12 - Finacial Markets and Monetary Policy Flashcards
1
Q
What is a financial Market?
A
Where buyers and sellers can trade financial assets.
2
Q
Draw a diagram to show what a financial markets are broken down into. (3 categories)
A
Money market
Capital market
Foreign exchange market
3
Q
What are money markets assets in?
A
Assets is highly liquid assets such as treasury bills and commercial bills.
Commercial Bills = banks short-term debt
Treasury Bills = government short-term debt
4
Q
What do money markets enable and give an example?
A
Money market enables commercial banks to perform the most important banking function of financial markets, intermediary linking savers to borrowers.
Exp - LIBRO which is the London Interbank Offered Rate which is the rater of interest charged when banks lend to each other.
5
Q
What are assets?
A
Things which people or organisation own.
6
Q
What are liabilities?
A
Things which people or organisation Owe
7
Q
What are commercial banks?
A
A commercial bank, high street banks, manages deposits, cheques and savings accounts for individuals and firms. They can make loans using the money saved with them. Everyday banking needs to consumers and small businesses.
8
Q
What are commercial banks functions?
A
1) Accept Deposits
2) Provide Loans
3) Overdraft
4) Investment of Funds
5) Agency Functions
9
Q
What is an investment bank?
A
Investment banks provide financial services for investors and large enterprises. It is financial advisory work, such as advising private companies on how to become a public company by floating on the stock market, or advising public companies on how to buy up another company. And also deal directly in Financial markets for their own account.
10
Q
What are investment bank function?
A
1) Raise finance for another financial institution by selling bonds or shares to investors and to limit the risk. They do this by underwriting share issues (people buying the shares).
2) Mergers (doing paperwork, media, structure)
3) Own trading globally
11
Q
What is systematic risk?
A
Risk of a breakdown of the entire financial system, cause by inter-linkages within the financial systems, rather than simply the failure of an individual bank.
12
Q
Which out of commercial banks and investment banks suffers from systematic risk?
A
Investment Banks
13
Q
What is a bond?
A
A bond is a specific type of security that is sold by firms or governments. It is a way for the firm or government to borrow money at a certain interest rate. In return for buying the bond an investor gets a certain interest rate for the duration of the bond.
14
Q
Why would governement sell bonds and why do people buy them?
A
Government bonds are used to finance the National Debt and the government’s public sector net borrowing requirement. They are issued by the Treasury and sold on the bond market. Bonds are typically bought by pension funds, investment trusts and private individuals. Government bonds are seen as one of the safest types of investment. As governments rarely go bankrupt.
15
Q
Why are Corporate bonds issued?
(Why bonds > shares)
A
Corporate bonds are issued to raise funding for large projects, such as to expand the firm, develop a product, move to a new premise, or takeover another firm. Bonds could be traded in a similar way to shares, and they are partially protected against variable interest rates or economic changes. However, the firm will have to pay the investors who buy the bonds interest.
16
Q
What is equation for the yield with bonds?
A
Yield = annual coupon payment / current market price X 100
17
Q
Explain this.
A
18
Q
If the price of the bond increases what happens and why?
A
The yield decreases, this is because THE RETURN OF MONEY ON INVESTMENT IS FIXED AND MUST BE THE SAME.
(Bond increases in value the yield must decrease in order to pay the same, if a bond decreases the yield must increase to pay the same)
19
Q
What happen if this bond in the bond market increases from £100 to £200
A
20
Q
What happen if this bond in the bond market falls from £100 to £50
A
21
Q
A
22
Q
What is a coupon, in bonds?
A
The guaranteed fixed interest payment, usually monthly, paid by the issuer of the bond to the owner of the bond.
(This does not change whether increase or decrease in bond, and government/corporation must pay this or they will have to go bankrupt).
23
Q
What is the ‘maturity date’, with bonds?
A
The date on which the issuer of the bond must pay to bond owner.
24
Q
A
25
What are the characteristics and functions of money?
1. A medium of exchange
2. A mesure of value
3. A store of value
4. A method of payment
26
How is a medium of exchange a characteristic and function of money?
without money, transactions were conducted through bartering. Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed. The goods and services exchanged were not always of the same value, which also posed a problem. Exchange could only take place if there was a double coincidence of wants, i.e. both parties have to want the good the other party offer.
Using money eliminates this problem.
27
How is a measure of value a characteristic and function of money?
Money provides a means to measure the relative values of different goods and services. For example, a piece of jewellery might be considered more valuable than a table because of the relative price, measured by money. Money also puts a value on labour.
28
How is a store of value a characteristic and function of money?
Money has to hold its value to be used for payment. It can be kept for a long time without expiring. However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.
29
How is a method of deferred payment a characteristic and function of money?
Money can allow for debts to be created. People can therefore pay for things without having money in the present, and can pay for it later. This relies on money storing its value.
30
What is money supply?
The money supply is the stock of currency and liquid assets in an economy. It includes cash and money held in savings accounts.
31
What is liquidity?
Measures the ease with which an asset can be converted into cash without loss of value. Cash is the most liquid of all assets.
32
What is the difference in broad money and narrow money which make up the stock of money?
Narrow money is physical currency (notes and coins), as well as deposits and liquid assets in the central bank. Highly liquid.
Broad money includes the entire money supply. Cash could be in restricted accounts, which makes it hard to calculate the money supply. It includes liquid and less liquid assets.
33
What is a share?
The capital of a company is divided into shares. Each share forms a unit of ownership of a company and is offered for sale so as to raise capital for the company.
Shares sold by public companies are marketable on the stock exchange. Shares sold by private companies are not marketable.
34
What is debt?
Debt is money which has been borrowed from a lender, which is usually a bank. There is little flexibility, and the loan is later repaid with interest.
35
What is equity?
Assets which people own.
Equity is a stock or security which represents interest in owning e.g. a firm, a car or a house. It is when there is no outstanding debt, such as when a loan for a car or a mortgage has been fully paid off. The owner’s equity is then the car or the house, which can be sold for cash.
36
What is definition for money markets
In the money market, liquid assets are traded. It is used to borrow and lend money in the short term.
37
What is a capital market?
The capital market is where shares and bonds are bought and sold. These can then be put to long-term productive use by firms and governments for finance. Medium-long term loan finance.
38
What are foreign exchange markets?
The foreign exchange market is a market where currencies are traded, mainly by international banks. It determines what the relative value of different currencies will be.
39
What are the role of financial markets in the wider economy?
- To facilitate saving
- To lend to businesses and individuals
- To facilitate the exchange of goods and services
- To provide forward markets in currencies and commodities.
- To provide a market for equities
40
How is to facilitate saving a role of the financial market?
Financial markets provide somewhere for consumers and firms to store their funds. Savings are rewarded with interest payments from the bank.
41
How is to lend to businesses and individuals a role of the financial market?
The transfer of funds between agents is aided by financial markets. The funds can be used for investment or consumption.
42
How is ‘to facilitate the exchange of goods and services’ to a role of the financial market?
The transfer of real economic resources is facilitated in a financial market. Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds.
43
How is ‘to provide a market for equities’ a role of the financial market?
Equity markets involve the trade of shares. It is also called a stock market. Equity markets provide access to capital for firms, and allow investors to own part of a market. Returns on the investment, usually in the form of dividends, are based on future performance. A dividend is a share of the firm’s profits.
44
How is ‘To provide forward markets in currencies and commodities’ a role of the financial market?
The currency market is another kind of financial market. They are used to trade one currency for another currency. Currencies can have speculative attacks taken on them, which can affect the value of the exchange rate.
In commodity markets, investors trade primary products, such as wheat, gold and oil. Future contracts are a method for investing in commodities. This involves buying or selling an asset with an agreed price in the present, but a delivery and payment in the future.
A forward market is an informal financial market where these contracts for future delivery are made.
45
Why is there an inverse relationship between market interest rates and bond prices?
There is an inverse relationship between market interest rates and bond prices. When a bond is bought, money is lent to the issuer. The issuer agrees to pay the value of the bond back when it matures, in addition to periodic interest payments. The rate of interest is fixed when the bond is issued.
New bonds have rates close to the market interest rate. If the market interest rate falls, for example, the bond would be worth more, since it carries a higher interest rate than current market conditions. Similarly, the bond is worth less is the rate increases. This is because the bond has a lower interest rate than the current market.
46
How is ‘Accept Deposits’ a function of a commercial bank?
47
How is accepting deposits a function of a commercial bank?
Commercial banks accept deposits from the public, usually in the form of savings. Those on low incomes might save a part of their income for security, whilst firms see saving as convenient. Banks can meet the different needs of their depositors by providing different accounts. Depositors could use Demand Deposits, which allow deposits to be made or withdrawn immediately. This is useful for firms who need to make immediate payments. Alternatively, Fixed Deposits store money for a long time. They have higher rates of interest, since banks can use these deposits knowing they will not be withdrawn. Saving Deposits are done by those who withdrawn money often, but not necessarily immediately, and who are generally receiving an income. They have lower rates of interest than Fixed Deposits.
48
How is ‘provide loans’ a function of a commercial bank?
The main source of income for commercial banks is interest, which banks earn through providing loans. Banks create credit by using deposited funds as loans.
Some loans are secured against an asset, such as a house. This is to protect the bank’s funds if the loan is not repaid.
49
How is ‘overdraft’ a function of a commercial bank?
When a current account has no deposits, consumers can still borrow money from the bank in the form of an overdraft. These are at a high interest rate and the amount that can be borrowed is limited.
50
How is ‘investment of funds’ a function of a commercial bank?
Surplus funds could be invested into securities such as Government bonds and treasury bills. These could earn a return for the bank.
51
How is ‘agency functions’ a function of a commercial bank?
Banks represent their consumers. For example, they collect cheques and dividends, they pay and accept bills, such as through a direct debit, they deposit interest and income tax, buy and sell securities and arrange the transfer of money between places for consumers.
52
Examples of Investment Banks and Commercial Banks?
IB: Goldman Sachs, Morgan Stanley, J.P Morgan
CB: HSBC, Barclays
53
What does a balance sheet show?
Balance sheets show the value of a company’s assets, liabilities and owner’s equity during a period of time. It is usually at the end of a quarter or an annum.
54
What make up the structure of a commercial banks balance sheet?
Liabilities and Assets.
Liabilities are made up of share capital, deposits, borrowing and reserve funds.
Assets are cash andinvestment. But Mainly
LOANS to UK households and businesses.
55
What is profitability?
The state or condition of yielding a financial profit or gain.
56
How can the Liquidity of commercial banks cause potential conflict between other objectives like Profitability or Security?
The liquidity of assets is how easy it is to turn the assets into cash. Liabilities are payable on demand, so in order to be profitable banks must have cash and liquid assets. If liquidity is prioritised, profits will be low, so banks need a balance between the two objectives.
Assets in commercial banks are liquid to different extents. Cash is the most liquid asset, whilst deposits are the next most liquid. Loans and long term bonds are the least liquid assets in a commercial bank.
If banks can borrow easily and cheaply, they are likely to keep fewer liquid assets. The more expensive and difficult it is to get a loan, the more liquid assets are likely to be kept.
57
How can the Profitability of commercial banks cause potential conflict between other objectives like Liquidity or Security?
Banks need to earn profits to pay their depositors interest, wages and general
expenses. And to make money and become RICH. Holding a lot of funds in cash means profitability is limited.
However, liquidity and safety are generally prioritised over profitability, which is considered to be a supplementary for the bank’s survival.
The banks makes money through investing its money it has (in for example Government Bonds) but means it will have less money in liquidity and less security therefore.
58
How can the Security of commercial banks cause potential conflict between other objectives like Profitability or Liquidity?
Banks face risks and uncertainties about how much cash they can get, and whether loans will be repaid or not. Banks therefore have to try and maintain the safety of their assets. A bank has to keep high proportions of their liabilities with itself and the central bank. However, following these principles means banks only hold their safest assets, so more credit cannot be created. (Not giving out loans)
This means that banks profits are lower and the bank might lose customers. The bank needs a balance between the risk level and their profits. Too much risk could be harmful.
Loans are assets for Banks, the more security they require to give loans may decrease the potential profit they can make with having more assests.
59
How do commercial banks Create Credit?
(Important)
60
Explain Briefly the relationship between liquidity and profitability and security?
The less liquid the more profitable.
The More liquid the less profitable.
The more liquid something the more security there is as it can easily been turned in the cash to pay to the customer. But holding onto something like cash which is extremely liquid makes no profit for the Banks. But something like loans which is not very liquid as they do not have the money now and can not be immediatley turned into cash. But will make profit in the future through interest.
61
What is an example of a bank struggling with liquidity problems in the UK?
Northern Rock, which was nationalised in 2008.
People wanted to withdraw their money after the financial crisis. But couldn’t as the bank did not hold enough money in liquid assets to do so. People lost pension and money in back accounts until the government stepped in. This is due to their assests were in loans so not actual money and liquidity, which no longer could be repaid by many due to financial crisis losing jobs, they had given loans to people with low-come jobs so not secure loans.
62
What is monetary policy?
Monetary policy is used to control the money flow of the economy. This is done with interest rates and quantitative easing. This is conducted by the Bank of England, which is independent from the government. In order to influence AD.
63
What is the Central Bank?
The national bank provides financial and banking services for its country’s governement and banking system. Implementing the governments monetary policy.
The Bank of England is the UK’s central bank.
64
What does the central bank do?
The central bank manages the currency, money supply and interest rates in an economy. For example, the European Central Bank (ECB), the Bank of England and the People’s Bank of China are central banks.
Central banks issue physical cash (notes and coins) securely and using methods to prevent forgery. This is so people trust the money.
The central bank can regulate bank lending to ensure there is stability in the financial system.
65
How is the implementation of monetary policy a function of the central bank?
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
The bank controls the base rate, which ultimately controls the interest rates across the economy.
66
Very simply what does the central bank do (bank of England)?
The central bank takes action to influence the manipulation of interest rates, the supply of money and credit, and the exchange rate.
67
What is the MPC?
The Monetary Policy Committee. The part of the Bank of England which implements monetary policy. It wants to hit the TARGET OF 2% INFLATION, main Goal
68
What is a Bank Rate?
The main interest rate set by the nation’s central bank. This is the rate of interest charged to commercial banks if they must borrow from the central bank when short of liquidity.
69
How is the Banker to the Government a function of the central bank?
The central bank provides services to the Central Government. It collects payments to the governments and makes payments on behalf of the government. It maintains and operates deposit accounts of the government. The central bank also manages public debt and issues loans. MANAGING GOVERNMENT DEBT, ISSUING GOVERNMENT BONDS
The Bank can also advise the government on finance, including the timing and terms of new loans.
70
How is the Banker to the Banks - Lender at Last Resort a function of the central bank?
The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the Bank of England will lend money to increase the supply.
If an institution is risky or is close to collapsing, the Bank might lend to them. This is when they have no other way to borrow money.
It can protect individuals who deposit funds in a bank and might otherwise lose them. It also aims to prevent a ‘run on the bank’, which is when consumers withdraw their bank deposits in a panic, because they believe the bank will fail.
Usually, banks will avoid borrowing from the lender of last resort, because it is suggests the bank is experiencing a financial disaster.
71
Five Main Roles of Central Banks:
1. Setting Interest Rates (help control inflation and promôte economic growth)
2. Regulating Banks (protect savers)
3. Maintaining financial stability (lender of last resort)
4. Issuing Currency
5. Conducting Reasearch/Giving advice to banks.
72
What do monetary policy and fiscal policy both affect?
Manage the Level of Aggregate Demand
AD = G + C + I + (X-M)
73
What is contractionary monetary policy?
Uses a higher interest rates to decrease aggregate demand and to shift the AD curve to the left.
Interest increase so demand is tacken out of the economy.
74
Draw the diagram to show Contractionary Monetary Policy, higher interest rates lower inflation.
75
Explain this contractionary monetary policy diagram.
76
What is expansionary monetary Policy?
Uses lower interest rates to increase aggregate demand and to shift the AD curve to the right.
77
Draw a diagram for expansionary monetary policy
78
What will happen in the economy if you cut the interest rates?
- Lower interest rates make it cheaper to borrow; this encourages firms to invest and consumers to spend.
- Lower interest rates reduce the cost of mortgage interest repayments. This gives households greater disposable income and encourages spending.
- Lower interest rates reduce the incentive to save.
- Lower interest rates reduce the value of the Pound, making exports cheaper and increase export demand.
79
What does Fiscal Policy focus on changing in the AGGREGATE Demand equation and what does Monetary policy focus on?
Fiscal Policy = government spending (mainly taxation)
Monetary Policy = Investment, Consumption and Imports and Exports
80
What are the effects of higher interest rates in the UK for Consumption?
1. Consumer Spending - higher interest rates makes it more expensive for households to service their debts (mortgage and credit card debts). Borrowers have less money to spend as more of their disposable income is being used on paying off debts.
2. Consumer Saving - high in rest rates encourages people to save as they get more money back if they do so, therefore less consumer consumption and less consumer demand.
3. Asset Prices - like houses and shares, will lose value, leads to a decrease in aggregate demand as households reduce spending due to lower WEALTH.
4. Consumer confidence falls, so consumption falls as their house prices and stock lose value.
81
What are the effects of higher interest rates in the UK for Investment?
Higher interest rates make borrowing more expensive for firms, which can reduce investment in new capital. As it will be less profitable due to the high borrowing cost. Or a company may invest less or postpone investment projects.
This creates a fall in buisnesses confidence so less likely to invest.
82
What are the effects of higher interest rates in the UK for Exports and Imports?
A rise in the interest rate can lead to an appreciation of the Pound. This is due to Hot Money, investors saving their money in UK banks for higher return, and less consumption and investment. All lead to a low supply of pound in the global market and therefore an appreciation of the domestic currency.
This makes Exports more expensive and imports cheaper. Making UK exports less competitive.
This can lead to a decrease in aggregate demand as firms and consumers reduce spending on foreign goods and more imports than exports.
83
What are the effects of lower interest rates in the UK for Exports and Imports?
Fall in the exchange rate will lead to more consumption, investment taking place as there is less saving and more disposable income. This will lead an increase of pounds on the global market and a depreciation of the pound.
Making exports from the UK cheaper and therefore more competitive globally. And imports will become more expensive.
Causing aggregate demand to increase on buying foreign imports. And selling more exports.
84
How can Expansionary Monetary Policy cause inflation but also not cause inflation?
Depends on the point on the SRAS as if it is on the inelastic point then there is no Chang rain price level so no inflation. So depends at what level of maximisation of short run aggregate supply.
85
What are Cons of expansionary monetary policy?
1. Can cause demand-pull inflation (higher AD increased price level)
2. Current account deficient (as people will spend more money of imports, a greater number of imports compared to the exports)
3. Liquidity Traps, cutting interest rates below a certain level fails to stimulate consumer consumption and businesses investment. Usually in recession or lower confidence. Consumers/businesses will keep a certain amount of money saved for safety. So even if you decrease interest rates this will have no effect as this money is going to be saved.
4. Time Lags, Bank of England estimates 2 years to see the impact on the economy for a change in exchange rates. Not Short Run Boost
5. Negative Impact on Savers, removes people’s safety net. If people lose jobs they saving will be weak and not have money. Living standards will drop may become homeless. This lack of safety we do not want to promote.
86
What is the evaluation of expansionary Monetary Policy’s? (Effectiveness)
1) Size of output gap (graph below) AD2 to AD1 very little growth in GDP, lots of inflation. But if it is AD4 to AD3 massive growth, little demand-pull inflation, so big impact.
2. CONSUMER CONFIDENCE, people will borrow and spend, think economy will grow or get a pay rise. If they don’t have this no effect from changing interest rates.
3. Business confidence - invest more money as they believe they will make profit and there will be demand. However if they don’t have this increasing interest rate will have no effect.
4. Banks may not be willing to lend money even with low interest rates due to low confidence and unsure of financial safety. Happened during the financial security.
5. Banks may not follow with the same cut as the Bank of England for banks with their interest rates for consumers.
87
Pros of Contractionary Monetary Policy, reducing interest rates?
1. Reduce demand push inflation
2. Discourage household and firms debt. People may not be able to afford to pay their debt say they lose their job. Need to secure the financial safety of banks so they will get their money. Banking sector is independent (systematic risk) if one fails all will fail. Reduce
risks on recession
3. More sustainable borrowing, only people and firms who need and can afford to borrow will do so. Reduce systematic risk of banks, not being repaid money. Low interest rates anyone will and can borrow, afford it. Even people with bad credit. This creates unstable Economic Growth creating credit bubble, housing bubble. These bubbles can’t last and when they burst create recession. This stops this from happening.
4. Encourages saving, pensioners and unemployed have higher living standards as more return on their money in banks. Safety net to support themselves if things go wrong.
5. More affordable housing, increase interest, mortgage rates these decreases the demand for housing. Decreasing the price of house prices or decreasing the rate of increase in house prices. First-time homeowners and low income families can get on the housing ladder. Improve wealth inequality and standards of living.
6. Flexibility to cut interest rates if needed to in the future, avoid the liquidity trap.
88
Cons of Contractionary Monetary Policy, reducing interest rates?
1. LOWER GROWTH - lowers AD with lower C, I and X. Can lead to recession. Can lower GDP with no lowering in price level (see below).
2. Higher unemployment less people needed to make products as consumption, investment and exports have been reduced.
3. Impact on Indebted. People with mortgages may go homeless as they can’t pay off their debts. Buisnesses may have to let people go and bankruptcy. Bad for standard of living.
4. Reduced investment, bad of short run growth AD. But also the LRAS stops productivity and competition increasing.
5. Worsening ÇA deficit, Hot Money coming in. People chasing the best interest for their saving.
89
What is the Problem with a decrease of Exchange Rate and its effect on imports and exports?
A reduction in the exchange rate causes exports to become cheaper, which increases exports. This assumes that demand for exports is price elastic. It also causes imports to become relatively expensive. This means the UK current account deficit would improve.
However, this is inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation.
Also, people may start buying from home more that abroad, as it is cheaper. Therefore more demand, could add to demand-pull inflation.
90
What is Forward Guidance?
This is used by central banks to detail what the future monetary policy will be. This is with the intention of reducing uncertainty in markets. For example, the MPC might state they will keep the interest rate at a certain level until a specified date.
91
What does Forward Guidance set out to achieve?
Business, Consumer and Bank confidence so that they feel calmer about future economic prospects. As they have good information to make economy in decisions and also have confidence that they will be told if it changes.
This means they will respond to changes in interest rates the way the Bank of England wants them to do so.
92
What are some factors the MPC will consider when setting the Bank Rate?
1. Unemployment rate: if unemployment is high, consumer spending is likely to fall. This suggests the MPC will drop interest rates to encourage more spending.
2. Savings rate: if there is a lot of saving, consumers are not spending as much. Interest rates might fall.
3. Consumer spending: if there is a high level of spending in the economy, there could be inflationary pressures on the price level. This would cause the MPC to increase interest rates.
4. High commodity prices: Since the UK is a net importer of oil, a high price could lead to cost-push inflation. This could push the MPC to increase interest rates to overcome this inflationary pressure.
Exchange rate: A weak pound would cause the average price level to increase. This makes UK exports relatively cheap, so UK exports increase. Since imports become relatively more expensive, there would be an increase in net exports. The MPC might consider increasing the interest rate.
93
Explain the relationship between increase in the interest rates, exchange rates and money supply.
Increased exchange rates, more saving, less consumption, hot money so more saving. This reduces the supply of pound on the global exchange market.
The demand for pound will increase, due to hot money and people wanting to save pounds in UK banks, as there is a high rate of return.
A higher demand for pounds and lower supply of pound leads to an appreciation of the Pound in the exchange market.
94
Explain the relationship between decrease in the interest rates, exchange rates and money supply.
95
96
What is Quantitive Easing?
QE is when the Bank of England buys assets, usually government bonds, with money that the Bank has created Electronically.
97
When did Quantitive Easing begin in the UK?
2009, but the concept has been around since the 1930’s
98
When is QE used?
QE is usually used where inflation is low (zero or close to zero) there is a limit to what monetary policy can do as interest rates can not be cut further.
Or in a Liquidity Trap.
99
How does Quantitive Easing?
(Important)
1. The central bank (BoE) creates new money electronically.
2. This money is used to buy financial assets, usually governement bonds bought from pension fund, high-street commercial banks.
3. Increased demand for government bonds causes an increase in the market price of bonds and therefore causes their price to rise
A higher bond price causes a fall in the yield on a bond (there is an inverse relationship between bond prices and yields)
4. Those who have sold their bonds may use the increased money may go out and spend it. They might buy assets with relatively higher yields such as shares of listed businesses and corporate bonds.
5. Commercial banks receive cash from asset purchases and this increases their liquidity. This in turn may encourage them to lend out to customers which will - hopefully - help to stimulate an increased in loan-financed capital investment
100
How does QE cause lower interest rates?
Higher asset prices means lower yields (inverse relationship), which brings down the cost of borrowing, for capital or houses (mortgage).
101
What are the main channels through which QE is supposed to work to operate?
1. Wealth effect - lower yields lead to higher share and bond prices
2. Borrowing cost effect - QE lowers the interest rate on long term debt such as government bonds and mortgages
3. Lending effect - QE increases the liquidity of banks and increased lending from banks to companies and households lifts incomes and spending in the economy
4. Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation)
102
What is QE doing very simply?
The financial institutions (banks, pension funds) which sell bonds to the B of E will lend the new money to buisness and individuals.
Increasing the money supply in the economy, so there is more consumption, investment and more exports.
103
What are the Pros of QE?
1. Important for the central bank to have additional policy instruments other than changing interest rates especially if the economy is experiencing a liquidity trap
2. Use of QE likely to have staved off the threat of a deflationary depression post 2008. Without QE, the fall in real GDP would have been deeper and the rise in unemployment greater.
3. Lower long term interest rates have kept business confidence higher and given the banking system extra deposits to use for lending
104
The Cons of QE?
1. QE has contributed to a surge in share prices and property values, the latter has worsened housing affordability for millions of people and also contributed to increase in rents which has worsened the geographical immobility of labour. The over 45s hold 80 percent of all of the wealth in the UK.
2. QE has contributed to a decade of ultra-low interest rates which has been bad news for millions of people who rely on interest from their savings.
3. Low interest rates and bond yields are a worry for pension fund investors because they inflate the present value of their liabilities, worsening their deficits. If companies are foreced to pay more into their employee pension schemes, they have less money to spend on investment which could harm productivity growth in the long run.
105
Why is it important banks are regulated?
Some economists argue that the banks have a huge influence in the economy; if they failed it would have huge consequences. Therefore, it is important to regulate the banking industry.
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What are the two regulator, that regulate the UK banking industry?
Prudential Regulation Authority (PRA)
Financial Conduct Authority (FCA)
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What does the Finacial Conduct Society(FCA) do?
The FCA regulates financial firms to ensure they are being honest to consumers and they seek to protect consumer interests. The FCA also aims to promote competition which is in the interests of consumers.
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What does the Prudential Regulation Authority (PRA) do?
The PRA promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policyholders are protected.
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What does the Financial Policy Committee (FPC)?
The Financial Policy Committee (FPC) regulates risk in banking and ensures the financial system is stable. It clamps down on unregulated parts and loose credit. The committee monitors overall risks to the financial system as well as regulating individual groups.
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What is the Difference between the FPC (Financial Policy Committee) and the PRA / FCA (prudential regulation authority / finacial conduct Authority)
FPC = remove risks that affect the stability of the financial systems as a WHOLE
PRA / FCA = remove the risks of INDIVIDUAL FIRMS that affect the stability of the financial system
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Explain how a bank may fail using the finacial crisis 2008-2009 as an example?
Before the crash, asset prices were high and rising, and there was a boom in economic demand. There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages. This means the borrowers had poor credit histories, and after house prices crashed in the US in
2006, several homeowners defaulted on their mortgages in 2007. Banks had lost huge funds, and required assistance from the government in the form of bailouts.
There are risks involved with lending long term and borrowing short term. They might lose money on investments, and if there are insufficient funds in a vault, banks might not be able to provide depositors with money when it is demanded.
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What does Liquidity ratio mean?
The ratio of a bank’s cash and other liquid assets to its deposits.
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What does capital ratio mean?
A capital ratio is a comparison between the equity capital and risk-weighted assets of a bank.
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How does Liquidity ratios affect the stability of a financial institution
A liquidity ratio is used to determine how able a company is to pay off short-term obligations.
The higher the ratio, the greater the safety margin of the bank. When creditors want payment, they look at liquidity ratios to decide whether the bank is a concern.
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How does capital ratio affect the stability of a financial institution?
A capital ratio is a comparison between the equity capital and risk-weighted assets of a bank. A bank’s financial strength is determined using this. Assets have different weightings, where physical cash has zero risk and credit carries more risk.
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What is a ‘Moral Hazard’?
The tendency of individuals or firms, once protected against some contingency, to behave so as to make the contingency more likely.
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Give an example a Moral Hazard that consumer exploit.
For example, if a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else.
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How does Moral Hazard relate to Banks?
During 2008 finacial crisis banks were taking to many risk (giving loans to people with low profit) in order to peruse high profits, knowing that the Bank of England has a role as lender of last resort, if the bank fails.
Banks might take more risks if they know the Bank of England or the government can help them if things go wrong. The financial crisis has been regarded as a moral hazard, due to the degree of risk taking.
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What does systematic risk refer to in a financial context?
Refers to the risk of a breakdown of the entire financial system, caused by inter-linkages within the finacial system, rather than simply the failure of an individual bank within the system.
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What does a credit crunch mean, and when did it happen?
A credit crunch is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks.
In 2007
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What caused financial regulatory authorities to be set up?
The finacial crisis and credit crunch, to prevent systematic risk and moral hazard.
