Week 4 Lecture 2 Flashcards
What is money?
Money is a set of assets in an economy that people regularly use to buy goods and services from other people
What distinguishes money from other assets?
The three roles or functions of money distinguish it from other assets
What are the three functions of money?
1- Medium of exchange: Money is an item that buyers give to sellers when they want to purchase goods and services
2- Unit of account: This includes money being used to post prices and record debts - essentially used as a measure of economic value
3- Store of value: This includes money being used as an item that people can use to transfer purchasing power from the present to the future
What is the relationship between money and liquidity?
Money is the most liquid of assets
Define liquidity
- Liquidity refers to the ease with which an asset can be converted into the economy’s medium of exchange
- Generally the more liquid an asset the lower its return is therefore money has the lowest return of any asset
What are the two types of money?
- Commodity money
- Fiat money
What is the difference between the two different types of money?
- Commodity money is money that takes the form of a commodity with intrinsic value
- Intrinsic value means that it would have value even if it were not used as money
- Fiat money is money without intrinsic value that is used as money because of government decree
What is the relationship between fiat money and
people’s trust?
With fiat money, people’s trust is critical. If people lose faith then fiat money will lose its value (eg. Russian Ruble in the 90s)
What is the relationship between commodity and fiat money and the three functions of money?
Both commodity and fiat money satisfy the three functions of money
How do you calculate a country’s money stock?
If you add up all the fiat money in a country then you get the money stock
What is M1 and M2?
M1 and M2 are the two most widely followed measures of the money stock
State the components of M1 and M2
M1 = Currency + Demand Deposits + Checkable Deposits
M2 = M1 + Savings deposits + Money market mutual funds
Is Fiat money regulated?
Fiat money is regulated by central banks
What is a central bank?
A central bank is a legal entity with authority to:
- Oversee the banking system
- Regulate the quantity of money in the economy
Explain the role of the Bank of England
- Founded in 1694
- Operationally independent since 1997
- Monetary policy committee (MPC) which sets interest rates to achieve the 2% inflation rate goal
What are the central banks of the US and Europe?
US: The Federal Reserve
Europe: European Central Bank
What is the trade-off created by increasing the money supply?
Increasing the money supply increases inflation and also leads to increased production and lower unemployment
What is quantitative easing?
QE is a way of affecting the money supply
What are reserves?
Reserves are deposits that banks have received but have not loaned out
Explain how 100% reserve banking works
- In 100% reserve banking, all deposits are held as reserves
- When banks adopt this way of banking they do not influence the money supply
Explain how fractional-reserve banking works
In fractional-reserve banking banks hold only a fraction of their deposits as reserves. They use the remainder to make loans and earn a return on their assets
What is the reserve ratio?
The reserve ratio is the fraction of deposits that banks hold as reserves in case depositors wish to withdraw their cash
What is the reserve requirement?
The reserve requirement is the minimum amount of reserves that banks must hold. This is a set level in some countries but unusually, it is not imposed by law in the UK
What is the rule about excess reserves?
Banks may hold reserves above any legal minimum
How much of total deposits do banks gold in reserve?
Banks hold only a fraction of deposits in reserve
What is the money multiplier and state the formula used to calculate it
- The money multiplier is the amount of money the banking system generates from each dollar of reserves
- MM = Reciprocal of the reserve ratio = 1/R
The higher the reserve ratio…
The smaller the money multiplier
What are the three main Tools of monetary control used by Central Banks?
1- Open market operations
2- The refinancing rate
3- Reserve requirements
Explain how Central Banks use open-market operations to control the money supply
- Central banks purchase outright and sell government bonds
- This can be done to increase the money supply as the central bank buys government bonds from the public putting additional currency in the hands of the public
- This can be done to reduce the money supply as the central bank sells government bonds to the public which takes currency out of the hands of the public
Explain how Central Banks use the refinancing rate to control the money supply
The refinancing rate is the interest rate at which the Central Bank will lend to commercial banks on a short-term basis
- It is called the refinancing rate in Europe, the repo rate in the UK and the discount rate in the US
- Banks lend money to each other and borrow from the central bank in the so called ‘money market’
- The central bank can control the money market interest rate through the refinancing rate as well as open market operations
Explain how Central Banks use reserve requirements to control the money supply
Reserve requirements are regulations on minimum amount of reserves that banks must hold against deposits
- An increase in reserve requirement will reduce the money supply
- A decrease in reserve requirement will increase the money supply
What are some problems that can arise when the Central Bank tries to control the money supply?
- The Central Bank’s control of the money supply is not precise as the money multiplier can vary due to fractional reserve banking
- This is because the central bank does not control the amount of money that households choose to hold as deposits in banks and they also don’t control the amount that bankers choose to lend rather than keep as reserves
