6. Money and Banking

creation of money

crested through loans by commercial banks

dependent of

probability of lending, risk, bank rate

destruction of money

when loans are repaid, banks sell assets and keep procedes

Banks do not lend out existing deposits; lending creates deposits.

Inflation formula

Pi = lnPt - lnP(t-1)

why inflation matters

money as a store of value

stableises expectations

reduces uncertinaty

improves economic planning

money market

where short term loans are made between banks

Arbitrage

making risk free profits by exploiting price differences

what does arbitrage explain in interest rates

arbitrage ensures that no risk-free profit opportunities remain, so prices and interest rates adjust via supply and demand mechanisms until returns are aligned

effective lower bound

nominal interest rates have a zero lower bound because people hold cash which pays zero interest → limitation on monetary policy

transmission mechanisms

high IR → high opportunity cost of consumption → reduces consumption and prices

increase OC of investment

lower AD → lower price level

quantitative easing

unconventional policy used when IR are at the ELB

central bank buys back govt bonds → increases money supply

Fisher equation

nominal intrest rate = real interest rate + expected inflation

therefore if inflation expectations rise and nominal rated don’t adjust real interest rates fall and borrowing becomes cheaper

Taylor principle

• raise rates when inflation is high,

• lower rates when inflation is low or output is weak