1.4 financial markets and monetary policy Flashcards
Bank of England
central bank in the uk economy which is in control of monetary policy
bond
debt; represents money that must be paid back over a period of time
broad money
money held in banks and building societies but that is not immediately accessible
central bank
controls the banking system and manages the government’s monetary policies
contractionary monetary polcy
monetary policy implemented to decrease aggregate demand
default
the failure or inability to meet the legal minimum requirements of a loan
equation of exchange
the stock of money in an economy multiplied by the velocity of circulation equals the price level multiplied by real output (MV=PQ)
dividend
portion of firms’ profits paid to shareholders
expansionary monetary policy
monetary policy implemented to increase aggregate demand
financial sector
firms that provide financial services
hot money
highly volatile money derived from investors storing money in different institutions, looking for the highest rate of return
interest
money paid to a lender by a borrower
monetary policy committee (MPC)
nine economists who meet monthly to set the bank rate as well as other monetary instruments
monetary policy
use of interest rates and other monetary instruments to achieve macroeconomic objectives
money supply
stock of money in the economy, comprised of cash and bank deposits
narrow money
physical money and more liquid assets
quantitative easing (QE)
by buying assets (generally government bonds) using newly created electronic money
rate of interest
the reward for saving and the cost of borrowing
repo rate
rate at which the central bank can lend money to commercial banks
reserve currency
foreign currency held in a country’s official reserves due to its value as a medium of exchange
reverse repo rate
rate at which the central bank can borrow money from commercial banks
shadow banking systen
unregulated firms that provide credit
sharw
equity; represents entitlement to a portion of a firm’s profits via dividends
systemic risk
when issues within one firm in the financial sector could bring about the collapse of the sector and/or the economy
transmission mechanism of monetary policy
the process by which alterations to the base rate affect determinants of aggregate demand
money
anything that can be used as a medium of exchange for goods and services
5 main functions of money
medium of exchange
unit of account
store of value
facilitates exchange
standard of deferred payment
how is money a medium of exchange?
serves as a standard unit of account that facilitates transactions by allowing goods and services to be exchanged for a common and widely accepted medium of exchange
how is money a unit of account?
serves as a standard unit of measurement for the value of goods, services and financial assets which enables individuals and businesses to compare prices and make informed decisions
how is money a store of value?
money allows individuals to save for future consumption by maintaining its purchasing power over time
how does money facilitate exchange?
by reducing the transaction costs and increasing the efficiency of exchanging goods and services
money helps to promote economic activity and growth
how is money a standard of deferred payment?
enables individuals and businesses to make deferred payments, such as loans and mortgages by providing a means of transferrable credit
6 characteristics of money
durable
portable
scarce
uniform
divisible
acceptable
yield
the interest received on a bond
payoff
the amount that the bondholder receives each year in interest from the government
assets
money the bank has
cash and everything else that will make the bank money in the future e.g. loans and cash
liabilities
money the bank owes
deposits
if you want to withdraw, the bank has to give it to you
financial market
one where buyers and sellers exchange financial assets (securities) such as shares (equities), currency or bonds
what trade-off does the bank face?
an increase in lending will increase profit but means customers are less able to access their deposits
an increase in lending will increase the amount of profit the bank can make
they make profit from lending by charging interest on the loans
however, increasing lending means they have less cash
they may not be able to give money to a customer who asks to take out some of the cash they have deposited in the bank
liquidity
how much cash a bank has
lending out more money means a bank will make more profit but it will have less liquidity
high capital ratio
when there is more capital compared to loans
this is good, can fall back on capital
if bank is running low on cash then can fall back on owner’s money
money supply
total supply of money in the economy
narrow money
cash and credit and debit card accounts ready to be spent immediately
broad money
narrow money and money in savings accounts, cheques and bonds
harder to access and can’t be spent immediately
money market
where you can buy and sell short-term financial assets e.g. overdrafts
capital market
where you can buy and sell long-term financial assets
foreign market
where you can buy and sell foreign currency like the american dollar
the amount paid for goods and traded in this market is given by the exchange rate
equity
percentage of a company owned
main advantage of selling shares
money raised does not need to be paid back
the investor purchasing the shares takes on all the risk - if company fails they will lose their money
disadvantage of selling shares
owner of the company loses a share in the company which means they will lose a share of all future profits as these need to be paid to the shareholders
maturity
when the final interest on a bond must be paid
coupon rate
annual interest rate received on a bond
the difference between the coupon rate of a bond and its payoff
coupon rate shows the actual amount of interest paid by the government as a percentage of the original bond price whereas the payoff shows the actual amount interest paid by the government
difference between bond yield and the coupon rate
bond yield is the interest rate based on the current price of the bond and the coupon rate is the interest rate based on the original price of the bond
when is quantitative easing used?
when the base interest rate is close to 0
how does quantitative easing work?
Bank of England electronically creates new money
Central bank uses new money to buy financial assets such as government bonds from highstreet banks
highstreet banks receive money which increases their money supply so they have more money to lend out
lend out to consumers, increasing consumption
lend to firms who invest
real life example of QE
Bank of England’s monetary policy committee pursued this in 2009 to 2012
they created £375bn new pounds and used it to purchase assets from highstreet banks
this meant highstreet banks could lend out more, higher money supply decreased the exchange rate
in 2009 the UK base interest rate was close to 0
AS wasn’t increasing enough to get out of recession
fischer’s equation
MV=PQ
M= money supply
V= money supply
P=price level
Q=quantity of goods/services
what variables remain constant in the Fischer equation?
V and Q
what does the quantity theory of money predict?
that quantitative easing will lead to an increase in price level which is inflation
how to evaluate quantitative easing
reference quantity theory of money
write out MV=PQ
quantitative easing, increases money supply, increases general price level
leads to inflation
what form of monetary policy is QE?
expansionary monetary policy
quantitative easing
when the central bank buys financial assets such as bonds from highstreet banks
this increases the amount of money that these banks can lend
more consumers and firms will be able to borrow
increasing consumption and increasing investment
increasing AD and real GDP
increased money supply leads to an increase in the supply of pounds
this causes a depreciation
this increases net exports and pushes out AD
negative consequence of QE
a high QE round can cause hyperinflation
hyperinflation can outweigh increase in real GDP
