4.2.2 financial markets and monetary policy

Question 1

characteristics of money

Answer 1

medium of exchange
unit of account
store of value
standard of deferred payment
portable
durable
scarce
difficult to forge

Question 2

functions of money

Answer 2

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

Question 3

what is the money supply

Answer 3

stock of currency and liquid assets in an economy including money within savings accounts

Question 4

narrow money

Answer 4

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)

Question 5

broad money

Answer 5

includes entire money supply, incorporates iliquid assets
eg savings account or time deposits

Question 6

money market

Answer 6

liquid assets are traded
used to borrow and lend in the short term

Question 7

capital market

Answer 7

equity and debt instruments are bought and sold which can be put into long term productive use by firms or the government

Question 8

foreign exchange market

Answer 8

currencies are traded mainly by international banks
determines relative value of the currency

Question 9

financial liquid assetts

Answer 9

exchanged in financial markets
eg stocks and bonds

Question 10

role of financial markets in the wider economy

Answer 10

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

Question 11

forward market

Answer 11

informal financial markets where these contracts for future delivery are made

Question 12

debt

Answer 12

money which has been borrowed from a lender (usually a bank), little flexibility as the loan is later repaid with interest

Question 13

equity

Answer 13

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

Question 14

market interest rates and bond prices

Answer 14

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

Question 15

how firms raise finance

Answer 15

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

Question 16

coupon

Answer 16

interest payment to bond holder from issue date to maturity date

Question 17

maturity

Answer 17

period of time the asset is outstanding

Question 18

formula for bond yield

Answer 18

coupon/ market price X100

Question 19

commercial bank

Answer 19

manages deposits, cheques and savings accounts for individuals and firms, they can make loans using money deposited with them

Question 20

investment bank

Answer 20

facilitate trading of stocks, bonds and other forms of investment, weak government regulation and thus they have higher risk tolerance

Question 21

functions of commercial bank

Answer 21

accept deposits
provide loans
investment of funds
overdraft
agency function

Question 22

functions of commercial bank- accept deposits

Answer 22

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

Question 23

functions of commercial bank- provide loans

Answer 23

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

Question 24

functions of commercial bank- overdraft

Answer 24

When current account has no deposit, can borrow using overdraft however there is limited amount you can borrow and interest is high

Question 25

functions of commercial bank- investment of funds

Answer 25

surplus funds can be invested into securities such as government bonds or t bills

Question 26

functions of commercial bank- agency function

Answer 26

represents their customers eg collects cheques and dividends, deposit interest and transfer money for consumers

Question 27

What do commercial bank balance sheets show

Answer 27

value of assets liabilities equities of owner

Question 28

Liabilities

Answer 28

Used to buy assets and income can be earned from these assets Made up of: share capital, deposits, borrowing and reserve funds

Question 29

Owners equity

Answer 29

Bank capital Left over when assets have been sold and liabilities have been paid

Question 30

Objectives of commercial banks

Answer 30

Liquidity Profitability Security

Question 31

Objectives of commercial banks- liquidity

Answer 31

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

Question 32

Objectives of commercial banks- profitability

Answer 32

Need to earn profits to pay depositors interest, wages and general expenses Usually liquidity is prioritised over profitability

Question 33

Objectives of commercial banks- security

Answer 33

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

Question 34

functions of the central bank

Answer 34

manages the currency, money supply and interest rates issue physical cash securely to prevent forgery and increase trust regulates bank lending

Question 35

implementing monetary policy

Answer 35

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.

Question 36

central bank controls the

Answer 36

base rate

Question 37

lender of last resort function

Answer 37

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

Question 38

bank run

Answer 38

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.

Question 39

expansionary MP

Answer 39

decreasing interest rates increases AD

Question 40

contractionary MP

Answer 40

increasing interest rates decreases AD

Question 41

when is QE used

Answer 41

when inflation is low and is it not possible to reduce interest rates any further

Question 42

how does QE work

Answer 42

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

Question 43

factors considered when setting the bank rate

Answer 43

unemployment rate savings rate consumer spending high commodity prices exchange rate

Question 44

derivatives market

Answer 44

financial assets whose value are derived from an underlying asset

Question 45

reasons for high bond yields

Answer 45

high private investment yields inflation risk default risk

Question 46

what do hedge funds do

Answer 46

pool money from high net worth individuals

Question 47

commerical bank balance sheet- assets

Answer 47

what they OWN cash balances at BoE money lent to other banks t bills investments advances fixed assets

Question 48

commerical bank balance sheet- liabilities

Answer 48

what they OWE short term borrowing customer deposits share capital reserves

Question 49

assets=

Answer 49

liabilities + capital

Question 50

assets

Answer 50

insolvency so may be bailed out may be because loans turn non performing eg NorthernRock

Question 51

liquidity crisis

Answer 51

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

Question 52

bank run

Answer 52

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.

Question 53

systemic risk

Answer 53

the risk of a cascading failure in the financial sector, caused by interlinkages within the financial system, resulting in a severe economic downturn.

Question 54

old method of banks giving loans

Answer 54

only from customer deposits

Question 55

how do banks create credit

Answer 55

- 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

Question 56

money multiplier

Answer 56

1/reserve ratio

Question 57

limits to credit creation

Answer 57

- stage of economic cycle - default risk - regulatory policies - monetary policy impact on demand for loans

Question 58

how commercial banks make profit

Answer 58

- higher interest rates on loans than the rate paid to savers - fees charged when arranging loans - brokerage fees for currency or share dealing services

Question 59

non performing loans

Answer 59

borrower stopped making payments and is in default, represents loss of revenue and has negative effects on banks capital and liquidity

Question 60

factors causing non performing loans

Answer 60

- economic crash causing job loss - industry specific issue around cyclical nature of industry - loose credit standards - fraud due to asymetric information

Question 61

case study- Northern Rock

Answer 61

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.