4.2.4 — Financial Markets And Monetary Policy Flashcards
What are the 4 characteristics / functions of money?
-
Medium of exchange:
Replaced bartering - A measure of value (unit of account):
Money provides a mean to measure the relative value of different goods / services. Money also puts a value on Labour - A store of value:
Money has to hold its value to be used for payment — it can be kept for a long time without expiring. However, the quantity that can be bought with money fluctuates with the forces of supply / demand -
Method of deferred payment:
Money can allow for debts to be created. People can therefore pay for things without having money in present and can pay for it later
Define money supply:
The stock of currency and liquid assets in an economy. It includes cash and money held in savings accounts
Define narrow money
Physical currency (notes and coins), as well as deposits and liquid assets in the central bank
Define broad money
It 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
What is the difference between the money market, capital market and the FOREX?
In the money market, liquid assets are traded which are used to borrow and lend money in the short term.
The capital market is where equity and debt instruments are bought and sold. These can then be put to long term productive use by firms and governments
The FOREX is a market where currencies are traded, mainly by international banks. It determines what the relative value of different currencies will be
What is 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
What is the difference between debt and equity?
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
Equity is a stock or security which represents interest in owning i.e a firm, a car etc. It is when there is no outstanding debt such as when a loan for a car or mortgage has been fully paid off. The owners equity is then the car or house which can be sold for cash
Why is there 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 interest.
New bonds have rates close to the market interest rate. If the market interest rate falls, i.e the bond would be worth more, since it carries a higher interest rate than current market conditions — Similarly, the bond is worth less than the current market
How can firms raise finance?
- by issuing shares
> relatively cheap
> a proportion of their profits has to be paid to shareholders - issuing corporate bonds
> used for larger projects I.e expansion
> traded in a similar way to shares - loans from a bank
> have to pay back with interest rates
> unaffordable for new, small firms
> flexible - Gov bonds
> coupons
Define maturity
Period of time for which the financial asset is outstanding. When it finishes and has been repaid it has matured
What is a commercial bank?
A bank which manages deposits, cheques and savings accounts for individuals and firms. They make loans using the money saved with them
What is an investment bank?
A bank which facilitates the trade of stocks, bonds and other forms of investment. Government regulation is weaker in the investment bank industry — this combined with their business model gives them a higher risk tolerance
What are the 5 main functions of a commercial bank?
- Accept deposits:
In the form of savings (from the public), banks can meet the needs of depositors by offering different accounts i.e demand or fixed deposits - Provide loans:
The main income source for banks is interest payed on loans (creation of credit) — loans can be used in the form of cash credit, on demand or only for the short term - Overdraft:
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 borrowed is limited - Investment of funds:
Surplus funds could be invested into securities i.e government bonds and treasury bills. These could earn a return for the bank - Agency functions:
Banks represent their consumers i.e they collect cheques and dividends, they pay and accept bills I.e via direct debit etc
Define loans on demand
When the entire loan is paid into the account of the borrower therefore the loan is charged with interest immediately
What is a balance sheet?
They are what show the value of a company’s assets, liabilities and owners equity during a period of time. It is usually at the end of a quarter or an annum
Define a liability
Something which must be paid. It is a claim on assets — takes money out of your pocket
Define an asset
Something which can be sold for value. The owners equity is also known as bank capital and it is what is left over once an asset has been sold and liabilities have been paid — puts money into your pocket
What are some assets and liabilities which you may find on a commercial banks balance sheet?
Liabilities:
- share capital
- deposits
- borrowing and reserve funds
Assets:
- cash
- securities and bills
- loans
- investments
What are the 3 main objectives of a commercial bank?
- Liquidity
- Profitability
- Security
What is the liquidity of assets?
The liquidity of assets is how easy it is to turn assets into cash. Liabilities are payable on demand, so 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 2 objectives
What assets within a commercial bank are liquid / illiquid?
Liquid:
- cash
- deposits
Illiquid:
- loans
- long term bonds
- property
If banks can borrow easily / 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
Why do commercial banks need to be profitable?
To pay their depositors interest, wages and general expenses.
Holding a lot of funds in cash mean profitability is limited, however liquidity and safety are generally prioritised over profitability
Why do commercial banks face risks?
They face uncertainties about 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.
> banks may be less profitable or lose customers — the bank needs to balance the risk between risk level and profits
What is monetary policy used to control (+ what tools)?
To control the money flow of the economy (done with interest rates and quantitative easing)
What are the 3 functions of a central bank?
- Implementation of monetary policy:
MPC alters interest rates to control the money supply — IR are used to help meet the Gov target of price stability (alters cost of borrowing / saving) - Banker to government:
The central bank provides services to the Gov. It collects and makes payments on behalf of the Gov. It also manages public debt and issues loans - Banker to the banks — lender of last resort:
If there is no other method to increase the supply of liquidity when it is low, BofE will increase supply (bail out commercial banks)
It can protect individuals who deposit funds in a bank and might otherwise lose them
What does the base rate that central banks set do?
The base rate ultimately controls the interest rates across the economy
Which factors are considered by the MPC when setting a bank rate?
- Unemployment rate:
> if high, C is likely to fall. This suggests the MPC will drop interest rates to encourage more spending - Savings rate:
> if there is a lot of saving, C is likely to fall. IR are likely to fall - Consumer spending:
> if C increases, there could be inflationary pressures on the PL. This would cause the MPC to increase IR - High commodity prices:
> since the UK is a net importer of oil, high prices may lead to cost-push inflation. This could push the MPC to increase IR to overcome inflationary pressure - Exchange rate:
A weak pound would cause PL to increase (SPICED WPIDEC). MPC might consider increasing the IR
How do changes in the exchange rate affect AD and the macroeconomic policy objectives?
- A reduction in exchange rate causes cheaper exports that are in higher demand. This assumes that demand is price elastic. It also causes imports to become relatively expensive — UK current account deficit would improve
> this is inflationary however, due to the increase in the price of imported raw materials. Production costs increase, causing cost-push inflation
An increase in IR relative to other countries makes it more attractive to invest funds as the rate of return on investment is higher — this increases the demand for currency, causing appreciation
