9.4 Money and banking Flashcards
Money and the money supply
Functions of money:
Medium of exchange - only other option we have is to barter and the problem with that is that the person who is selling you something will accept the good that you have. However if both parties accept money then the transaction can be so much easier
Has to act as a store of value - can’t deteriorate over time. Inflation over time can erode the value. 100 pound in 10 years time won’t have the same value
It needs to act as a measure of value. If you have goods with diff prices, you know the good that is more expensive is different in some way
It needs to act as a standard of deferred payment - you can pay it back at a later date. This brings the idea of lenders and borrowers together
Characteristics of money:
Acceptable
Portable
Durable
Divisible - can be split up easily
Limited in supply - keeps its worth
Difficult to forge
Commodity money is anything that has intrinsic value like gold. Fiat money is something that has no type of intrinsic value which is cash. If hyperinflation occurs or a massive currency crisis erodes the value of the money then the money that we have is simply worthless
Different types of money:
Notes and coins
Deposits that individual or firms have in the bank or banks have in the bank of England. There are highly liquid and can be converted to cash easily
Near money - non cash assets that can be converted to liquid money. Money isn’t as liquid as notes and coins etc. Examples of these would be bonds with maturity dates of 1 year 3 year 5 years etc. You can sell these and convert them to cash.
The money supply is the total amount of money circulating in the economy:
M0 is a measure that includes simply the total amount of notes and coins and total deposits individuals have in bank accounts
As you get from M1 M2 M3 M4 the money gets less liquid. M4 is a broad way of looking at money
M4: Certificates of deposits, bonds. Non cash assets with maturity dates of 5 years or less
What is the quantitative theory of money? (MV=PQ)
The theory states there is a direct link between the money supply and inflation
M = money supply
V = velocity of circulation (amount of times money changes hands in an economy)
P = average price level - inflation
Q = quality of goods/services sold
Monetarists believe V and Q are fixed and that it is only money supply that affects change in prices. More money chasing the same quantity of goods will mean prices will rise to compensate.
Keynesian argue that V and Q aren’t fixed and that V changes a lot during recession
The equation argues that increasing the money supply causes inflation.
When the money supply increases, consumers have more money to spend. This causes AD to shift to the right. Firms then increase supply in the short run. A positive output gap occurs, which is inflationary.
As a result, more workers are employed, so wages increase. This means costs increase for firms, so they put up prices.
This inflationary pressure means the real value of money falls. Since money can buy less, there is a contraction in demand.
Workers demand higher wages to make up for the increase in inflation. This leads to a left shift in the SRAS curve.
The output in the economy returns to equilibrium, but the price level is higher.
What is the difference between a commercial bank and an investment banks?
A commercial bank manages deposits, cheques and savings accounts for individuals and firms. They can make loans using the money saved with them.
Accept savings from those with excess cash
Lend out to borrowers
Act as financial intermediaries - give a small er rate of return on savings compared to the IR charged to borrowers
Allow payment from one agent to another
Offer advice - financial or insurance advice
Investment banks facilitate the trade of stocks, bonds and other forms of investment. Government regulation is weaker in the investment bank industry, and this combined with their business model gives them a higher risk tolerance.
Prop trading - take any excess capital and invest it to get a better rate of return by buying shares/bonds/derivatives. Basically take profits and try to make more profits out of them
Market making - ensures markets can exist. They’re a place where bonds/shares can be bought and sold on behalf of lenders. If you want to buy or sell bonds and shares you can do this through an investment bank
M&A - companies that are looking to take over or merge with another, they go to IB for advice. (When to go through with it? How to structure the deal? Due diligence to make sure everything is okay with the takeover firm. Make sure all paperwork is done and meets regulatory requirement. To make sure media is all fine)
New issues - of bonds and shares. Ib’s can put people into contact with people who want to buy these.
What is systemic risk?
Joint banks have more systemic risks as if IB fails, it will bring down the commercial side too which can break down the entire financial system. The entire financial system is interconnected
What is reserve ratio?
What are the different types of ratios?
Cash ratio: This is forcing commercial banks to hold enough cash assets to meet their short term liabilities
Liquidity ratio: Includes all the current assets and this makes sure they hold enough short term liquid assets to meet short term liquid liabilities to prevent a bank run
Capital ratio: Make sure a a bank holds enough capital to offset any losses in loans to avoid risk of insolvency
Reserve ratio: Making sure a certain fraction of the deposits are kept at the bank of England
Making sure a certain fraction of deposits are kept in the BofE. Will make sure banks got enough liquid assets to meet needs of depositors or any short term liabilities that they need to pay.
What are assets and examples?
Anything of value that the commercial bank owns:
Going down in order of liquidity
Cash - notes and coins
Reserves of BofE - when deposits are put into a commercial bank a fraction of those will be put in the bank of England
Money at short notice
Short term investments - short term bonds
Long term investments - short term bonds
Advances (issuing loans and mortgages to individuals or firms)
Fixed assets
What are liabilities and examples?
Anything that the commercial bank owes:
Deposits - depositors can come back whenever they want and ask for money back and commercial bank has to pay straight away
Short term borrowing
Long term borrowing
Shareholders funds
Retained profit
Bottom 2 are capital - they belong to shareholder snot the commercial bank
The objectives of a commercial bank and potential conflicts between these objectives
Profit maximise - keep shareholders happy. Do this by borrowing short term and lend long term. You take more risks
Liquidity
The liquidity of assets is how easy it is to turn the assets into cash. Liabilities are payable on demand, so in order to be profitable banks must have cash and liquid assets. If liquidity is prioritised, profits will be low, so banks need a balance between the two objectives.
If banks can borrow easily and cheaply, they are likely to keep fewer liquid assets.
The more expensive and difficult it is to get a loan, the more liquid assets are likely to be kept.
Profitability
Banks need to earn profits to pay their depositors interest, wages and general expenses. Holding a lot of funds in cash means profitability is limited. However, liquidity and safety are generally prioritised over profitability, which is considered to be supplementary for the bank’s survival.
Security
Banks face risks and uncertainties about how much cash they can get, and whether loans will be repaid or not. Banks therefore have to try and maintain the safety of their assets. A bank has to keep high proportions of their liabilities with itself and the
central bank. However, following these principles means banks only hold their safest assets, so more credit cannot be created.
This means that banks profits are lower and the bank might lose customers. The bank needs a balance between the risk level and their profits. Too much risk could be harmful.
What is the role of a central bank?
To implement monetary policy - control money supply and set IR in order to meet inflation targets and to make sure other macro objectives like growth or unemployment are being looked after as well
Act as a banker to the government - central banks can buy and sell gov bonds on behalf of the gov. Can also look at ways to reduce IR being paid by gov on gov bonds
Act as a banker to the banks - Prevents a bank run. To get involved when there is a liquidity crisin to a commercial bank. Won’t intervene if a bank goes insolvent due to risky decisions made by themselves
Regulate financial system
The bottom 2 are financial stability roles.
Financial stability is crucial for confidence in the financial system to remain high
It prevents panic
It reduces instability and systemic risk
They advise the gov of bank bailouts to prevent financial crash and deep recession
How does the central bank control the monetary policy?
The central bank takes action to influence the manipulation of interest rates, the supply of money and credit, and the exchange rate.
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
The bank controls the base rate, which ultimately controls the interest rates across the economy.
What is lender of last resort?
The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the Bank of England will lend money to increase the supply.
If an institution is risky or is close to collapsing, the Bank might lend to them. This is when they have no other way to borrow money.
It can protect individuals who deposit funds in a bank and might otherwise lose them. It also aims to prevent a ‘run on the bank’, which is when consumers withdraw their bank deposits in a panic, because they believe the bank will fail.
Usually, banks will avoid borrowing from the lender of last resort, because it suggests the bank is experiencing a financial disaster.
Evaluating lender of last resort
Moral hazard - occurs where a decision is taken that if it goes bad, it is worn by a 3rd party in this case the BofE. Also encourages risky behaviour as they know banks will bail them out
Banks may not hold sufficient liquidity as they know central banks will just hold their hands
Regulatory capture - Regulators who may be influenced as they’ve got buddies who still work in the industry. Maybe managers from a central bank get in contact with regulators from BofE and say lower IR a bit on that emergency liquidity etc.
Why should banks have the luxury of emergency liquidity but other firms don’t have this luxury?
What are the monetary policy instruments?
QE and interest rates
Interest rates
When interest rates are high, the reward for saving is high and the cost of borrowing is higher. This encourages consumers to save more and spend less, and is used during periods of high inflation.
When interest rates are low, the reward for saving is low and the cost of borrowing is low. This means consumers and firms can access credit cheaply, which encourages spending and investment in the economy. This is usually used during periods of low inflation. However, during the financial crisis, the UK interest rate fell to a historic low of 0.5%, and has been at this rate since March 2009. Despite high inflation, the interest rate was set at a low rate to stimulate AD and boost economic growth
QE
This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency.
QE is usually used where inflation is low and it is not possible to lower interest rates further.
QE is a method to pump money directly into the economy. It has been used by the European Central Bank to help stimulate the economy. Since the interest rates are already very low, it is not possible to lower them much more. The bank bought assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, since it makes the cost of borrowing lower. The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
If inflation gets high, the Bank of England can reduce the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy.
