The monetary system Flashcards
(26 cards)
What are the three functions of money that distinguishes it from other assets
- medium of exchange
- unit of account (measure of economic value)
- a store of value
Define liquidity
- the ease at which an asset can be converted into society’s main medium of exchange
- generally, the more liquid that an item is, the lower its return
What are the two types of money
- commodity money
- fiat money
Define commodity money
Has intrinsic money (value even if it were not money). For example, cattle or gold
Define fiat money
Has value due to government decree, people’s trust is critical. For example, currency or bitcoin
What is the money stock
Accumulation of all governmental approved fiat money
What is M1
Currency + demand deposits + checkable deposits
What is M2
M1 + savings deposits + money market funds
Explain the composition of the money stock
M2 is worth considerably more than M1
What is a central bank
A legal entity with the authority to oversee the banking system and regulate the quantity of money
Give background info on the bank of england
- founded in 1694
- operationally independent since 1997
- aims to achieve 2% CPI interest rate
What does increased money supply lead to
- inflation
- increased production
- lower unemployment
How does increased money supply increase production and lower unemployment
More money means interest rates drop and it is easier to borrow, this means more consumption which leads to more demand so businesses expand
What is Quantitative easing (QE)
- a way of affecting the money supply
- authorisation of buying bonds from the banks
- this increases the money supply
Define reserves
Deposits that the bank has received but not loaned out
What is 100% reserve banking
All deposits are held as reserves so the bank cannot influence money supply
Define fractional reserve banking
Only a fraction of the deposits are held as reserves and the remainder makes loans to earn a return
What is the reserve ratio
The fraction of deposits held as reserves
Define reserve requirement
- minimum amount of reserves that banks must hold
- any reserves held above this legal minimum are called ‘excess reserves’
Give an example of fractional reserve banking affecting the money supply
- say a bank receives £100 and the reserve ratio is 10%, they can loan out £90. This increases the money supply from £100 to £190
- this does not create wealth however as this loan counts as debt for the borrower
Define the money multiplier
- the amount of money that the banking system generates
- money multiplier is the reciprocal of the reserve ratio
- the higher the reserve ratio, the lower the money multiplier
The central bank’s three main tools of monetary control
- open market operations
- the refinancing rate
- reserve requirements
Explain open market operations
- outright purchase and sale of government bonds by the central bank
- this increases the money supply when purchasing from the public
- this decreases the supply when selling government bonds
Explain the refinancing rate (aka repo rate)
- the interest rate at which the central bank lends to commercial banks
- banks lend money to each other and borrow from the central bank
- the central bank can control the interest rate through these refinancing rates
