Unit 10 - Banks, Money and the Credit Market

Question 1

What is money

Answer 1

A medium of exchange used to purchase goods or services

Question 2

What is wealth

Answer 2

Stock of things owned or value of that stock

= buildings, land, machinery, capital goods - debts owed + debts owed to you

Question 3

What is income

Answer 3

The amount of money one receives over some period of time (flow)

from market earnings, investments, governments

Question 4

What is Depreciation

Answer 4

Reduction in the value of a stock of wealth over time

Question 5

What is Net income

Answer 5

Maximum amount that one could consume without running down wealth

Net income = gross income - depreciation

Question 6

What are Earnings

Answer 6

Wages, salaries and other income from labour

Question 7

What are Savings

Answer 7

Income that is not consumed

Question 8

What is Investment

Answer 8

Expenditure on newly produced capital goods

Question 9

What is interest rate in economic terms

Answer 9

The price of bringing some buying power forward in time

Question 10

Equation for amount a person can borrow

Answer 10

income/(1+r)^t

i.e.

Interest of 10% per annum, income of £100 the next year

100/(1+0.1)^1 ~ 91

Question 11

What is consumption smoothing

Answer 11

How much a person will smooth their consumption to avoid consuming a lot in one period and little in the other

Question 12

What does diminishing marginal returns on consumption mean

Answer 12

It’s the idea of less value for every additional unit of consumption when an individual consumes more and more

Allows consumption smoothing

Question 13

What is pure impatience and what could influence it

Answer 13

Being impatient as a person

Myopia (short-sightedness): People experience present satisfaction more strongly that the same satisfaction later

Prudence: People know that they may not be around in the future so want to consume now

Question 14

What does discount rate indicate (p)

Answer 14

It is a measure of a persons impatience via

Consumption smoothing
Pure impatience

Question 15

What is Base money or Higher-powered money

Answer 15

Notes and coins. Money as legal tender

Question 16

What bank creates legal tender

Answer 16

The central bank

• usually owned by the government
• Acts as the banker for commercial banks who have account which hold legal tender
• BY crediting these accounts, the central bank can create money

Question 17

How do commercial banks make profit

Answer 17

By making loans (bank money; this is not legal tender). They lend much more than they hold in legal tender

Banks then charge a higher interest on loans that on deposits –> profit

Question 18

What is the equation for broad money

Answer 18

Broad money = Base money + Bank money

Question 19

What is maturity transformation

Liquidity transformation

Answer 19

Deposits can be withdrawn at any time
but loans only need to be repaid after a specified time

Deposits are liquid
Loans to borrowers are frozen (illiquid)

Question 20

What risks are is the bank exposed to due to maturity and liquidity transformation

Answer 20

Default risk
Liquidity risk

Question 21

What is bank run

Answer 21

Situation when all depositors demand their money at once; may result in bank failure

Question 22

What effects how much base money a bank will borrow

Answer 22

• How many transactions commercial banks have to make
• The supply of base money which is decided by the central bank

Banks borrow base money on the money market at the short-term interest rate

Question 23

What is Policy interest rate

Bank lending rate

Answer 23

Policy = interest rate on base money set by central bank

Bank = average interest rate charged by commercial banks to firms and households

Question 24

What is Policy interest rate

Bank lending rate

Answer 24

Policy = interest rate on base money set by central bank

Bank = average interest rate charged by commercial banks to firms and households

Question 25

What are the banks cost’s and bank’s revenue

Answer 25

Costs:
Operational: Salaries, branch rents
Interest costs: Paying interest on liabilities (deposits etc.)

Revenue:
Interest and repayment of loans

Question 26

What is expected return for a bank

Answer 26

The return on loans, taking into account the default risk (risk of someone not paying loan back on time)

Question 27

How can the Principle-Agent problem be deal with

Answer 27

Via Equity and Collateral

E.g. financing a project

Equity: lender requires the borrower to put some of their own wealth into the project (to ensure project finishes)

Collateral: the borrower has to set aside property that will be transferred to the lender if loan is not repaid

Question 28

What is credit rationing

Answer 28

When those with less wealth:

• Borrow on unfavourable terms compared to those with more wealth (credit-constrained)
• Are refused loans entirely (credit-excluded)