ECO2102 Money and Banking (5) Flashcards
(42 cards)
What do we call the interest rate the central bank sets?
The policy rate
What are the notations for lending rate and policy rate?
policy rate - (r^p)
lending rate - (r)
Why is the lending rate relevant for the IS-PC-MR model?
the rate of interest on bank loans and holdings to the public are relevant for spending decisions of households and firms which is then represented by the IS schedule
What sort of competition is the banking system?
imperfect competition
How is the policy rate a cost for commercial banks?
When banks are short on reserves they borrow from the CB and pay interest on this.
Banks also borrow from other banks interbank market, these rates are closely tied with policy rates.
What is the equation for the lending rate (r)?
r=(1+μ^B)r^P
μ^B= banking mark-up
r^P=policy rate
How does the central bank consider lending rates when setting interest rates?
After the central bank decides its optimal output gap it figures out the desired lending rate(r) to achieve this.
CB then predicts what the mark up is.
CB then choose policy rate ,r^P, required to achieve the desired lending rate.
What are the four factors that effect the banking mark-up?
Competition
Risk
Risk Tolerance
Bank equity
Explain how the four factors of the banking mark-up affect it?
Competition - less competition increases the mark-up
Risk - the riskier loans are, the higher the mark-up
Risk Tolerance - banks with lower risk tolerance require a higher mark-up
Bank equity - the smaller the capital cushion (equity) the higher the mark-up
What is credit risk?
Credit risk is the risk that a borrower will fail to repay a loan or meet their debt obligations.
What is credit risk brought about by?
Uncertainty - future is difficult to predict
Information problems can generate
Borrower defaults (unable/unwilling to pay)
What are risks other than credit that banks face?
Liquidity Risk
Insolvency risk
What is liquidity risk?
Risks that banks can’t meet depositor demands to withdraw money.
What is insolvency risk?
Risk of bankruptcy when asset values change.
How is liquidity risk and insolvency risk managed by banks?
They hold enough cash for withdrawals and also have enough equity to absorb reasonable variations in the value of assets.
How does a change in the banking mark-up affect the IS-PC-MR model?
It is represented as a move along the IS schedule (no shift)
What do we assume about the central banks reaction to a change in the mark-up?
That they don’t react immediately to this shock, they change the interest rate at t=1 and not t=0.
Draw graphs showing the banking mark-up and then an increase in the banking mark-up
Check PowerPoint
How does the Central Bank deal with changes in the lending rate?
It counters the change by changing the policy rate
What are the functions of money?
Medium of exchange
Store of value
Unit of account
Give an example of a time where money looses one of its functions
Hyperinflation wipes out the store of value function and with that money stops being a reliable medium of exchange or unit of account.
How is money measured?
Monetary aggregate = cash + reserves ( of commercial banks held with central bank)
Broad money = cash + deposits
How is money created?
The central bank lends reserves to commercial banks who then make loans to the public, these loans return as deposits which generate more lending and so on.
How is the supply of money decided?
Money is endogenous:
The supply of money is decided by the demand of the economy, banks create money in response to demand for credit then central banks accommodate this by providing the necessary reserves.
