L1-2: Money and Banking

Flashcards covering the major concepts discussed in the Money and Banking lecture.

What is the primary function of money?

• medium of exchange -

• unit of account -

• store of value

Why is the use of money a significant advancement over a barter economy?

A barter economy requires a double coincidence of wants, which money eliminates.

Besides being a medium of exchange, what are three other important roles of money?

1. unit of account:

2. store of value:

3. standard of deferred payment:

What does it mean for money to be 'legal tender'?

By law, it must be accepted as a means of payment.

How do banks function as financial intermediaries?

They connect depositors and businesses that need to borrow.

What are the main assets of private commercial banks?

Loans to firms and households, and purchases of financial securities.

What is the 'spread' in banking?

The difference between the interest rate paid to depositors and that charged to borrowers. This spread is a key source of profit for banks, as they earn interest on loans at a higher rate than they pay on deposits.

What crucial feature do banks have that distinguishes them from other financial intermediaries?

Some of their liabilities can be used as a means of payment and are part of the money stock.

What is the 'reserve ratio' in banking?

The percentage of deposits that banks cannot lend out.

What is fractional reserve banking?

A banking system where banks keep a fraction of deposits as reserves and use the remainder to make loans and investments. This practice allows banks to create money through lending while maintaining liquidity for depositors.

What is the formula for the money multiplier?

1 divided by the reserve ratio

What does the money supply comprise?

Currency in circulation and deposits at banks.

How does the central bank change the level of the monetary base?

By buying or selling financial assets in exchange for cash.

Give three examples of measures of money

Monetary base, M0, and M1

Why did the money multiplier fall significantly in the US post-2008 crisis?

Banks were less willing to lend, and the private sector was less willing to borrow.

What is the role of central banks?

To set/manage monetary policy in a country.

What is 'discount rate'?

the interest rate that banks must pay in order to borrow from the central bank

What are open market operations (OMO’s)?

Open market operations (OMOs) are the buying and selling of government securities by a central bank to regulate the money supply and influence interest rates in the economy.

What is the role of the central bank as a lender of last resort?

To provide funds to commercial banks during times of financial panic and crises.

What is the difference between liquidity risk and insolvency risk?

Liquidity risk refers to the inability to meet short-term obligations, while insolvency risk refers to the inability to pay off debts.

What is the lender of last resort?

the central bank may also need to rescue insolvent institutions, because a prominent financial institution becoming bankrupt may create systemic risk for the entire financial system

What is deposit insurance and its solution?

Deposit insurance is a protection scheme provided by financial institutions to safeguard depositors' funds against bank failures.

It ensures that depositors are reimbursed a certain amount, typically up to a specified limit, thereby maintaining public confidence in the banking system.

What is moral hazard?

Incentivizing risk taking and irresponsible behavior

Why are bond prices and interest rates inversely related?

When interest rates rise, the existing bonds with lower rates become less attractive, causing their prices to fall. Conversely, when interest rates fall, existing bonds become more valuable as they yield higher returns compared to new issues.