12 - Monetary Policy Flashcards
What is a policy instrument?
A tool or set of tools used to try to achieve a policy objective.
What is a Central Bank?
A national bank providing financial and banking services for the government and banking system.
What are the objectives of monetary policy?
Sustainable economic growth, Keeping unemployment low, protecting the value of the currency.
What is the UK’s central bank?
The Bank of England.
What is the aim of the Bank of England?
Achieve monetary and financial stability by regulating the financial system, and lending government bonds.
What does the Bank of England do with monetary policy?
Sets interest rates, depending on the state of the economy.
What does monetary policy aim to influence?
Consumption, Investment, Net trade.
How does an increase in Interest rates affect Aggregate Demand?
Reduces household income, reduces business investment, affects imports and exports.
How does an increase interest rates reduce consumption?
Higher interest rates encourage people to save money, and means that less income is available for consumption, as more is spent on loan/debt repayments.
How does an increase in interest rates reduce business investment?
Businesses may postpone investment projects, as they believe that higher borrowing will make investment unprofitable.
How does an increase in interest rates affect imports and exports?
Higher interest rates increase demand for the pound, attracting capital flow into the currency, causing the exchange rate to rise, making exports less price competitive.
What has the main monetary policy tool been in the last 50 years?
Controlling inflation.
What is the target for inflation?
2%.
What happened to interest rates between 2009-2022?
Interest rates remained historically low, between 0.1-0.5%.
What did lower interest rates mean in the 2010’s?
People borrowed more money, and saved less, consumption was encouraged.
What do commercial banks charge money on?
Loans they give to each other, as well as customers.
What is the LIBOR rate?
The rate a bank pays when borrowing money from another bank.
Where does the LIBOR rate usually sit?
Just above the bank rate, during the financial crisis, the gap widened.
Why was the interest rate cut in 2009?
In part, because of LIBOR rates, which some say undermined the effectiveness of the 0.5% rate, as it didn’t fully stimulate Aggregate Demand.
What is Contractionary monetary policy?
Involved interest rates being increased, in order to take demand out of the economy.
What does this do to income, and AD?
The AD curve shifts to the left, and income falls from Y1 to Y2.
What is expansionary monetary policy?
Monetary policy which discourages saving, and encourages consumption.
What does expansionary monetary policy cause?
Exports increase, exchange rate falls, exports become more competitive, imports become less competitive.
What happened to the Bank of England in 1997?
It was made independent.
What type of relationship do bond yields have with interest rates?
An inverse relationship - as interest rates rise, bond yields fall.
What are gilts?
Fixed interest securities sold by the government, when they borrow in the long term.
What is a commercial bank?
A financial institution aiming to make profit, selling services to its’ customers.
What is an investment bank?
A bank which doesn’t accept deposits from members of the public, but does advisory work to companies.
What is Systemic Risk?
The risk of a breakdown of the entire financial system, caused by inter linkages of the financial system.
What does a one off risk affect?
A single bank.
What does systemic risk affect?
The entire banking system.
What have new regulations on banks been since the financial crisis?
Firms must separate investment banking from retail banking activities.
What is the difference between cash and deposits?
Cash is tangible, but deposits are intangible.
What are the assumptions of a monopoly system?
Only one bank in the economy, only has cash assets, it must always possess cash equal to 10% of customer deposits.
What happens in a monopoly system, if a member of the public deposits £1000 into the bank?
Assets and liabilities increase by £1000. The cash is an asset, but the deposit is a liability, as it’s in the customer’s name.
What are the examples of Banks?
HSBC, Barclays, Lloyds, Natwest.
What happens if all banks expand deposits?
Payments to customers of other banks will cancel out.
Where would bank profits come from, if a bank held all its’ assets in cash?
Fees it charges customers, for keeping their deposits safe.
What would 100% cash mean for a Bank’s liquidity?
It would be completely liquid, but not profitable.
Why does a bank have to use cash?
To allow banks to make advances to customers.
How do firms try to maximise profitability?
Preserving liquidity.
What do banks have to trade off between?
Security, Liquidity, and profitability.
What does profitability depend on?
The degree of risk attached to a loan.
Why is a non secured loan risky?
If a customer defaults on a payment, the bank can’t recover money.
What are the assets of a bank ordered from liquidity to profitability?
Cash, BOE Balances, Money lent to other banks, Bills, Investments in Gov bonds, Advances - credit/loans, Non-current assets - premises.
What does contractionary monetary policy aim to do?
Shift AD to the left.
What does the extent of price fall depend on?
The shape of the AS curve.
What do lower interest rates do to the economy?
Discourage saving, stimulate borrowing, encourage investment, cause exchange rate to fall, makes exports more price competitive.
What does a flat AS curve cause?
An increase of real output.
What does a steep AS curve cause?
Inflation.
What is the Transmission mechanism?
A chain of how change in interest rates affects different parts of the economy.
What does the official rate affect?
Market Rate, Asset prices, confidence, exchange rate.
What does market rate, asset prices, confidence and exchange rate affect?
Domestic demand, net external demand.
What is the equation for total demand?
Domestic demand + net external demand.
What does total demand affect?
Domestic inflationary pressure.
What do interest rate changes affect?
The affordability of mortgages, which changes the price of assets.
What is the impact of an increase in Bank rates?
Rate increases, market price increases, domestic demand decreases, fall in total demand, less inflationary pressure, stagflation.
What is the impact on the exchange rate?
Increase commercial rates available, higher rates mean overseas investors want to place their money in UK accounts. Increase in demand for sterling.
Why is there a time lag between a change in the bank rate, and the rate of inflation?
Output is affected within one year, but inflation occurs after a lag of two years.
What is Quantitative Easing?
A monetary policy which aims to increase liquidity of financial system, by purchasing long term government bonds, Stimulating economic growth, encouraging banks to lend or invest more freely.
What was QE1?
£200 billion of QE between March 2009 and January 2010.
What was QE2?
£125 billion of QE between October 2012 and May 2014.
What was QE3?
£50 billion between July 2012 and October 2012.
What was QE4?
£60 billion from August 2016.
What was QE5?
£450 billion between March and November 2020.
What has the total QE been since 2009?
£895 billion.
What is forward guidance?
Attempts to send signals to financial markets and businesses about interest rate policies in months and years ahead.
What does forward guidance aim to do?
Increase credibility of monetary policy, ease financial markets, enables people to feel more confident in the long term.
What does forward guidance mean for interest rates?
Helps convert low interest rates in the short term into lower rates in the long term.
What are Shares?
The ownership part of a company.
What are Bonds?
Loans to governments or large corporations.
What are forex markets?
Where people exchange one currency for another.
What are the main financial markets?
Money markets, capital markets, forex markets.
What are Money Markets?
The market for short term loan finance for businesses and households.
What are Capital markets?
The market where securities such as bonds are issued to raise medium to long term finance for business and government.
What are the functions of money?
Medium of exchange, unit of account, store of value, standard of deferred payment.
What are the types of money?
Narrow money, broad money.
What is narrow money?
Cash, notes, coins.
What is broad money?
Notes, coins, deposits - paper money, as banks don’t keep the real value of deposits.
What is Equity?
Assets individuals own such as house, cars, art.
What is Debt?
An individuals’ financial liability - mortgages.
What are commercial banks?
Offer services to businesses and individuals.
What are retail banks?
Services to individuals and small businesses - services to larger businesses.
What are the main roles of commercial banks?
Accept savings deposits, lend money to households and firms, facilitate payments from one party to another, act as financial intermediaries from savers to borrowers.
What are the objectives of commercial banks?
Liquidity, profitability, security.
What are Investment Banks?
They provide a range of services to customers, don’t accept savings deposits - JP Morgan.
What are the main roles of investment banks?
Buying and selling securities, offering financial advice to customers wanting to raise money, helping to facilitate M+A’s, arranging issuing of bonds.
What are UK Bond Yields?
The rate of interest received by those holding government bonds.
What is a coupon payment?
A payment made every year to the holder of a government bond.
What is the calculation of a bond yield?
Annual coupon payment/current market price.
What is the type of relationship between bond yields and interest rates?
Inverse relationship - As the market value of the bond rises, the yield falls.
What are coupon rates?
The percentage of the value of the coupon paid in relation to the bond’s par value.
Who regulates Banks?
The Financial service authority - FSA.
Which areas does the FSA regulate?
Market abuse, Insider trading, customer data security, liquidity risk.
How does the FSA regulate market abuse?
Monopoly power, preventing competitors and charging high prices to consumers.
How does the FSA regulate Insider Trading?
Use of insider knowledge to make personal gains through buying and selling shares on the stock market.
What is the FPC’s main role?
To identify, monitor and take action to reduce risks that threaten the resilience of the UK financial system.
What does the FPC have the power to do?
Instruct commercial banks to change capital reserves.
What is the role of the Prudential regulation authority?
Creates policies for firms to follow, as well as watch over aspects of the business. Supervises over 1500 financial institutions, including banks and insurance companies.
What is the role of the FCA?
Protect consumers, keep industry stable, promote healthy competition between financial service providers.
What is Financial market failure?
Situations where financial markets fail to operate efficiently, causing lost economic output, reductions in national wealth.
What are the examples of financial market failure?
Asymmetries and information failure, moral hazard - risk. Excessive speculation, fall out from externalities, lack of competition.
Why is there systemic risk associated with financial market failure?
High risk investments which fail may be bailed out by the taxpayer.
Where is the social optimum on a financial market failure diagram?
MSC = MSB.
What does the social optimum mean, when talking about financial market failure?
Greater regulation will reduce the availability of risky investments.
How can the UK government reduce risk associated with financial market failure?
Tougher regulation and accountability, taxation on profits, provision of information - transparency of fees and risk. Legalisation - criminalisation of fraud. Cap on bonuses, reducing moral hazard.
What are the reasons why banks fail?
Lack of regulation, excessive risk taking, long term lending, short term borrowing, asset bubbles, systemic risk.
What is the Capital ratio?
Measures the funds a bank has in reserve against riskier assets it holds that could be vulnerable in the event of a crisis.
Why are short date government gilts highly liquid?
They are easy to sell on bond markets.
Why is a house a very illiquid asset?
Because of the time and expense to sell.
What is Moral Hazard?
The concept that individuals have incentives to alter their behaviour when their risk is borne by others.
What are the examples of moral hazard?
Comprehensive insurance policies decrease the incentive to take care of your possessions. Governments promising to bail out loss making banks can encourage banks to take greater risks.
How are falling bond prices an issue for governments?
Lower bond revenues, more difficult to fund debt or government spending projects. Instability on financial markets, pressure to increase coupon rates. Greater budget deficits.
What is Hot money?
Capital flows moving to countries with higher interest rates and expected changes in exchange rates.
