Topic 3: Money, Banking and Interest Rates Flashcards
What is a barter economy?
Where there is no money and individuals trade by exchanging different goods and services.
What is the double coincidence of wants problem?
. 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
What are the basic functions of money?
. 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
What is the difference between money and cash?
implications: money is a broader concept than cash
cash is legal tender-something you can use to pay for something in a transaction
What are virtual currencies or digital money?
Digital currencies controlled by software developers, not central banks & not legal tender e.g. Bitcoin and Litecoin
What are the risks of using virtual currencies?
. 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
What are the motivations for holding money?
. 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
What are the ways an individual can hold assets?
. 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
What are interest rates?
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
What is a central bank?
Acts as a banker to the commercial bank, taking deposits and extreme circumstances, making loans.
Explain central banks
. 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
What is a retail bank?
Lends money for non-banks, including households and non-bank firms e.g. Halifax in the UK
Explain the function of retail banks?
. 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
Explain wholesale or investment banks
. 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
What are the key important services of banking to the economy?
. Provide liquidity . Maturity transformation . Risk Pooling . reduce search and transaction cost for lenders . reduced risk for depositors . risk pricing
Explain the role of banking in providing liquidity
. 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
Explain the role of banking in maturity transformation
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)
Explain the role of banking in risk pooling
Having a large number of depositors & lenders make the proportion of defaulters predictable (similar to insurance)-diversification of risk leads to benefits
Explain the role of banking in reducing search and transaction costs for lenders
. advertising-lenders don’t have to find borrower
. reduces the average cost of intermediation, e.g. standard contracts
Explain the role of banking in reducing risk for depositors?
Specialist staff assess risk of borrowers and price the risk
Explain the role of banking in risk pricing?
Riskier borrowers pay a high-interest rate on their loan
What is an alternative to banking? and risks
. 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
What are the measures of the money supply?
. 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
How can banks use the reserve balance to alter the money supply?
BoE can reduce money supply by encouraging banks to deposit into them through higher interest rates
What does the balance sheet tell of UK banks tell us about?
. 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
How do banks create money?
. Money multiplier effect via credit creation
. Banks minimise cash holdings to facilitate profitable
lending
What is credit creation?
Process of turning existing bank deposits into credit facilities for borrowers. The process can increase the money supply (deposits+ notes and coins(monetary base))
What is the money multiplier?
The ratio of the money supply to the monetary base
What determines the value of the money multiplier?
. 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
What are examples of monetary policy used by central banks?
. Minimum reserve requirements
. Offical banks rates (base rate)
Explain Minimum Reserve Requirements (MRS)
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
Explain Official Bank rates (base rates)
. 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
What has happened to the BoE base rate since 2008?
Fell after financial crash and only starting to increase now=less money supply in circulation
. got to historic low of 0.25%
Explain the context before the financial crash 2008
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
Explain the effect of the financial crash that caused BoE base rate to lower
. 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
What is the monetary transmission mechanism?
Channel through which monetary policy impacts economic output and prices
What occurs to investment when official bank rate has fallen?
. 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
What occurs to Consumer Expenditure when official bank rate has fallen?
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
What occurs to Exports when official bank rate has fallen?
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
What is the overall effect when the offical bank rate has fallen?
. 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
What can the central bank do when the official rate gets close to zero ?
Use quantitative easing (QE)
What is quantitative easing?
Involves the bank buying government debt, corporate debt and other financial securities. In return, cash is provided to the vendors of these assets.
What is the background of QE and aim?
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
What is a disadvantage of QE?
Banks may not spend the additional cash injected from the central bank if they feel that lending out more money is very risky
