Money, Banking and Monetary Policy
This domain tests both mechanics and institutions. You need the functions and characteristics of money, the credit-creation process, and the instruments and transmission of monetary policy in the euro area. The crucial Cyprus-specific point is that the Republic does not set its own interest rate: the Central Bank of Cyprus is part of the Eurosystem and implements ECB decisions. Questions often ask you to explain why that constrains national policy.
Money
- Functions: medium of exchange, unit of account, store of value, standard of deferred payment.
- Characteristics: general acceptability, divisibility, portability, durability, homogeneity, relative scarcity.
- Measures: narrow money (currency in circulation plus overnight deposits) through broader aggregates that add time deposits and money-market instruments.
Credit creation
- Banks keep reserves and lend the remainder; the theoretical deposit multiplier is 1 ÷ reserve ratio.
- Leakages into cash holdings, excess reserves held voluntarily, and insufficient creditworthy borrowers all make the actual expansion smaller.
Central banking and the euro area
- The Central Bank of Cyprus became part of the Eurosystem on 1 January 2008 when the euro replaced the pound at the irrevocable rate of €1 = £0.585274.
- Functions: implementing monetary policy, holding reserves, issuing euro banknotes with ECB authorisation, overseeing payment systems, contributing to financial stability, acting as lender of last resort and banker to government.
- ECB instruments: main refinancing operations, the deposit and marginal lending facilities that form the corridor, minimum reserve requirements, asset purchase programmes and forward guidance.
- Transmission: policy rate → money-market and bank rates → credit, investment, consumption, asset prices and the exchange rate.
Worked example
A bank receives a €5,000 deposit and the reserve requirement is 10 per cent. It may lend €4,500, which returns to the banking system as a new deposit, and the process continues. The maximum total deposit expansion is 5,000 ÷ 0.10 = €50,000, so new credit created is €45,000. If the Fisher relationship is used to check the real cost of borrowing when the nominal rate is 4.25 per cent and inflation is 1.8 per cent, the real rate is approximately 2.45 per cent.
Traps that cost marks
- Claiming the ECB sets the rate on mortgages and business loans; it sets policy rates, which feed through.
- Assuming banks lend out every euro deposited, ignoring reserves and cash leakages.
- Describing the Central Bank of Cyprus as setting national interest rates.
- Confusing the money multiplier with the Keynesian spending multiplier.