EC2B3 Notes
1
Copyright © 2025 Rico Mak.
,Contents
MONEY AND CENTRAL BANKS............................................................................................................. 3
BANKS AND FINANCIAL INTERMEDIATION................................................................................... 7
BUSINESS CYCLES.................................................................................................................................... 12
NOMINAL RIGIDITY................................................................................................................................. 16
INFLATION AND THE PHILLIPS CURVE.......................................................................................... 20
CONVENTIONAL AND UNCONVENTIONAL MONETARY POLICY.........................................23
MONEY AND EXCHANGE RATES........................................................................................................ 28
INTERNATIONAL TRADE IN GOODS AND ASSETS.....................................................................32
INTERNATIONAL MACROECONOMICS............................................................................................ 37
FINANCIAL MARKETS AND FISCAL POLICIES.............................................................................. 41
2
Copyright © 2025 Rico Mak.
,-----------------------------------------------------------------------------------------------------------------
MONEY AND CENTRAL BANKS
-----------------------------------------------------------------------------------------------------------------
Money: anything that serves as a means of payment, with the following features:
- Medium of Exchange: overcoming the “absence of double coincidence of wants”,
provides a generally accepted object for transactions purposes.
- Unit of Account: provides a standard measure of pricing for goods and services,
to facilitate the comparison of relative values.
- Store of Value: maintains value over time (like an asset).
Physical Cash: notes and coins issued by the government and/or central bank.
- ‘Fiat’ Money: its value is not backed by or tied to a commodity.
- its value is determined by the market, which depends on the inflation rate.
o no interest is paid for holding cash.
Bank Deposits: money held by households or firms, at commercial banks.
- Credit Money: they are claims to cash, exercised by withdrawal.
- interest may be paid on deposits, depending on the account type.
Reserves: deposits held by banks, at the central bank.
- Central Bank Ledger: a purely electronic form of fiat money.
- they are passed among banks, not held directly by households or firms.
o used to settle payments occurring between banks.
- reserves are only redeemable for cash for the equivalent amount.
Deposit Creation: the process of increasing deposit by making a loan and crediting a
bank account with the funds.
- it can create asset for commercial banks, thus increasing money supply.
- more deposits imply a potential shortfall of reserves when depositors make
payments or withdraw money.
- regulatory capital requirements might limit the fraction of deposits by reserves.
-----------------------------------------------------------------------------------------------------------------
Central Bank
Central Bank (CB): a government branch that issues fiat money, with following roles:
- Banker of Financial Institutions: clearing house for interbank payments; allowing
bank reserves to be held.
- Financial Regulator: imposing reserve requirements, such as a minimum ratio of
reserves to customer deposits or minimum liquidity coverage ratios.
- Monetary Policies: adjusting interest rates and conducting quantitative easing.
Balance Sheet of Central Bank:
ASSETS LIABILITIES
Government Bonds Cash
Mortgage-Backed Securities Bank Reserves
Foreign-Exchange Reserves Treasury Accounts
Discount Loans Capital (Equity or Net Worth)
3
Copyright © 2025 Rico Mak.
, Open Market Operations: the purchase and sale of monetary assets made by the
Central Bank, to manage the liquidity and money supply.
- CB’s Balance Sheet shrinks when assets mature and receives repayment.
- Quantitative Easing (QE): purchasing mortgage-backed securities in the US to
inject money into the banking system.
- Repurchase Agreement (Repo): banks earning interest on reserves, by buying an
asset from CB and selling it back at an agreed, inflated price.
Standing Facilities: a monetary policy instrument that enables the Central Bank to
provide or absorb liquidity in the financial system, initiated by financial institutions.
- Discount Window: banks can borrow reserves at an administered interest rate
(not the market rate), by securing against a collateral (like government bonds).
o Pro: manages short-term liquidity needs; CB is ‘lender of last resort’.
o Con: carries ‘stigma’ (reputational cost), as these loans are usually made
for emergency times or when bank runs occur.
- Interest on Bank Reserves: influences bank behaviour and monetary conditions.
Central-Bank Digital Currency (CBDC): a centralised, electronic, monopolistic form of
monetary system, managed by the Central Bank.
- anyone can access Central Bank money electronically and hold an account at CB.
- it is not subject to bank runs as it is not redeemable yet challenges the deposit
base of commercial banks.
Monetary Policy: a set of instruments available to the Central Bank, to influence
inflation and macroeconomic activities.
- Ultimate Aim: affecting Interest Rates to influence aggregate demand.
o it is determined by the market, so CB can intervene to change them.
- Tools: Open-Market Operations, Standing Facilities, Reserve Requirements.
Central-Bank Money Market: an exchange market where financial institutions raise or
lower holding of fiat money by borrowing and lending.
- Examples:
o Interbank Market: unsecured short-term loans of reserves among banks.
o Repo Market: loans among financial institutions secured by collateral.
- Assumption: there is a single interest rate for all banks and money markets.
Reserve Demand ( R D): borrowing and lending demand for banks to ensure liquidity; if
borrowing cost (interest rate) increases, the demand for reserves contracts.
- with higher interest rates, banks have less incentive to borrow and greater
incentive to lend, and vice versa.
- the R D curve is bounded between the CB’s standing facility interest rates:
o if i>i b, loans from CB are cheaper, notwithstanding stigma.
o if i<i r, no banks will lend reserves as they can exploit arbitrage.
i r ≤i ≤i b
Market Interest Rate (i)
Interest paid on Bank Reserves (i r )
4
Copyright © 2025 Rico Mak.
1
Copyright © 2025 Rico Mak.
,Contents
MONEY AND CENTRAL BANKS............................................................................................................. 3
BANKS AND FINANCIAL INTERMEDIATION................................................................................... 7
BUSINESS CYCLES.................................................................................................................................... 12
NOMINAL RIGIDITY................................................................................................................................. 16
INFLATION AND THE PHILLIPS CURVE.......................................................................................... 20
CONVENTIONAL AND UNCONVENTIONAL MONETARY POLICY.........................................23
MONEY AND EXCHANGE RATES........................................................................................................ 28
INTERNATIONAL TRADE IN GOODS AND ASSETS.....................................................................32
INTERNATIONAL MACROECONOMICS............................................................................................ 37
FINANCIAL MARKETS AND FISCAL POLICIES.............................................................................. 41
2
Copyright © 2025 Rico Mak.
,-----------------------------------------------------------------------------------------------------------------
MONEY AND CENTRAL BANKS
-----------------------------------------------------------------------------------------------------------------
Money: anything that serves as a means of payment, with the following features:
- Medium of Exchange: overcoming the “absence of double coincidence of wants”,
provides a generally accepted object for transactions purposes.
- Unit of Account: provides a standard measure of pricing for goods and services,
to facilitate the comparison of relative values.
- Store of Value: maintains value over time (like an asset).
Physical Cash: notes and coins issued by the government and/or central bank.
- ‘Fiat’ Money: its value is not backed by or tied to a commodity.
- its value is determined by the market, which depends on the inflation rate.
o no interest is paid for holding cash.
Bank Deposits: money held by households or firms, at commercial banks.
- Credit Money: they are claims to cash, exercised by withdrawal.
- interest may be paid on deposits, depending on the account type.
Reserves: deposits held by banks, at the central bank.
- Central Bank Ledger: a purely electronic form of fiat money.
- they are passed among banks, not held directly by households or firms.
o used to settle payments occurring between banks.
- reserves are only redeemable for cash for the equivalent amount.
Deposit Creation: the process of increasing deposit by making a loan and crediting a
bank account with the funds.
- it can create asset for commercial banks, thus increasing money supply.
- more deposits imply a potential shortfall of reserves when depositors make
payments or withdraw money.
- regulatory capital requirements might limit the fraction of deposits by reserves.
-----------------------------------------------------------------------------------------------------------------
Central Bank
Central Bank (CB): a government branch that issues fiat money, with following roles:
- Banker of Financial Institutions: clearing house for interbank payments; allowing
bank reserves to be held.
- Financial Regulator: imposing reserve requirements, such as a minimum ratio of
reserves to customer deposits or minimum liquidity coverage ratios.
- Monetary Policies: adjusting interest rates and conducting quantitative easing.
Balance Sheet of Central Bank:
ASSETS LIABILITIES
Government Bonds Cash
Mortgage-Backed Securities Bank Reserves
Foreign-Exchange Reserves Treasury Accounts
Discount Loans Capital (Equity or Net Worth)
3
Copyright © 2025 Rico Mak.
, Open Market Operations: the purchase and sale of monetary assets made by the
Central Bank, to manage the liquidity and money supply.
- CB’s Balance Sheet shrinks when assets mature and receives repayment.
- Quantitative Easing (QE): purchasing mortgage-backed securities in the US to
inject money into the banking system.
- Repurchase Agreement (Repo): banks earning interest on reserves, by buying an
asset from CB and selling it back at an agreed, inflated price.
Standing Facilities: a monetary policy instrument that enables the Central Bank to
provide or absorb liquidity in the financial system, initiated by financial institutions.
- Discount Window: banks can borrow reserves at an administered interest rate
(not the market rate), by securing against a collateral (like government bonds).
o Pro: manages short-term liquidity needs; CB is ‘lender of last resort’.
o Con: carries ‘stigma’ (reputational cost), as these loans are usually made
for emergency times or when bank runs occur.
- Interest on Bank Reserves: influences bank behaviour and monetary conditions.
Central-Bank Digital Currency (CBDC): a centralised, electronic, monopolistic form of
monetary system, managed by the Central Bank.
- anyone can access Central Bank money electronically and hold an account at CB.
- it is not subject to bank runs as it is not redeemable yet challenges the deposit
base of commercial banks.
Monetary Policy: a set of instruments available to the Central Bank, to influence
inflation and macroeconomic activities.
- Ultimate Aim: affecting Interest Rates to influence aggregate demand.
o it is determined by the market, so CB can intervene to change them.
- Tools: Open-Market Operations, Standing Facilities, Reserve Requirements.
Central-Bank Money Market: an exchange market where financial institutions raise or
lower holding of fiat money by borrowing and lending.
- Examples:
o Interbank Market: unsecured short-term loans of reserves among banks.
o Repo Market: loans among financial institutions secured by collateral.
- Assumption: there is a single interest rate for all banks and money markets.
Reserve Demand ( R D): borrowing and lending demand for banks to ensure liquidity; if
borrowing cost (interest rate) increases, the demand for reserves contracts.
- with higher interest rates, banks have less incentive to borrow and greater
incentive to lend, and vice versa.
- the R D curve is bounded between the CB’s standing facility interest rates:
o if i>i b, loans from CB are cheaper, notwithstanding stigma.
o if i<i r, no banks will lend reserves as they can exploit arbitrage.
i r ≤i ≤i b
Market Interest Rate (i)
Interest paid on Bank Reserves (i r )
4
Copyright © 2025 Rico Mak.
