week 4 Flashcards
Savings, investment, and Financial Markets; the monetary system
What is money?
- A set of assets in an economy that people regularly use to buy goods and services from other people
- Liquid
what are the three functions of money which distinguish it from other assets?
1. Medium of exchange
Item that buyers give to sellers when they want to purchase goods and services
2. Unit of account
Yardstick people use to post prices and record debts
… A Measure of economic value
3. Store of value
Item that people can use to transfer purchasing power from the present to the future
what is a unit of account?
Something which, if I give it to you, you know its worth (or can immediately find out)
Money is the _____ ________ of assets
most liquid
what is liquidity?
the ease with which an asset can be converted into the economy’s medium of exchange.
why is money the most liquid of all assets?
it IS the medium of exchange thus the most liquid
Generally, the _____ liquid an asset, the _____ its return.
Generally, the more liquid an asset, the lower its return.
what is money’s return compared to other assets?
Not surprisingly, money has the lowest return of any asset (zero or close to zero).
What are the 2 TYPES of money?
- fiat money
- commodity money
what is fiat money?
Money without intrinsic value that is used as money because of government decree
SATISFIES THE THREE ROLES OF MONEY + HAS NO INTRINSIC VALUE
what does intrinsic value mean?
Intrinsic value: would have value even if it were not used as money
what is critical to remember with fiat money?
peoples’ trust is critical!!!!!
..If people lose faith, fiat money will lose its value (e.g., Russian Ruble in 90ies).
if people have faith in each other (fiat money) then..?
No government is neede! (BITCOIN… STONES ON YAP)
what is COMMODITY money?
Money that takes the form of a commodity with intrinsic value
Satisfies the three roles and has intrinsic value
The money stock is calculated how?
By adding all the fiat money up in a country
Formula for money stock M1
M1 = CURRENCY + DEMAND DEPOSITS + CHECKABLE DEPOSITS
M2 measure of the money stock is calculated by…?
M2 = M1 + short-term savings deposits + money market mutual funds
Who regulates fiat money?
Central Banks
WHAT is a Central bank?
It is a legal entity with authority to:
- Oversee the banking system
- Regulate the quantity of money in the economy
When was the bank of england founded? What does it do?
1964
- Monetary policy committee sets interest raves to achieve 2% CPI inflation rate
- New powers for financial regulation, with the abolition of FSA in the aftermath of the global financial crisis
(The Financial Services Authority (FSA) was abolished because it was criticized for not effectively preventing the financial crisis in 2008. After the crisis, it was decided that a new approach to financial regulation was needed)
When was the US FED reserve created? What is its policy goal?
1913 - created after a series of bank failures in the decade prior
POLICY GOAL: ensure the health of the nation’s banking system
When was the ECB created? What’s it’s policy goal?
1988
POLICY GOAL: achieving price stability
Inflation rates below but close 2% over medium run
What is the importance of monetary policy?
Prices rise when “too much” money is printed…
@ the same time, interest rates/money supply affect activity and unemployment
so there is a “trade-off”
Increased money supply leads to:
- Inflation (bad if inflation is already at or above target but could be good if inflation is below target)
- Increased production and lower unemployment, at least in the short run (good in a recession!).
explain Quantitative Easing
when Inflation is low and not possible to lower IR more.
Used by banks to help stimulate the economy when standard monetary policy is no longer effective.
- Banks digitally create money
- Buy government bonds from commercial banks w/ money.
- Commercial banks use money to loan to firms ↑investment
- Banks can lend to consumers. ↑consumption
However, It could lead to demand-pull inflation
Example of real-life use of QE?
Between March 2009 and January 2010, the MPC authorised the purchase of £200 billion worth of assets, mostly gilts
This has since been repeatedly renewed.
What does QE do?
- Lowers interest rates,
- boosts activity…
- and increases inflation all else equal
(e.g., could prevent deflation in an otherwise deflationary environment).
Who also influences the money supply?
BANKS
What are reserves?
Deposits that banks have received but have not loaned out
what is 100% reserve banking?
All deposits are held as reserves and Banks DO NOT influence the supply of money
Money supply in banks is calculated from…?
Money supply = demand deposits + currency
define Fractional-Reserve Banking
Banks hold only a fraction of their deposits as reserves. Use the remainder to make loans and earn
what is Reserve Ratio
Fraction of deposits that banks hold as reserves (incase depositors wish to withdraw their cash)
reserve requirement/deposits
define Reserve Requirement
Minimum amount of reserves that banks must hold; set in some countries (Fed, ecb) BUT not imposed by law in UK.
what is Excess Reserve?
when banks hold reserves above any required legal minimum
e.g., First National Bank : Reserve ratio 10%
banks only hold….. in reserve?
a fraction of deposits in reserve
What is the process of money creation through banks? (Money mutliplier)
The process of money creation continues…
- Suppose the borrower from First National Bank uses the $90 to buy some goods, the proceeds of which are then deposited in Second National Bank
→ Second National Bank then holds 10% in reserves ($9) and lends out a further $81
and so on… and on… and on…
Original deposit = $100.00
- First National lending = $ 90.00 [= .9 × $100.00]
- Second National lending = $ 81.00 [= .9 × $90.00]
- Third National lending = $ 72.90 [= .9 × $81.00]
Total money supply (sum of the above) = $1,000.00
how does a bank’s loan increase money supply?
- First National bank’s $90 loan increases the money supply (puts money in the borrowers’ pockets).
- So FNB has increased the money supply from $100 to $190
Note that this does not create wealth.
Bank loans are debt for the borrowers who are therefore NOT any richer.
Define the money multiplier
Amount of money the banking system generates from each dollar of reserves.
It is the RECIPROCAL OF THE RESERVE RATIO
Money multiplier M.M relation to reserve ratio?
Reciprocal
1/R
So, M.M=1/0.1 = 10 in our example (“$100 becomes $1.000”)
The higher the reserve ratio….?
The smaller the money multiplier
- Money multiplier = 1 when R=1
How does CB use open-market operations to increase money supply?
To increase the money supply
The Central Bank buys government bonds from the public (thus putting additional currency in the hands of the public).
WAT ARE The Central Bank’s Tools of Monetary Control? [3]
- Open market operations
- The refinancing rate
- Reserve requirements
WHAt are Open-Market Operations?
Outright purchase and sale of government bonds by the Central Bank
What is the refinancing rate?
The interest rate at which the Central Bank will lend to commercial banks on a short-term basis
– Called the refinancing rate in Europe; repo rate in the UK; discount rate in the US
How does CB use open-market operations to reduce money supply?
The Central Bank sells government bonds to the public (and the currency it receives is now out of the hands of the public).
NOTE: Unconventional OMOs=buying other types of assets such as e.g. private bonds
How does the refinancing rate work?
- Banks lend money to each other, and borrow from the central bank in the so-called “money market”.
- The central bank can – in normal times - control the money market interest rate through the refinancing rate (as well as through OMOs)
What are reserve requirements?
Regulations on minimum amount of reserves that banks must hold against deposits
An increase in reserve requirement will…?
reduce the money supply (multiplier ↓)
A decrease in reserve requirement will…?
increase the money supply (multiplier ↑)
BoE, Fed, ECB prefer not to use reserve requirements since…?
It greatly upsets banks’ business models.
However, it does happen (e.g. Basel III increased reverse requirement; China’s CB uses frequently).
What are the problems with the Central Bank’s monetary tools?
The Central Banks’s control of the money supply is not precise…
So money multiplier can vary due to fractional reserve banking
OMOs, refinancing rate, reserve requirements are the _____ ?
“monetary policy tools”.
Why is CB’s control of money supply not PRECISE?
a) Does not control the amount of money that households choose to hold as deposits in banks
b) Does not control the amount that bankers choose to lend rather than keep as reserves
Money supply and interest rates controlled by …
central banks… albeit imperfectly.
OMOs may be __________ or __________
“conventional” (government bonds only) or “unconventional”
How to use OMOs to increase or decrease the money supply?
- To increase the money supplyThe Central Bank buys government bonds from the public (thus putting additional currency in the hands of the public).
- To reduce the money supplyThe Central Bank sells government bonds to the public (and the currency it receives is now out of the hands of the public).
