4.2.2 financial markets and monetary policy Flashcards
characteristics of money
medium of exchange
unit of account
store of value
standard of deferred payment
portable
durable
scarce
difficult to forge
functions of money
facilitate exchange: eases exchange of goods and services
unit of measurement: common unit, simplifies transactions
store of value: save and transfer wealth across time
standard for debt settlement: fulfill financial commitments
what is the money supply
stock of currency and liquid assets in an economy including money within savings accounts
narrow money
M1
physical currency eg notes and coins
as well as deposits and liquid assetts in the central bank
can be converted to cash at any time (eg demand deposits)
broad money
includes entire money supply, incorporates iliquid assets
eg savings account or time deposits
money market
liquid assets are traded
used to borrow and lend in the short term
capital market
equity and debt instruments are bought and sold which can be put into long term productive use by firms or the government
foreign exchange market
currencies are traded mainly by international banks
determines relative value of the currency
financial liquid assetts
exchanged in financial markets
eg stocks and bonds
role of financial markets in the wider economy
facilitate saving: consumers or firms store funds
lending: transfer of funds between agents is aided
facilitate exchange of goods or services: provides a way buyers and sellers can interact and exchange funds
provides a forward/ futures market: for currencies or commodities
provides market for equities: access to capital form firms, returns on investment (dividends) are based on future performance
forward market
informal financial markets where these contracts for future delivery are made
debt
money which has been borrowed from a lender (usually a bank), little flexibility as the loan is later repaid with interest
equity
stock or security which represents interest in owning, no outstanding debt
eg when mortgage is fully paid off, the equity in the house can then be sold for cash
market interest rates and bond prices
inverse relationship
interest rate is fixed once the bond is issued
new bonds have rates close to the market IR
market IR rises, less demand for old bonds, bond price falls
how firms raise finance
Shares: relatively cheap for firms, only pay dividends when there are distributeable profits and its voted for by shareholders
Borrowing: involves high interest rates which is expensive however they can easily adjust amount their borrowing
Corporate bonds: issued to raise funds for large projects, partially protected against variable interest rates or economic changes
coupon
interest payment to bond holder from issue date to maturity date
maturity
period of time the asset is outstanding
formula for bond yield
coupon/ market price X100
commercial bank
manages deposits, cheques and savings accounts for individuals and firms, they can make loans using money deposited with them
investment bank
facilitate trading of stocks, bonds and other forms of investment, weak government regulation and thus they have higher risk tolerance
functions of commercial bank
accept deposits
provide loans
investment of funds
overdraft
agency function
functions of commercial bank- accept deposits
Demand deposits: made or withdrawn immediately
Fixed deposits: store money for longer but has higher interest rates
Savings deposits: lower interest rates than fixed, when money is withdrawn often but not immediately
functions of commercial bank- provide loans
their main source of income is interest, which they earn by providing loans
create credit by using deposits and turning them into loans
some loans are secured against an asset protecting the bank if loan is not repaid
cash credit: based on bonds and approved securities, bank deposits money periodically to borrower
on demand: entire loan paid at once also has very high IR
short term/personal: against a security
functions of commercial bank- overdraft
When current account has no deposit, can borrow using overdraft however there is limited amount you can borrow and interest is high
functions of commercial bank- investment of funds
surplus funds can be invested into securities such as government bonds or t bills
functions of commercial bank- agency function
represents their customers eg collects cheques and dividends, deposit interest and transfer money for consumers
What do commercial bank balance sheets show
value of assets
liabilities
equities of owner
Liabilities
Used to buy assets and income can be earned from these assets
Made up of: share capital, deposits, borrowing and reserve funds
Owners equity
Bank capital
Left over when assets have been sold and liabilities have been paid
Objectives of commercial banks
Liquidity
Profitability
Security
Objectives of commercial banks- liquidity
How easy it is to turn assets to cash
Liabilities are payable on demand so to be profitable banks must have cash and liquid assets
If prioritised profits will be low
The cheaper and easier it is to borrow the less likely the bank are to keep liquid assets
Objectives of commercial banks- profitability
Need to earn profits to pay depositors interest, wages and general expenses
Usually liquidity is prioritised over profitability
Objectives of commercial banks- security
have to try and maintain the safety of their assets
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
functions of the central bank
manages the currency, money supply and interest rates
issue physical cash securely to prevent forgery and increase trust
regulates bank lending
implementing monetary policy
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.
central bank controls the
base rate
lender of last resort function
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.
aims to prevent a bank run
bank run
when the customers of a bank or other financial institution withdraw their deposits at the same time over fears about the bank’s solvency. As more people withdraw their funds, the probability of default increases, which, in turn, can cause more people to withdraw their deposits.
expansionary MP
decreasing interest rates
increases AD
contractionary MP
increasing interest rates
decreases AD
when is QE used
when inflation is low and is it not possible to reduce interest rates any further
how does QE work
BoE creates new electronic money and uses it to buy government bonds, increased demand for gov bonds causes bond priced to rise, fall in bond yields, sell bonds, cash used to buy assets, commercial banks recieve this cash, increased liquidity incentivising them to lend
factors considered when setting the bank rate
unemployment rate
savings rate
consumer spending
high commodity prices
exchange rate
derivatives market
financial assets whose value are derived from an underlying asset
reasons for high bond yields
high private investment yields
inflation risk
default risk
what do hedge funds do
pool money from high net worth individuals
commerical bank balance sheet- assets
what they OWN
cash
balances at BoE
money lent to other banks
t bills
investments
advances
fixed assets
commerical bank balance sheet- liabilities
what they OWE
short term borrowing
customer deposits
share capital
reserves
assets=
liabilities + capital
assets<liabilities
insolvency so may be bailed out
may be because loans turn non performing
eg NorthernRock
liquidity crisis
a sudden shortage of cash or liquid assets that prevents a business or financial institution from meeting its obligations
need emergency funding from BoE (lender of last resort)
so they may need to sells of assets very quick (fire sale) however probably make less profit from assets
bank run
when the customers of a bank or other financial institution withdraw their deposits at the same time over fears about the bank’s solvency. As more people withdraw their funds, the probability of default increases, which, in turn, can cause more people to withdraw their deposits.
systemic risk
the risk of a cascading failure in the financial sector, caused by interlinkages within the financial system, resulting in a severe economic downturn.
old method of banks giving loans
only from customer deposits
how do banks create credit
- fractional reserve system: banks are only required to hold a fraction of their deposits as liquid reserves and can lend out the rest
- money multiplier: they lend a proportion, chain reaction as this money is spent and more is saved etc
- credit creation: banks make loans and create new money in the form of additional deposits, multiplies initial deposut and contributing to economic activity
money multiplier
1/reserve ratio
limits to credit creation
- stage of economic cycle
- default risk
- regulatory policies
- monetary policy impact on demand for loans
how commercial banks make profit
- higher interest rates on loans than the rate paid to savers
- fees charged when arranging loans
- brokerage fees for currency or share dealing services
non performing loans
borrower stopped making payments and is in default, represents loss of revenue and has negative effects on banks capital and liquidity
factors causing non performing loans
- economic crash causing job loss
- industry specific issue around cyclical nature of industry
- loose credit standards
- fraud due to asymetric information
case study- Northern Rock
Northern Rock collapsed in 2007 due to a reliance on short-term funding from the global money markets and exposure to subprime mortgage risks. When the financial crisis led to a loss of confidence, it faced liquidity problems, unable to secure enough funds. The UK government intervened, nationalizing the bank to prevent further instability.
