Money, Banking, Inflation and Monetary Policy
This section covers money, banking, inflation and monetary policy. The exam tests functions of money, credit creation, inflation measurement and the Eurosystem's role in Ireland.
Core rules
- Money functions as a medium of exchange, store of value, unit of account and standard for deferred payment. It needs acceptability, divisibility, durability, portability and scarcity.
- Commercial banks create credit when they lend: loans become deposits, subject to reserve and capital constraints.
- The central bank, for Ireland the Central Bank of Ireland within the Eurosystem and the ECB, maintains price stability, supervises banks, manages payment systems and acts as lender of last resort. It does not set Irish fiscal policy.
- Inflation is a sustained rise in the general price level, measured by the CPI or HICP using a weighted basket. Demand-pull and cost-push are main causes.
- Monetary policy tools include policy interest rates, asset purchases, reserve requirements and forward guidance. Higher rates raise borrowing costs and tend to reduce demand and inflation.
Worked example
A CPI basket costs €120 last year and €126 this year. Inflation = (126 minus 120) divided by 120 times 100 = 5%. If a nominal wage rises 4%, the real wage change is approximately 4% minus 5% = -1%; exactly (1.04 divided by 1.05) minus 1 = -0.95%.
Traps
Do not call a one-off price rise inflation. Do not assume the ECB sets interest rates for Ireland alone. Do not confuse the central bank with the government. Do not ignore quality changes and substitution bias in CPI interpretation.