Banking Sector

Question 1

Functions of Money

Answer 1

• Medium of Exchange
• Store of Value
• Unit of account
• Method of deferred payment

Question 2

Roles of financial institutions

Answer 2

• Maturity transformation
• Risk transformation
• Expert advise
• Transmission of funds

Question 3

Liquidity ratio

Answer 3

• Fraction of bank deposits which have to be held in reserve

Question 4

Bank Multiplier

Answer 4

=1/Liquidity ratio (r)

Question 5

Money types

Answer 5

• Monetary base
  -Narrow: coins and notes in
  circulation
  -Wide: + reserves in central
  bank
• Broad money: + Retail bases, building societies, wholesale banks, certificates of deposits, sight and time deposits

Question 6

Types of money demand

Answer 6

• Active (L1)
  -Transitionary
  -Precautionary
• Idle (L2)
• Speculative

Question 7

Determinants of L1 money

Answer 7

• Income
• Interest rates: Opportunity cost

Question 8

Determinants of L2 money

Answer 8

• Interest rates
• Expectations
• Exchange rate

Question 9

Money equation

Answer 9

MS=L1(Y)+L2(r)
M̄+mr=L1Y+L2r+L̄
mr-L2r=L1Y+L̄-M̄
r(m-L2)=L1Y+L̄-M̄
r=L1Y+L̄-M̄/(m-L2)

Question 10

Interest rate transmission mechanism

Answer 10

Increase money supply
Decrease interest rates
Decrease savings
Increase investment
Increase income

Question 11

Elasticity stages of the interest rate transmission mechanism

Answer 11

• MS->r : Elasticity of liquidity preference
• r->I: Elasticity of investment
• I->Y: Elasticity of withdrawals

Question 12

Problems of interest rate transmission mechanism

Answer 12

• Liquidity trap: Additional money is absorbed into idle balance at very low interest rates as the expectation is that interest rates will increase
• Unstable demand for money: The liquidity preference curve is also effected by expectations and other factors
• Unstable investment: Investment is effected by factors other than the interest rate
• Interest rate on money flow: Interest rates also alter the change of money via debt repayments

Question 13

Exchange rate transmission mechanism

Answer 13

Increase money supply
Decrease interest rates
Decrease exchange rate
Increase exports
Decrease imports
Increase income
Decrease withdrawals

Question 14

Classical Analysis of price and inflation
Equation of exchange

Answer 14

MV=PY=GDP

• Money supply
• Velocity of circulation
• Price level
• Income

Question 15

Velocity of circulation

Answer 15

The average number of times annually that money is spent on goods and services that make up GDP

Question 16

Neutrality of Money

Answer 16

The principle that changes in the money supply only affects nominal variables and does not effect real variables

Question 17

Types of deposits

Answer 17

Sight deposits
Time deposits
Certificates of deposits
Repurchase agreement Repos

Question 18

Central bank roles

Answer 18

Issuing of currency
Lender of last resort
Banker to the government
Control monetary policy
Provide liquidity to banks
Regulate financial sector
Operates exchange rate policy

Question 19

Types of banks

Answer 19

Retail bank - operates services to individuals and small businesses
Wholesale banks - large scale deposits and loans with large companies

Question 20

Functional separation

Answer 20

Separation of investment and retail banks

Question 21

Financial deregulation

Answer 21

The removal or reduction of legal rules over financial practices

Question 22

Monetary financial institutions

Answer 22

Deposit taking institutions

Question 23

Maturity gap

Answer 23

Difference in the average maturity of loans and deposits

Question 24

Liquidity ratio

Answer 24

The proportion of a bank’s total assets held in liquid form

Question 25

Secondary market

Answer 25

When assets are sold before maturity to another party

Question 26

Securitisation

Answer 26

Where future cash flows are turned into marketable securities

Question 27

Special purpose vehicle

Answer 27

Legal entity created by financial institutions for conducting specific financial functions

Question 28

Liquidity

Answer 28

The ease with which assets can be converted into deposits

Question 29

Reasons for the endogenous nature of money supply

Answer 29

-Banks accommodating an increase in the demand for credit. Higher credit demand will lead to higher supply if banks have surplus liquidity or are willing to operate with lower liquidity or can increase liquidity through secondary markets -Depositors switch to less liquid deposits. Higher interest rates encourages individuals to switch from sight to time deposits. This increases the certainty of the banks as they have a higher maturity. This may allow them to decrease their liquidity and increase credit and thus money supply -Inflow of funds from abroad. Higher interest rates will increase the reward for saving in a UK bank leading to an increase in UK money supply to the extent that the Bank of England allows the exchange rate to appreciate

Question 30

Variability of the velocity of circulation across time periods

Answer 30

V is more unpredictable in the short run due to uncertainty and changing expectation leading to individuals to hold on to more money - precautionary money In the long run, according to monetarists, the velocity of circulation is relatively stable. The reason for this is that sufficient time has elapsed for the direct mechanism to have worked fully through. This is also explained by the effect on inflation and interest rates. An increase in the money supply will decrease the interest rates. But if money supply continues to increase, expenditure will increase and thus so will expenditure leading to inflation. This will drive up nominal interest rates even though real interest rates are low. Since nominal interest rates is the opportunity cost of holding money people economise on money balance and the velocity of money falls.

Question 31

Monetary effects of changes in the goods market

Answer 31

An increase in expectations will lead to an increase in investment. This will cause an increase in the transactionary demand for money. If the central bank does not wish for the economy's money supply to rise, they will increase interest rates. This will cause a fall in injections and an increase in savings

Question 32

Financial crowding out

Answer 32

Where an increase in government borrowing diverts money away from the private sector. When the government borrows money they issue new bonds. If these bonds are brought by banks then the banks will have less cash to give out to businesses as credit

Question 33

Factors affecting level of financial crowding out

Answer 33

Elasticity of money demand - If demand is elastic the increase in demand will lead to only a small increase in interest rates The elasticity of investment to a change in interest rates

Question 34

If Central bank finances government expansionary fiscal policy at a balanced budget without tax increase

Answer 34

Central bank buys government bonds Government gets money Increase in the Money supply MS curve shifts right Interest rates decrease LM curve shift right AD curve shifts creates Price level increases

Question 35

If Central bank does not finance government expansionary fiscal policy at a balanced budget without tax increase

Answer 35

Government sells bonds to private sector banks Increase demand for money L curve shifts upwards Interest rates increase Decrease LM curve

Question 36

Financial accelerator

Answer 36

The amplification of effects on the macroeconomy from economic shocks because of changes in pricing and supply of credit by financial institutions

Question 37

Financial instability hypothesis

Answer 37

The theory that the economy goes through stages of credit accumulation which initially fuel aggregate demand but because of increasing financial distress eventually sees a collapse in AD