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Short Answer Questions: Chapter 12
Q1. Explain the concept of Fiat money.
Q2. Explain the difference between a retail and a wholesale bank.
Q3. What are the main tasks of a central bank?
Q4. What has been the main consequence of abandoning the fixed rate regime in 1971 for
the general public and the financial sector?
Q5. What is the monetary base?
Essay questions
E1. Explain what are the main determinants of money demand.
E2. Why is an independent central bank likely to be more successful than one which is not
independent?
ANSWERS:
Short Answer Questions:
Q1. Explain the concept of Fiat money.
A: Fiat money is notes and coins guaranteed by the government, rather than by gold
deposits.
Q2. Explain the difference between a retail and a wholesale bank.
A. A retail bank takes deposits from retail customers, borrows from other banks and
the money markets and raises funds from shareholders. Taken together all these
funds are then loaned out to retail borrowers or invested in financial instruments or
deposited at the central bank. Wholesale banks take very large cash deposits and
broker very large loans both for banks and other commercial companies. Wholesale
banks are sometimes also referred to as investment banks. Such banks tend to
locate in financial hubs such as London and New York where they can raise money
on the wholesale financial markets and bring large lenders together to lend in
syndicate to large commercial borrowers.
Q3. What are the main tasks of a central bank?
A. The central bank issues money into the economy through the banking system
and the money markets more generally. The central bank acts as banker to the retail
and wholesale banks. If a retail bank has spare cash, then it can safely deposit this
money at the central bank. Likewise, in extreme circumstances, if a commercial
bank cannot gain funds from any other lender, then the central bank may act as the
lender of last resort and provide a loan to the commercial bank.
Q4. What has been the main consequence of abandoning the fixed rate regime in 1971 for
the general public and the financial sector?
A. From 1971 the fixed exchange rate systems were abandoned by leading
economies. This also meant that currency controls could be abandoned. This
allowed tourists and more importantly banks to move currency around the world,
lending and investing money where it was possible to make the highest rate of
return. The globalisation of financial services had begun.
Q5. What is the monetary base?
A. We formally refer to cash as the monetary base, or the stock of highpowered
money, which is the quantity of notes and coins held by private individuals, or held
by the banking system.
Essay questions
E1. Explain what are the main determinants of money demand.
Answer guidelines. First, you should highlight that when we refer to money demand
we refer to demand for real money balances. You can then list and explain in turn
the three main reasons to hold money: transaction motive, precautionary motive,
and the asset motive. You should highlight for each motive what are the main
determinants of demand.
E2. Why is an independent central bank likely to be more successful than one which is not
independent?
Answer guidelines. First, you should explain what the main difference is between an
independent central bank and one that depends directly from the government. Then
you can proceed with the explanation of the advantages of independence,
highlighting certainty of economic environment and credibility issues.