15

Question 1

What are the two main roles of a central bank?

Answer 1

The Government’s Bank and The Bankers’ Bank.

Question 2

What are the functions of a central bank as the Government’s Bank?

Answer 2

Manages government finances

Prints currency

Controls money and credit through interest rates

Question 3

What are the functions of a central bank as the Bankers’ Bank?

Answer 3

Operates interbank payments network

Provides loans during crises

Oversees financial intermediaries to ensure safety and soundness

Question 4

Who are the main players and their roles in the money supply process?

Answer 4

Central bank: Conducts monetary policy.

banks: financial intermediaries, accept deposits, and make loans.

depositors: Hold deposits in banks.

borrowers: Borrow funds from banks.

Question 5

What are the main liabilities of a central bank?

Answer 5

Currency in circulation

Reserves (bank deposits at the CB and vault cash)

Question 6

How is total reserves calculated?

Answer 6

Total Reserves = Required Reserves + Excess Reserves

Question 7

What are the main assets of a central bank?

Answer 7

Government securities (CB holdings of Treasury securities)

Discount loans (provide reserves to banks and earn the discount rate)

Question 8

How do government securities and discount loans affect the money supply?

Answer 8

Both impact the total money supply by influencing the availability of reserves.

Question 9

What are the key assets of a commercial bank?

Answer 9

Reserves and cash items

Securities

Loans

Other assets

Question 10

What are the key liabilities of a commercial bank?

Answer 10

Checkable deposits

Non-transaction deposits

Borrowings

Bank capital

Question 11

What is the formula for the monetary base (High-powered money)?

Answer 11

𝑀𝐵=𝐶+𝑅

C = Currency in circulation

𝑅 = Total reserves in the banking system

Question 12

What happens when the central bank buys a £100 bond from a commercial bank?

Answer 12

The central bank pays with a £100 check.

Reserves increase by £100.

No change in currency.

Monetary base increases by £100.

Question 13

What happens when the central bank buys a £100 bond from an individual, and the check is deposited in a bank?

Answer 13

The person deposits the CB’s check in a bank.

Identical result as purchasing from a bank.

Reserves increase by £100.

No change in currency.

Monetary base increases by £100.

Question 14

What happens when the central bank buys a £100 bond from an individual, and the check is cashed instead of deposited?

Answer 14

The check is cashed, so currency in circulation increases.

Reserves remain unchanged.

Monetary base increases by the amount of the open market purchase.

Question 15

How does an open market purchase affect reserves?

Answer 15

It depends on whether the seller keeps the proceeds in cash or deposits.

Question 16

How does an open market purchase affect the monetary base?

Answer 16

It always increases the monetary base.

Question 17

What happens when the central bank sells a £100 government bond?

Answer 17

The monetary base decreases by £100.

Reserves remain unchanged.

Question 18

Why is the effect of open market operations on the monetary base more certain than on reserves?

Answer 18

Because reserves can fluctuate due to various factors, while the monetary base changes directly with central bank actions.

Question 19

What is the net effect on the central bank’s monetary liabilities when deposits shift into currency?

Answer 19

Zero net effect.

Question 20

What happens to reserves when depositors withdraw cash?

Answer 20

Reserves decrease by the amount withdrawn.
Reserves vary according to random fluctuations

Question 21

How does a shift from deposits to currency affect the monetary base?

Answer 21

The monetary base remains relatively stable despite fluctuations in reserves.

Question 22

How can the central bank (CB) change the monetary base through discount loans?

Answer 22

By granting or recalling discount loans to banks.

Question 23

How does a discount loan appear on the balance sheet of the banking system?

Answer 23

Assets increase: Reserves +£100.

Liabilities increase: Loans +£100.

Question 24

What happens when the CB makes a £100 discount loan to a bank?

Answer 24

The monetary liabilities of the CB increase by £100.

The monetary base increases by £100.

Question 25

What happens when a bank pays off a £100 discount loan to the CB?

Answer 25

The monetary base decreases by £100. The monetary base changes one-for-one with changes in CB borrowings.

Question 26

How does repaying a discount loan appear on the balance sheet of the banking system?

Answer 26

Assets decrease: Reserves -£100. Liabilities decrease: Loans -£100.

Question 27

What are two factors that affect the monetary base but are not under the CB’s control?

Answer 27

Float and Treasury deposits at the CB.

Question 28

How does float affect the monetary base?

Answer 28

Due to the CB’s check clearance system, crediting occurs before debiting. This creates temporary excess reserves.

Question 29

How do Treasury deposits at the CB affect the monetary base?

Answer 29

When funds are transferred from commercial banks to the CB, reserves decrease.

Question 30

Can the CB control Treasury interventions in foreign exchange markets?

Answer 30

Yes, the CB can control these fluctuations.

Question 31

What is the formula for the monetary base (MB) in terms of reserves?

Answer 31

MB = MBn+BR Where: 𝑀𝐵 = Monetary base 𝑀𝐵𝑛= Non-borrowed monetary base 𝐵𝑅 = Borrowed reserves

Question 32

Why does the CB split the monetary base into borrowed and non-borrowed components?

Answer 32

Because there is uncertainty about loans to financial institutions, but the CB has full control over open market operations.

Question 33

How does the CB maintain control over the monetary base despite fluctuations in borrowed reserves?

Answer 33

By adjusting the non-borrowed monetary base through open market operations to hit a target monetary base.

Question 34

What is the formula for the money supply (M)?

Answer 34

M=M1=C+D C = Currency in circulation 𝐷 = Deposits

Question 35

How does the central bank (CB) manipulate the money supply, and what is the role of the simple model of deposit creation?

Answer 35

The CB influences the money supply (𝑀=𝐶+𝐷) by controlling the monetary base (𝑀𝐵). To understand this process, we need to link 𝑀𝐵 to deposits (𝐷). The simple model of deposit creation explains how multiple deposits can be created from an initial injection of reserves.

Question 36

What happens when a bank sells securities to the central bank (CB)?

Answer 36

The bank’s reserves increase as it receives money from the CB.

Question 37

What does a bank do with increased reserves?

Answer 37

It can use excess reserves to grant loans, which increases deposits to make money available. Borrower uses the money to purchase goods. Money from deposit gets paid to other banks

Question 38

Why must banks avoid granting loans higher than their excess reserves?

Answer 38

Because the loaned money gets spent and transferred to other banks, reducing the lending bank’s reserves.

Question 39

What happens when a borrower deposits money into Bank A?

Answer 39

Bank A’s reserves increase. If the required reserve ratio is 10%, Bank A can lend out excess reserves.

Question 40

How does the loan process create money?

Answer 40

Deposits increase by £100. Bank A keeps 10% (£10) as reserves. The remaining £90 is loaned out, which creates new deposits.

Question 41

What happens when loans from Bank A are deposited into Bank B?

Answer 41

Bank B’s reserves increase by the loan amount. Bank B keeps 10% as required reserves and lends out the rest.

Question 42

How does multiple deposit creation work?

Answer 42

The loan from Bank A (£90) is deposited in Bank B. Bank B keeps 10% (£9) in reserves and lends out £81. This process continues, creating new deposits at each step.

Question 43

What is the total increase in deposits with a 10% reserve ratio?

Answer 43

The total increase in deposits is tenfold the initial deposit due to the money multiplier effect.

Question 44

How does the multiplier effect work when banks use excess reserves to buy securities?

Answer 44

Payments for securities create new deposits. These deposits generate new reserves. Excess reserves are used to buy more securities, repeating the cycle.

Question 45

Why can a single bank not grant loans greater than its excess reserves?

Answer 45

Because the money from loans is spent and transferred to other banks, reducing the lending bank’s reserves.

Question 46

How does the central bank's (CB) initial action propagate through the banking system?

Answer 46

The CB’s initial stimulus increases reserves. Banks use excess reserves to grant loans or buy securities. This process creates more deposits and reserves, amplifying the money supply.

Question 47

What is the formula that defines total reserves (R)?

Answer 47

R=RR+ER, where RR = required reserves, and ER = excess reserves.

Question 48

How are required reserves (RR) calculated?

Answer 48

RR=rr×D, where rr is the required reserve ratio, and D is checkable deposits.

Question 49

What assumption simplifies the derivation of the deposit multiplier?

Answer 49

Assume excess reserves (ER) = 0.

Question 50

How do you isolate D (checkable deposits) from the reserves equation?

Answer 50

Divide both sides by rr: D=1/rr × R

Question 51

What is the deposit multiplier formula?

Answer 51

ΔD= 1/rr ×ΔR

Question 52

What does Δ𝐷, ΔR represent in the deposit multiplier formula?

Answer 52

The change in checkable deposits. The change in reserves in the banking system.

Question 53

why is 1/rr > 1

Answer 53

Because the required reserve ratio 𝑟𝑟<1

Question 54

What does 1/rr>1 imply about Δ𝐷 and Δ𝑅?

Answer 54

It implies ΔD>ΔR; a change in reserves leads to a larger change in deposits.

Question 55

When does deposit creation or contraction in the banking system stop?

Answer 55

When all excess reserves have been used.

Question 56

What is the effect of a £100 open market purchase with a 10% reserve ratio?

Answer 56

It creates £1000 in checkable deposits.

Question 57

Why does £100 in reserves create £1000 in deposits?

Answer 57

Because the simple deposit multiplier is 1/𝑟𝑟=1/0.10=10

Question 58

Formula for the simple deposit multiplier?

Answer 58

1/rr

Question 59

Key assumptions of the simple deposit model?

Answer 59

People hold only deposits (no currency) Banks hold no excess reserves

Question 60

What limits deposit/money creation?

Answer 60

Currency held by public Banks holding excess reserves

Question 61

What is the goal of the money supply model?

Answer 61

Show how the monetary base affects the money supply.

Question 62

Define M1.

Answer 62

Currency + checkable deposits.

Question 63

What is the money multiplier formula?

Answer 63

M=m×MB

Question 64

What does 𝑚 represent?

Answer 64

Sensitivity of money supply (M) to changes in monetary base (MB).

Question 65

If m>1, what is MB called?

Answer 65

High-powered money.

Question 66

Currency ratio (c)?

Answer 66

c= C/D

Question 67

Excess reserve ratio (e)?

Answer 67

𝑒=𝐸𝑅/𝐷

Question 68

Required reserve ratio (rr)?

Answer 68

𝑟𝑟=𝑅𝑅/𝐷

Question 69

Monetary base (MB) equation?

Answer 69

MB=C+RR+ER=(c+rr+e)D

Question 70

M1 in terms of D and c?

Answer 70

M1=(c+1)D

Question 71

Final money multiplier formula?

Answer 71

m= (c+1)/(c+rr+e)

Question 72

Given: rr=0.1, C=400, D=800, ER=0.8. Find m.

Answer 72

c= 400/800=0.5 e= 0.8/800 =0.001 m= (0.5+1)/(0.5+0.1+0.001) ≈ 2.5

Question 73

Why is m < 1/𝑟𝑟?

Answer 73

Because some MB is held as currency or excess reserves.

Question 74

Full MB breakdown?

Answer 74

MB=MBn+BR (non-borrowed + borrowed reserves)

Question 75

Full money supply formula?

Answer 75

M=m×(MBn+BR)

Question 76

Effect of ↑ rr on m?

Answer 76

↓ m (less deposit expansion)

Question 77

Effect of ↑ c on m?

Answer 77

↓ m if 𝑟𝑟+e<1 ↑ m if 𝑟𝑟+e>1

Question 78

Effect of ↑ e on m?

Answer 78

↓ m (banks hold more reserves, lend less)

Question 79

Market interest rate effect on e?

Answer 79

↑ interest → ↓ e ↓ interest or ↑ expected outflows → ↑ e

Question 80

What does the Central Bank control?

Answer 80

rr, discount rate, and OMO (MBn)

Question 81

What do depositors influence?

Answer 81

The currency ratio (c)

Question 82

What do banks control?

Answer 82

e and borrowing (BR)

Question 83

What role do borrowers play?

Answer 83

Affect interest rates → influence e and BR