GEE problem set 7

What is money and what functions does it perform?

Money is a generally accepted means of payment that serves as a medium of exchange, a store of value, and a unit of account.

What are the key properties required for an item to work well as commodity money?

1. Medium of Exchange

   • Portability (easy to carry)

   • Divisibility (can be broken down into smaller units)

   • Identifiability (easy to recognize and verify)

2. Store of Value

   • Durability (lasts over time)

   • Stable Supply (not easily destroyed or lost)

   • Stable Demand (people continue to value it)

   • Anonymity (transactions do not require personal details)

3. Unit of Account

   • Homogeneity (each unit is identical and interchangeable)

What potential drawbacks might arise when using a commodity like paper clips as money?

Although paper clips can be portable and divisible, their easy production may lead to unstable supply and counterfeiting issues, making them poor as a store of value.

How did early banks create money, and how do modern banks create money now?

Early banks issued IOUs as promises to pay, while modern banks create money by extending loans that increase demand deposits, effectively expanding the money supply.

that is, by crediting a borrower’s checking account or debit card. When a bank

grants a loan, it doesn’t hand out physical cash; instead, it opens an account

in the borrower’s name and credits it with the loan amount. These newly

created deposits can then circulate throughout the economy as borrowers

use them to make payments, transfer funds, or settle obligations. As the

funds move from one account to another — across individuals, businesses,

and institutions — they function as money, increasing the overall money

supply in the economy.

What is the liquidity mismatch in modern banking?

Commercial banks’ assets, which consist primarily of long-term loans (such

as mortgages, business loans, and personal loans), are generally not very

liquid. These assets are tied to contracts with fixed repayment schedules

that may span several years, meaning they cannot be quickly converted into

cash without potentially incurring losses or disrupting the bank’s operations.

In contrast, the liabilities of commercial banks are typically highly liquid, as

they are largely composed of demand deposit accounts. These are accounts

— such as checking accounts — from which depositors can withdraw funds

at any time, on demand, without prior notice. This creates a structural

imbalance: banks hold relatively illiquid assets while simultaneously being

obligated to meet potentially immediate and large-scale withdrawals.

The problem here is that banks hold a lot of illiquid assets (long-term loans) but have to be ready to pay out liquid liabilities (demand deposits) on demand.

Why is liquidity management important in banking?

Because the mismatch between illiquid assets and liquid liabilities exposes banks to liquidity risks during sudden deposit withdrawals.

What is a banking panic?

A banking panic occurs when depositors, fearing insolvency, withdraw their funds en masse from banks, potentially leading to a systemic collapse

How do central banks help prevent or stop a banking panic?

Central banks provide liquidity through pooled reserves and open market operations, helping to stop bank runs and restore confidence.

banks hold reserves or liquid assets (e.g. government bonds)

Are central banks responsible for fixing banks’ solvency problems?

No, central banks address liquidity problems—not solvency issues—which require recapitalization or restructuring.

• Liquidity: short-term cash issue → Central Banks can help

• ●  Solvency = liabilities > assets → needs recapitalizations, not

  CB duty, action by governments or shareholders.

What is fiat money?

Fiat money is currency without intrinsic value that is declared legal tender by a government; its value is based on public trust rather than a physical commodity.

not convertible by a physical commodity such as gold or silver.

How did the transition from gold-convertible money to fiat money occur?

With events like the Nixon Shock in the United States decided in 1971, economies moved from gold-backed currency to fiat money because most transactions had already been conducted without reference to gold, making trust the key factor.

What risks are associated with fiat money?

Its value depends solely on public trust, which if eroded by political or economic instability, can lead to hyperinflation and loss of value

E.g. Weimar Germany, Zimbabwe

Has fiat money always been accepted as a reliable means of payment?

Not always; historical examples like Germany in the 1920s and Zimbabwe show that when trust fails, fiat money can collapse.

How does extending credit help mitigate a shortage of physical money in an economy?

Credit allows trade to continue when there isn’t enough cash by temporarily creating liquidity, though credit limits can eventually constrain economic activity.

1. Credit can substitute money - but limited

2. Exports increase local liquidity

3. Imports drain it

What impact does the circulation of money (such as from a tourist spending locally) have on a small economy?

It keeps money circulating within the economy, enhancing liquidity and supporting ongoing economic activity

tourist’s spending = external injection (like exports)

What role might electronic money or local cryptocurrencies play in a community’s economy?

They can provide alternative channels for transactions and help resolve local liquidity issues by keeping the money supply active.

Bank opening or issuing local cryptocurrency = new money creation options

How is the money supply defined?

The money supply is defined as the sum of cash in circulation and demand deposits (M = C + D).

What is the monetary base, and how is it defined?

The monetary base (B) consists of the currency in circulation and bank reserves (B = C + R) and is created directly by the central bank.

Why is the money supply typically larger than the monetary base?

Because under fractional reserve banking, banks lend out a portion of their deposits, creating additional demand deposits and expanding the money supply beyond the base

M>B because R<D (fractional reverse banking)

This means that for every dollar a bank promises to repay on demand (represented by D), it holds only a portion in reserve (R), usually determined by the required reserve ratio set by the central bank. As a result, the process of deposit creation through lending amplifies the money supply, making it larger than the monetary base. This mechanism is at the core of how modern banks contribute to money creation.

Why isn’t the money supply defined simply as M = B + D?

Because demand deposits are generated through the lending process and not directly from the monetary base; reserves represent only a fraction of total deposits.

D already include C and R multiplies via bak lending → would be double counting

What must a central bank do to reduce the monetary base?

To reduce the monetary base, a central bank SELLS government securities/public debt, which withdraws liquidity from the banking system.

C or R decrease → M decreases

to increase monetary base = BUY public debt

In order to reduce the money supply, central banks engage in open market

operations, specifically by selling government securities (such as bonds or

treasury bills) to the public or to commercial banks. When buyers pay for

these securities, the funds used for the purchase are withdrawn from the

banking system, which reduces the monetary base in circulation.

especially in a fractional reserve system where the money supply is a multiple of the base.

This tool is commonly used to tighten monetary policy, for example, in

response to inflationary pressures.

Why do central banks focus on buying public debt instead of private goods when increasing the monetary base?

Buying public debt avoids conflicts of interest and maintains neutrality, preventing the central bank from favoring specific sectors.

helps preserve public trust, minimize political interference, and

ensure that monetary policy is conducted in an impartial and effective man-

ner.

Why do central banks typically purchase public debt in the secondary market?

To avoid directly financing government deficits and to maintain a separation between fiscal and monetary policy.

●  Primary purchases = monetizing debt → inflation risk

●  Now prohibited to ensure central bank independence

Why might investors buy bonds that do not pay periodic interest?

Investors can purchase zero-coupon or discount bonds at less than face value and earn a return from the difference when the bond matures.

Sold at a discount ((e.g., pay €950, get €1,000) → return = price difference)

For example, suppose an investor buys a government bond for 950, and at

maturity, the government repays the face value of 1,000. The investor earns:

50.

This 50 gain is the interest earned, even though no periodic payments were

made. To calculate the rate of return, we use the formula:

Rate of Return = 50/950 ≈ 0.0526 or 5.26%

How do you calculate the yield of a zero-coupon bond?

Example: Buy for €800, get €1,000 → Return = 25% > market rate →

Yes, buy it

FV − P / P = 1000 − 800 /800 = 25%

FV − P / P = (FV /P)− 1

P = market price of the bond

FV = face value at maturity

when the price P increases, the rate of return decreases. In other words, as investors are willing to pay more upfront for the same future payoff, the yield they receive from holding the bond until maturity becomes smaller.

What is the relationship between a bond’s price and its yield?

There is an inverse relationship; as the bond’s price increases, its yield decreases.

Another way to interpret this is through the concept of a discount: as the

price of the bond increases, the discount (the difference between face value

and purchase price) becomes smaller, and thus the investor’s return declines.

This inverse relationship between price and return is a fundamental charac-

teristic of all bonds.

Can a bond trade at a price above its face value?

Yes, a bond can trade at a premium (above face value), which means investors accept a negative yield when safe assets are in high demand.

This situation occurs when investors are willing to pay more today than what they will receive at

maturity — effectively accepting a negative interest rate. This was the case

with German public debt a few years ago, when yields on many government

bonds turned negative due to high demand for safe assets and the European

Central Bank’s ultra-loose monetary policy. More recently, in a Spanish

government bond auction, the market price also exceeded the face value,

resulting in the Spanish government receiving funds at a negative interest

rate.

What action does a central bank take to lower market interest rates?

The central bank buys government securities, which increases liquidity and drives down interest rates through higher bond prices

To lower interest → buy public debt → demand increases → price increases → yield goes down

When the central bank buys these

assets, it pays for them by creating new monetary base, which increases the

amount of liquidity circulating in the economy. This rise in the monetary

base (typically through increased bank reserves) enhances the capacity of

commercial banks to lend, contributing to downward pressure on interest

rates.

In addition to injecting liquidity, the central bank’s purchases increase the

demand for public debt, pushing its market price up. Since bond prices

and yields move in opposite directions, this reduces the return (yield) on

government debt, which in turn leads to a decline in overall market interest

rates.

In summary, through asset purchases, the central bank both increases the

money supply and lowers yields, which together contribute to stimulate eco-

nomic activity.

How can central bank asset purchases lead to lower unemployment?

Lower interest rates reduce borrowing costs, encouraging investment and consumption, which increases aggregate demand, production, and ultimately reduces unemployment.

• CB buys debts → increase liquidity

• ●  Demand bonds increase → price increases → yield decreases

• ●  Interest rates decrease

• ●  Firms/ households borrow more → invest/spend more

• ●  AD increases →inventories begin to fall —> output increases→ employment increases →income increases —> Real GDP increases, boosting overall economy IN THE SHORT RUN

How do central banks target a specific level of interest rates?

They influence the prices of government securities via open market operations, thereby indirectly setting benchmark yields that guide overall market interest rates.

securities—because interest rates and bond prices

are inversely related. This means that when the price of a bond increases,

its yield (or interest rate) decreases, and vice versa.

*Yield is the rate of return an investor earns on a bond or investment, usually expressed as a percentage of the bond’s price. It shows how much you earn compared to what you paid for the asset.

This approach allows the central bank to guide

short-term interest rates, which in turn influence borrowing costs, invest-

ment decisions, and overall economic activity.

What is Quantitative Easing (QE)?

an unconventional monetary policy used by central banks to stimulate the economy. Here's how it works:

• The central bank creates new money (digitally) and uses it to buy financial assets like government bonds.

• By buying these assets, the central bank injects money into the economy.

• This lowers interest rates, making borrowing cheaper for businesses and consumers.

• More spending and investment should occur, helping to boost economic growth and raise inflation (if it's too low).

When is QE used?

It’s used when interest rates are already very low, and the economy needs extra help to grow.

What is a Liquidity Trap?

A liquidity trap occurs when interest rates are near zero and monetary policy becomes ineffective in stimulating the economy.

• People prefer holding cash rather than investing in low-yield bonds.

• Even if the central bank increases the money supply, it does not lower interest rates further or stimulate spending.

• Common during periods of deep recession or deflation.

• In such cases, fiscal policy may be more effective than monetary tools.