Topic 5: Monetary Policy

Question 1

What is Money?

Answer 1

Money is anything that is generally accepted as a way of paying for goods and services. e.g. gold, cattle etc

Question 2

How has money evolved?

Answer 2

Today we use notes and coins, cheques, credit cards, and online banking transactions. These are called ‘near money’.
* Two types of money:
* Commodity money – E.g. Gold, silver, copper.
* Fiat money [token money] – No intrinsic value. e.g. notes, coins

Question 3

What are the four functions of Money?

Answer 3

1. Medium of exchange: Facilitates exchange of goods and services– barter system, more difficult.
2. Unit of account/value: Money measures the value of various goods and services which are produced in an economy.
   E.g. A €26 haircut is worth twice as much as a €13 umbrella. It provides an common denominator. This is something that wasn’t possible with barter .
3. Standard of deferred payment: We operate based on credit.
   Credit is paid in the form of money only, Makes trade more flexible.
4. Store of value: Money can be saved to use at a future date

Question 4

What are the seven Characteristics of Money?

Answer 4

1. Acceptable: money stops being money if it’s no longer accepted. People should have confidence that the money they have will be accepted, otherwise trade will break down.
2. Scarce: it should be scarce in relation to the demand for it. Otherwise, it lacks value.
3. Homogenous: each denomination of it should be identical, e.g. One €10 note should look like another €10
4. Portable: It should be easy to carry around. Small amounts of notes and coin don’t weigh much, cows do.
5. Durable: It should last a long time, e.g. Coins are made of metal, and notes are made of high- quality paper.
6. Recognisable: People should not have to question whether they’ve been handed real money. This is why so much effort is put into stopping counterfeiting (the making of fake money).
   Again, this preserves confidence.
7. Divisible: It must come in small as well as large denominations, not just €500 notes but also 10c and 20c coins for smaller transactions.

Question 5

Keynes’s Liquidity Preference theory – Why do people hold money?

Answer 5

• Transactions motive: This is determined by the level of people’s transactions. If the need to spend cash is immediate (as is almost always the case) and the delay is considerable, sufficient cash must be readily available to bridge the gap.
• Precautionary motive: people hold money as a cushion against an unexpected need. Precautionary money balances come in handy if you are hit with an unexpected bill e.g. car repair, “rainy day fund”.
• Speculative motive: People hold money as a store of wealth. The speculative motive, on the other hand, is more a result of extraordinary economic circumstances like financial crises and bubble bursts that result in irrationally depressed asset prices and consequently, opportunities to earn abnormally high returns.

Question 6

What is Monetary Policy?

Answer 6

Monetary Policy is the actions of a central bank that determines the size and rate of growth of the money supply.
The central bank can control the money supply in two ways:
1. Directly: Printing money, Danger: leads to inflation
2. Indirectly: A variety of tools are available to the central bank to indirectly control money supply

Question 7

What monetary policy instruments are available to the ECB?

Answer 7

1. Open market operations
2. Standing facilities
3. Minimum reserve requirements for credit institutions

Question 8

Describe Open market operations

Answer 8

It is used fo 3 purposes:
1. Steer interest rates
2. Manage the amount of liquidity in the financial system
3. Signal the ECB’s monetary policy stance (what does the interest rate tell us?)
- It primarily consists of
– main refinancing operations (commercial banks borrow from the ECB for one week
– longer-term refinancing operations (3 months)

Question 9

Describe Standing facilities

Question 10

Describe Minimum reserve requirements for credit institutions