Topic 6 - Money and Banking Flashcards
What limits the store of value property of money
- Inflation, if inflation is high, then money is worth considerably less
What is money
- Primary means of payment
- Means of exchange
- Store of value
- Unit of account
What does it mean for money to be a “unit of account”
- Money is in the same units as the goods and services we buy, so there is no exchange rate or price risk
What does UK money consist of
- Currency, notes and coins
- Deposits, in banks and building societies
- Deposits are money, that can be easily converted into currency and can settle debts
What is not classed as money
- Cheques and Credit cards
What is the official measure of UK money supply and how is it calculated
- M4 = C + D
- Where C is currency held by the public and D is deposits of customers in UK banks
What is money mostly made up of
- Deposits
- BoE cannot directly control this!
- Deposits depend on the banks willingness to loan, and the demand of consumers/firms for loans
How would a family needing a £1million loan for a mortgage increase M4
- The bank credits £1million to the customers account to then be payed over a time period
- This money is then deposited in a bank
- Therefore M4 increases
How can M4 fall
- As bank loans are repaid, deposits decrease
- If more loans are repaid than originated, M4 falls
What does the money market consist of
- Demand for money by households and firms
- Supply of money by BoE and commercial banks
What does money creation achieve
- Money creation makes financial capital more plentiful
- More purchasing power and increased supply of loanable funds
- This means the price of money will fall, therefore excessive money creation can lead to financial crisis
What are banks and why are they crucial
- Banks are monetary financial institutions
- They loan to households and firms, Take in deposits and Electronic payments
What makes banks risky
- Banks are said to “borrow short, lend long”
- In short, meaning that banks take on deposits and pay interest and lend to indivduals and firms, earning interest
- “Maturity Mismatch”
How is bank profit calculated
- Profit = rl * L - rd * D
- Where rl is loan interest and rd is deposit interest
What is the profit margin on a new loan
- Profit margin = rl - rd
- Banks must earn more on loans than paid on deposits
- rl > rd => Profit > 0
What are the challenges for banks trying to make profit
- Not all bank loans will be repaid
- There are costs on top of interest paid on deposits
Why do banks hold liquid cash
- Liquid assets like long term loans cannot be used to meet demand for cash
- So liquid cash must be hold to meet demand
What are the two types of liquid assets banks hold
- Cash and Bonds, usually short-term gov bonds (gilts)
- Reserves, commercial bank deposits at BoE
What does a balance sheet show
- Assets, Liability and Capital
What two problems can arise if banks are run poorly
- Bank Runs
- Insolvency
What causes a bank run
- Belief or evidence shows bank is in financial difficulty
- Many customers withdraw deposits as they want their money now
- Deposits are invested elsewhere, if bank does not have enough reserves they cannot pay all withdrawals
- illiquidity will force the bank to close
- Bank runs exhaust liquid assets
How is bank net worth calculated and what else is it referred to as
- Net worth = Assets - Liabilites
- Known as “Bank Capital”
When is a bank insolvent
- If Net worth is negative
How is the leverage ration calculated
- Leverage = Total Assets / Net Worth
- More loans creates higher leverage as assets increase
- Insolvency problems are usually a result of high leverage
- Net worth is needed to absorb losses on loans
In short, what do banks need to survive
- Sufficient liquid assets and capital
What is a central bank
- A public authority that:
- Provides banking services to central banks
- Conducts monetary policy
- Regulates the financial system
- Lender of last resort
What is the UK’s central bank
- The Bank of England
- Founded 1694, Nationalised 1946, Independant since 1997
How does the BoE influence the economy
- Interest Rate paid on banks reserves
- Changes in its balance sheet
What is the monetary base and how is it calculated
- Monetary base (MB) is equal to BoE’s liabilities
- MB = C(tot) + r
- Where C(tot) is currency in circulation and r is reserves of banks at BoE
- Includes currency with public and banks
What is Monetary base useful for
- Monetary base is the central banks money
- Allows banks to pay eachother
- Helps banks meet withdrawals
- Primarily reserves
- This is one way the CB can influence the economy
How can the BoE influence money supply
- Through open-market operations (OMPs)
- BoE buys / sells government bonds and transacts with commercial banks
- BoE could buy £10,000 worth of bonds from a bank, this gives the bank £10,000 of reserves in order to create loans with, increasing deposits and money supply
What do open-market operations rely on
- Banks having “excess reserves”
Why are OMPs used alongside interest rate cuts
- Prevents excess demand for reserves
- Gets other short-term interest rates to fall
What is the timeline for OMP’s and interest rate cuts
- BoE announces cut in Bank Rate
- Banks demand more reserves
- OMPs increase the supply of reserves
- Banks make more money available
- Lending and economic activity increase
What does M4 exclude
- Notes + coins held by banks
- Deposits of the UK government
How is the money multiplyer calculated
- mm = M4 / MB
- Ratio of “broad money” to Central Bank money
- Indicator of private money creation
How can the central bank influence money creation without using OMPs and interest rates
- Through regulation of financial institutions
What is Macro-Prudential regulation of capital
- Requires banks to ensure that bank capital (equity) remains above a minimum threshold
- Capital affects commercial banks’ loss-absorbing capacity
- In the UK, MAcro-pru regulation is done by the BoE
