Unit 10 - Banks, Money and the Credit Market Flashcards
What is money
A medium of exchange used to purchase goods or services
What is wealth
Stock of things owned or value of that stock
= buildings, land, machinery, capital goods - debts owed + debts owed to you
What is income
The amount of money one receives over some period of time (flow)
from market earnings, investments, governments
What is Depreciation
Reduction in the value of a stock of wealth over time
What is Net income
Maximum amount that one could consume without running down wealth
Net income = gross income - depreciation
What are Earnings
Wages, salaries and other income from labour
What are Savings
Income that is not consumed
What is Investment
Expenditure on newly produced capital goods
What is interest rate in economic terms
The price of bringing some buying power forward in time
Equation for amount a person can borrow
income/(1+r)^t
i.e.
Interest of 10% per annum, income of £100 the next year
100/(1+0.1)^1 ~ 91
What is consumption smoothing
How much a person will smooth their consumption to avoid consuming a lot in one period and little in the other
What does diminishing marginal returns on consumption mean
It’s the idea of less value for every additional unit of consumption when an individual consumes more and more
Allows consumption smoothing
What is pure impatience and what could influence it
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
What does discount rate indicate (p)
It is a measure of a persons impatience via
Consumption smoothing
Pure impatience
What is Base money or Higher-powered money
Notes and coins. Money as legal tender
What bank creates legal tender
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
How do commercial banks make profit
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
What is the equation for broad money
Broad money = Base money + Bank money
What is maturity transformation
Liquidity transformation
Deposits can be withdrawn at any time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)
What risks are is the bank exposed to due to maturity and liquidity transformation
Default risk
Liquidity risk
What is bank run
Situation when all depositors demand their money at once; may result in bank failure
What effects how much base money a bank will borrow
- 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
What is Policy interest rate
Bank lending rate
Policy = interest rate on base money set by central bank
Bank = average interest rate charged by commercial banks to firms and households
What is Policy interest rate
Bank lending rate
Policy = interest rate on base money set by central bank
Bank = average interest rate charged by commercial banks to firms and households
What are the banks cost’s and bank’s revenue
Costs:
Operational: Salaries, branch rents
Interest costs: Paying interest on liabilities (deposits etc.)
Revenue:
Interest and repayment of loans
What is expected return for a bank
The return on loans, taking into account the default risk (risk of someone not paying loan back on time)
How can the Principle-Agent problem be deal with
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
What is credit rationing
When those with less wealth:
- Borrow on unfavourable terms compared to those with more wealth (credit-constrained)
- Are refused loans entirely (credit-excluded)
