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Legal tender is the official currency of a country and must be accepted in payment for goods and services.
Functions of Money
[1] Medium of exchangeIt is used in the process of exchange where one person buys with money and another sells for money.
[2] Measure of value
We use money to decide how much something is worth. The relative value of goods can be compared.
[3] Store of wealth
Money can be saved (in bank accounts) and can be used in the future.
[4] Standard for deferred payments Money is capable of measuring value for a future date, therefore credit transactions can take place.
Characteristics of Money
[1] DivisibleIt can be divided into small and large units for all sizes of transactions to take place.
[2] Portable We must be able to carry it around easily.
[3] Durable
It must be long-lasting.
[4] Recognisable
It must be easily recognisable as genuine therefore making it difficult to produce counterfeit money.
[5] Scarce
It must be relatively scarce so that it maintains it's value.
How Money is Created
A commercial bank has the power to create credit. It receives cash deposits from it's customers. It can keep this money in cash form or it can put it to some profitable use. It is told by the Central bank to keep a certain amount of the deposits in cash form. This is known as the reserve ratio or the primary liquidity ratio.Formula:
Using this reserve ratio, it can give out credit (loans and overdrafts) which is greater than it's own cash deposits.
EXAMPLE
Mr X goes into a bank and deposits £1000 in cash. The reserve ratio is 10% which means the bank must keep 10% of it's deposits in cash form.
The bank has an asset of £1000 cash and a liability of £1000 to Mr X.
The £1000 cash is 10% of £10,000 therefore the bank is able to give credit of the balance of £9,000. When it gives out a loan, it makes a deposit for Mr X for £9,000.
The bank has deposits of £10,000 but it has £1000 in cash.
Therefore the reserve ratio is satisfied and money or credit is created.
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Profitability-V-Liquidity
A bank must be profitable for it's shareholders. It must also have liquid assets to satisfy their customer's cash requirements. A bank attempts to satisfy both needs by dividing it's assets in a certain manner.
If a bank holds too many liquid assets, it will lose out on profit making opportunities like giving out loans and buying bonds.
Also if it has too many profitable assets, it may not be able to meet the cash demands of the customers. Therefore it attempts to balance these two objectives by organising their assets in the above manner.
Functions of the Central Bank
[1] Issues legal tenderPrints the currency of the country. It is presently in the process of minting the new Euro coins which will be in circulation in 2002.
[2] Bankers bank
All licensed banks must have an account with the Central bank. It accepts deposits from commercial banks and it acts as a lender of last resort.
[3] Governments bank All gov. revenue (taxes) are lodged in the Central bank and it is also the drawee of govt. cheques.
[4] Currency value
It protects the value of the Irish pound on foreign markets.
[5] Manages the external reserves
This is the amount of foreign currency that is held in reserve. This should be in strong currencies to protect the value of the punt.
[6] Foreign representative It represents Ireland at international monetary meetings, e.g World Bank and the IMF and also at European monetary meetings.
How the Central Bank implements monetary policy
Monetary policy is defined as any action taken by the Central Bank which affects the rate of interest, credit availability or the money supply.Expansionary monetary policy will increase the money supply to speed up an economy.
Contractionary monetary policy will decrease the money supply to slow down the economy.
[1] Open market operations
This involves the buying and selling of government bonds.
To increase the money supply, govt bonds are bought by the Central bank, therefore putting more money into circulation.
To decrease the money supply, govt bonds are sold by the Central bank, therefore taking money out of circulation.
[2] Changing the Primary and Secondary Liquidity ratios.
If the ratios are increased, the banks must hold a greater percentage of their deposits in cash and govt bonds. This reduces the amount of credit that a bank can give. It reduces the money supply. The opposite is the case if the ratios were decreased.
[3] Special Deposits
The Central bank can make banks lodge a special deposit with it. Again this will reduce the credit that a bank can give.
[4] Lending to commercial banks
[i] Short-term Facility
The Central bank will lend to commercial banks on a short term basis if they are having liquidity problems. They will be charged for this service.
[ii] Secured Advances
This is longer term borrowing by commercial banks and is used when they have used up their STF quota.
[iii] Sale and Repurchase Agreements The banks can sell govt stock to the Central bank for cash to solve a liquidity problem and buy them back in the future.
[iv] Advice and Directives
The Central bank will offer advice regarding the amount of loans they give out or their interest rates.
Definitions of Money
M1: This is all currency in circulation and all current balances in associated banks.M3: This is M1 plus deposit account balances in all licensed banks minus inter-bank balances.
M3E: This is M3 plus deposits in building societies, Post offices and state sponsored financial institutions.
