supply

Question 35

Explain the effect of the financial crash that caused BoE base rate to lower

Answer 35

. Mortgage rates in the US rose in 2006 → poorer households defaulted on their repayments

. use of securitization spread the crisis in the US globally: ‘bundled’ mortgage debt had been bought by European investors & banks, e.g. Northern Rock in the UK

. Outcome: banks holding poor quality mortgage debt so reduced lending

. Macroeconomic consequences:

- fall in household & business confidence - fall in government tax receipts → austerity measures due  to attempts to reduce government deficits & debt

Question 36

What is the monetary transmission mechanism?

Answer 36

Channel through which monetary policy impacts economic output and prices

Question 37

What occurs to investment when official bank rate has fallen?

Answer 37

. Companies increase investment expenditure (I↑) & employ more workers

Why?

. Cost of borrowing falls → profitability of investment increases

. Business confidence likely to increase because consumers with debts feel better off & consumer spending increases

Question 38

What occurs to Consumer Expenditure when official bank rate has fallen?

Answer 38

Three effects
. increase as national income increases via the expenditure multiplier effect (Topic 2) associated with an increase in investment

. borrowing may also increase because consumers face lower interest payments, e.g. mortgages

. savings (S) falls

Question 39

What occurs to Exports when official bank rate has fallen?

Answer 39

demand for sterling decreases in international foreign exchange rate markets → sterling depreciates in value, e.g. from £1 = $2 to £1=$1 →

UK exports are cheaper so X increases

imports more expensive so M decreases

Question 40

What is the overall effect when the offical bank rate has fallen?

Answer 40

. Overall effect of a decrease in the official rate is to increase GDP

  = C↑ + I↑ + G + X↑- M↓  

. The above effects are likely to be enhanced by improved confidence

Question 41

What can the central bank do when the official rate gets close to zero ?

Answer 41

Use quantitative easing (QE)

Question 42

What is quantitative easing?

Answer 42

Involves the bank buying government debt, corporate debt and other financial securities. In return, cash is provided to the vendors of these assets.

Question 43

What is the background of QE and aim?

Answer 43

First used in Japan between 2001 & 2005

Since 2008 by the Bank of England
QE is aimed at injecting liquidity into the economy:

- central bank holds bonds & equities,the private sector now holds 	 ‘cash’ which is supposed to be lent to households & firms at lower 	 interest rates

Question 44

What is a disadvantage of QE?

Answer 44

Banks may not spend the additional cash injected from the central bank if they feel that lending out more money is very risky