4.2.4 Financial markets and monetary policy

Question 1

What are the functions of money?

Answer 1

• A medium of exchange: exchange could only take place with a double coincidence of wants when bartering
• A measure of value: provides means to measure relative values of goods and services, as well as labour
• A store of value: has to hold its value to be used for payment
• A method of deferred payment: can allow for debts to be created, relying on money storing its value

Question 2

What is a double coincidence of wants?

Answer 2

When both parties in an exchange have to want the good the other party offers

Question 3

What are the characteristics of money?

Answer 3

• Commodity money: such as shells/teeth, which have an intrinsic value of their own
• Representative money: replaced commodity money with materials such as gold and silver, and is scarce, portable, durable, accepted, divisible, and secure
• Token money: has no intrinsic value, such as notes and coins, or bank deposits

Question 4

What is the money supply?

Answer 4

The stock of currency and liquid assets in an economy, including cash and money held in savings accounts

Question 5

What is narrow money?

Answer 5

Money used as a means of payment, consisting of physical currency, such as notes and coins, as well as deposits and liquid assets in the central bank

Question 6

What is broad money?

Answer 6

Consists of the entire money supply, including physical currency, deposits and liquid assets, as well as less liquid assets

Question 7

What is a money market?

Answer 7

Where short term (maturity of one day to a year) liquid assets are traded, providing means for lenders and borrowers to satisfy short term financial needs

Question 8

What are examples of bills traded in a money market and how liquid are they?

Answer 8

Commercial bills and treasury bills, which are both very liquid

Question 9

What are commercial bills?

Answer 9

Unsecured short term debt instruments that private firms use to ensure they have enough cash to cover operating costs, and often mature overnight

Question 10

What are treasury bills?

Answer 10

US government debt securities with a maturity of less than a year

Question 11

What do money markets provide for banks?

Answer 11

A mechanism for banks to arrange their assets in terms of their liquidity or profitability, enabling them to be the intermediary between savers and borrowers

Question 12

What is a capital market?

Answer 12

Where equity and debt instruments, such as shares and bonds, are issued to raise medium to long term finance for firms and governments, and then can be traded second hand

Question 13

What is an example of a capital market?

Answer 13

The London Stock Exchange

Question 14

What enables a government to run a budget deficit?

Answer 14

Government bonds, gilts

Question 15

How do PLC’s (public limited companies) raise medium to long term finance?

Answer 15

Shares or corporate bonds

Question 16

What is maturity?

Answer 16

The period of time for which the financial asset is outstanding, so one that has matured has finished and been repaid

Question 17

What is a coupon?

Answer 17

An annual interest payment to the bond holder between the date of issue and the date of maturity

Question 18

How is yield calculated?

Answer 18

(Coupon) / (market price) x 100

Question 19

What happens to the yield from a bond as its market price increases?

Answer 19

Yield decreases as bond price increases

Question 20

What are primary markets?

Answer 20

Where bonds and shares are initially sold

Question 21

How are bonds and shares initially sold in a primary market?

Answer 21

There is either an initial public offering, or if a firm is issuing new shares, they are offered first to existing shareholders at a discounted price, as current shareholders will have less equity

Question 22

What are secondary markets?

Answer 22

Where existing financial securities, such as bonds and shares, are bought and sold, for example the London Stock Exchange

Question 23

What is the purpose of secondary markets?

Answer 23

• Enables investors to manage their portfolios (range of investments)
• Makes the financial securities more liquid
• Without them, primary markets would suffer, as investors would be unable to sell held assets, so are therefore crucial to the economy

Question 24

What are foreign exchange markets?

Answer 24

Where currencies are traded, mainly by international banks, and determines the relative value of different currencies will be

Question 25

What is the difference between a spot rate and a forward rate in a foreign exchange market?

Answer 25

A spot rate is used for immediate purchase or sale, whereas a forward rate is an agreed rate for future transactions, which provides more stability on the balance of payments, reducing exchange rate risk

Question 26

What is the role of financial markets in the wider economy?

Answer 26

• To facilitate saving: by providing somewhere for consumers and firms to store their funds, rewarding savings with interest payments from the bank
• To lend to businesses and individuals: by aiding the transfer of funds between agents, which can be used for investment or consumption
• To provide forward markets in currencies and commodities
• To provide a market for equities: provide access to capital for firms, and allow investors to own part of a market, returns on the investment (usually dividends) are based on future performance
• To provide mortgages for a housing market
• To help governments fund a budget deficit: by borrowing money through gilts
• To allow the accumulation of wealth: increasing living standards (but rich get richer so maybe increasing inequality?)

Question 27

What are dividends?

Answer 27

Returns on an investment, in the form of a share of the firm’s profits

Question 28

What is the difference between debt and equity?

Answer 28

Debt is money which has been borrowed from a lender, 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, for example, a firm, car or house, there is no outstanding debt, so when a loan for a car or a mortgage has been fully paid off, the owner’s equity is the car or house, and can be sold for cash.

Question 29

Why is there an inverse relationship between market interest rates and bond prices?

Answer 29

When a bond is bought, money is lent to the issuer, who agrees to pay the value of the bond back when it matures, in addition to periodic fixed interest payments. New bonds have rates close to the market interest rate, and if it falls, existing bonds would be worth more, as they carry a higher interest rate than current market conditions.

Question 30

How can firms raise finance?

Answer 30

By issuing shares, corporate bonds, or borrowing from a bank

Question 31

What are the advantages of the methods of firms raising finance?

Answer 31

• It is relatively cheap
• Dividends are only paid when there are distributable profits and it is voted for by shareholders
• Borrowing is flexible and the funds can be increased or decreased by borrowing more or paying back the loan
• Corporate bonds can be traded in a similar way to shares, are partially protected against variable interest rates or economic changes

Question 32

What are the disadvantages of the methods of firms raising finance?

Answer 32

• Firms are legally obliged to pay their shareholders dividends
• Borrowing could involve paying back loans with high interest rates, which could be expensive, so might be unaffordable for new, smaller firms
• Firms have to pay interest to investors who buy corporate bonds

Question 33

What are corporate bonds?

Answer 33

Bonds issued by firms to raise funding for large projects, such as to expand the firms, develop a product, move to a new premise, or takeover another firm

Question 34

What is the difference between a commercial bank and an investment bank?

Answer 34

A commercial bank manages deposits, cheques and savings accounts for individuals and firms, and can make loans using the money saved with them.
Investment banks facilitate the trade of stocks, bonds and other forms of investment, for other firms and financial institutions, as well as on their own behalf. Government regulation is weaker in the investment bank industry, and this combined with their business model gives them a higher risk tolerance.

Question 35

What are the main functions of a commercial bank?

Answer 35

• Accept deposits, usually in the form of savings
• Provide loans, in the form of cash credit, on demand or only for the short term
• Offer overdraft
• Investing funds
• Represent their consumers: collect cheques and dividends, pay and accept bills (such as though a direct debit), deposit interest and income tax, buy and sell securities, and arrange the transfer of money between places for consumers

Question 36

How do commercial banks accept deposits from the public?

Answer 36

Usually in the form of savings, which those on low incomes do for security, whilst firms do it for convenience.

Question 37

What are the different types of deposits commercial banks offer, and how are they different?

Answer 37

Commercial banks can meet the different needs of their depositors by providing different accounts:
- Demand Deposits allow deposits to be made or withdrawn immediately, which is useful for firms who need to make immediate payments
- Fixed Deposits store money for a long time, with higher rates of interest, since banks can use these deposits knowing they will not be withdrawn
- Saving Deposits have lower rates of interest than the previous, and are done by those who withdraw money often, but not necessarily immediately, and who are generally receiving an income

Question 38

Why are some loans secured against an asset, such as a house?

Answer 38

To protect the bank’s funds if the loan is not repaid

Question 39

What are the different types of loans offered by commercial banks, and how do they differ?

Answer 39

• Cash credit loans are based on bonds and approved securities - banks enter agreements with customers so money can be withdrawn several times a year, and deposit money periodically into their accounts
• Loans on demand are when the entire loan is paid into the account of the borrower, so it is charged with interest immediately
• Short-term loans tend to be personal or for working capital and are usually against a security

Question 40

What is an overdraft?

Answer 40

The money consumers can still borrow from the bank when a current account has no deposit, at a high interest rate and the amount that can be borrowed is limited

Question 41

How can commercial banks invest funds and why?

Answer 41

Surplus funds can be invested into securities such as government bonds and treasury bills, which could earn a return for the bank

Question 42

What is a balance sheet?

Answer 42

They show the value of a firm’s assets, liabilities and owner’s equity during a period of time, usually at the end of a quarter or an annum

Question 43

What is a liability?

Answer 43

Something owed which must be paid, and is a claim on assets, so is used to buy assets

Question 44

What is an asset?

Answer 44

Something owned that can be sold for value

Question 45

What is an advance?

Answer 45

An asset on a bank’s balance sheet

Question 46

What is a deposit to a bank?

Answer 46

A liability

Question 47

What is a firm owner’s equity and what is it also known as?

Answer 47

It is what is left over when assets have been sold and liabilities have been paid, also called bank capital

Question 48

What can be earned from assets?

Answer 48

Income

Question 49

What are liabilities made up of?

Answer 49

Deposits, shareholder capital, borrowing and reserve funds (retained profit)

Question 50

What are examples of assets?

Answer 50

Cash, securities and bills, loans and investments

Question 51

What are the objectives of a commercial bank?

Answer 51

• Liquidity
• Profitability
• Security

Question 52

What is liquidity?

Answer 52

How easy it is to turn assets into cash without suffering a loss

Question 53

What are examples of a bank’s assets in order of most liquid to least liquid?

Answer 53

1. Cash - notes and coins
2. Balance at the Bank of England
3. Money at short call notice - overnight maturity
4. Bills - commercial and treasury
5. Investments - government and corporate bonds
6. Advances - loans and mortgages
7. Fixed assets - buildings

Question 54

Why do banks need high liquidity?

Answer 54

Liabilities are payable on demand, so in order to be profitable banks must have cash and liquid assets

Question 55

What are banks likely to do if they can borrow easily and cheaply?

Answer 55

Keep fewer liquid assets

Question 56

What are banks likely to do if it is expensive and difficult for them to get a loan?

Answer 56

Keep more liquid assets

Question 57

What is profitability?

Answer 57

The ability to make revenue that exceeds the total cost

Question 58

Why do banks need to earn profits?

Answer 58

To pay their depositors interest, shareholders dividends, as well as wages and general expenses

Question 59

Why is there a trade off between liquidity and profitability?

Answer 59

In general, assets which are liquid aren’t profitable, such as cash, and assets which are illiquid are very profitable, such as mortagages

Question 60

What is security?

Answer 60

How safe a bank’s assets are

Question 61

Why might banks aim for high security?

Answer 61

Banks face risks and uncertainties about how much cash they can get, and whether loans will be repaid or not, so they have to try and maintain the safety of their assets.

Question 62

What are the possible conflicts between the objectives of a commercial bank?

Answer 62

• Trade-off between liquidity and profitability: holding a lot of funds in cash means profitability is limited, but liquidity and safety are generally prioritised over profitability, which is considered to be a supplementary for the bank’s survival.
• Trade-off between risk level and profitability: banks need to keep high proportions of their liabilities with itself and the central bank, but following these principles means banks only hold their safest assets, so more credit cannot be created.

Question 63

What is the main source of income for commercial banks?

Answer 63

Interest, earned through providing loans

Question 64

How do banks create credit?

Answer 64

By using deposited funds as loans, with each loan resulting in the creation of an advance and a deposit

Question 65

What are the main functions of a central bank?

Answer 65

• Price stability & growth management: manages the currency, money supply and interest rates in an economy
• Financial stability: can regulate bank lending to ensure there is stability in the financial system
• Issue physical cash securely and use methods to prevent forgery, so that people trust the money

Question 66

What is monetary policy?

Answer 66

The central bank taking action to influence interest rates, the supply of money and credit, as well as the exchange rate, to manage the economy

Question 67

What are the current objectives of monetary policy set by the government?

Answer 67

Price stability and a 2% inflation rate

Question 68

What is the role of the Monetary Policy Committee of the Bank of England (MPC)?

Answer 68

The MPC alters interest rates to control the supply of money, altering the cost of borrowing and reward for saving, aiming to achieve price stability

Question 69

What is the base rate?

Answer 69

The interest rate set by central banks for lending to other banks, used as a benchmark for interest rates set by commercial banks

Question 70

How does increasing the base rate lead to price stability through decreasing demand-pull inflation?

Answer 70

• Savings increase, decreasing consumption, decreasing domestic demand and inflation
• Market rates increase, increasing the cost of borrowing, and mortgage repayments, decreasing discretionary income, both decreasing consumption, etc.
• Asset prices decrease, decreasing confidence, decreasing domestic demand and inflation

Question 71

How does increasing the base rate lead to price stability through decreasing cost-push inflation?

Answer 71

Exchange rate increases, decreasing the number of exports and cost of imports, therefore decreasing the costs for raw materials/ commodities, decreasing inflation

Question 72

What does contractionary monetary policy involve?

Answer 72

Increasing the base rate and decreasing the money supply

Question 73

What does expansionary monetary policy involve?

Answer 73

Decreasing the base rate and increasing the money supply

Question 74

What factors are considered by the MPC when setting the bank rate?

Answer 74

• Employment rate/growth/confidence/productivity/wages: if low then consumer spending is likely to fall, so interest rates might fall
• Savings rate: if high then consumers are not spending as much
• Consumer spending: if high then there could be inflationary pressures on the price level, causing the MPC to increase interest rates
• High commodity prices: as the UK is a net importer of oil, a high price could lead to cost-push inflation, which could push the MPC to increase interest rates
• Exchange rate: a weak pound would cause the average price level to increase, making UK exports relatively cheap, so exports increase

Question 75

Describe the demand-side monetary policy transmission mechanism if the base rate is decreased.

Answer 75

Domestic demand increases due to increased consumption, due to various reasons:
- There is less incentive to save, increasing consumption.
- Market rates decrease as commercial banks follow direction of the central bank, decreasing the cost of borrowing and therefore increasing consumption, as well as decreasing mortgage repayments, increasing discretionary income and consumption.
Demand also increases due to the wealth effect, as asset prices increase, as people are more likely to purchase assets rather than save, therefore increasing confidence.

Question 76

Describe the supply-side monetary policy transmission mechanism if the base rate is decreased.

Answer 76

The exchange rate decreases, as the currency depreciates due to lower demand for foreign investors of the currency, increasing the number of exports, as they are relatively cheaper to other countries, and increasing the cost of imports, increasing the costs for raw materials and commodities, leading to cost-push inflation as the cost of production for firms increases.

Question 77

What does the effect of lowering interest rates on inflation and growth depend on?

Answer 77

• The current state of the economy, as in a recession there is low confidence, so people may continue to save instead of spend, also leading to asset prices not increasing
• The action of commercial banks, as they do not have to pass on the base rate
• The interest rates abroad, as in 2008 they were the same, so the exchange rate stays the same
• The current interest rates, as if they are very low, there is very little impact
• There is a time lag when implementing monetary policy
• Savers may lose out, decreasing potential future spending

Question 78

What is quantitative easing?

Answer 78

The non-traditional expansionary monetary policy, where central banks buy up bonds, usually government bonds, known as gilts, from the financial markets, as a way of injecting money into the economy

Question 79

Why might quantitative easing be used?

Answer 79

When standard monetary policy is no longer effective, such as if interest rates cannot be lowered any further than their current rate

Question 80

Explain the effects of quantitative easing.

Answer 80

• As banks have more money, they will naturally lend more to households and firms, increasing spending and investment, thus increasing overall demand and re-stimulating the economy
• The demand for bonds increases, pushing up prices, decreasing yields on these bonds, acting as a benchmark for wider rates, as, if the interest rate on government bonds decreases then the market interest rates decrease, thus decreasing the cost of borrowing, increasing consumption

Question 81

What is a bond?

Answer 81

An IOU given by a borrower, the bond seller, to a lender, bond buyers. They do not have to be kept by the investors, as they can be bought and sold on the financial markets

Question 82

What is funding for lending?

Answer 82

The Funding for Lending Scheme was introduced by the UK government when banks were faced with higher funding costs after conditions in the Euro area worsened. It aimed to lower these costs and provide cheap funding to banks and building societies.

Question 83

What is forward guidance?

Answer 83

Used by central banks to detail what the future monetary policy will be to the general public, with the intention of reducing uncertainty in markets, for example the MPC might state they will keep the interest rate at a certain level until a specified date.

Question 84

What is a liquidity trap?

Answer 84

When expansionary monetary policy becomes ineffective at stimulating demand in the economy, occurring when interest rates are very low, because even if the central bank cuts interest rates further, it does not significantly increase borrowing or investment as people and firms prefer to hold onto cash rather than spend or invest it.

Question 85

What is a central bank’s role to the government?

Answer 85

• Provides services to the central government, collecting payments and making payments on behalf of them, as well as maintaining and operating deposit accounts of the government
• Can advise the government on finance, including the timing and terms of new loans

Question 86

What is a central bank’s role to commercial banks?

Answer 86

• The Bank of England is considered to be a lender of last resort, meaning if there is no other method to increase the supply of liquidity when it is low, it will lend money to increase this supply
• It might lend to an institution which is risky or close to collapsing, if they have no other way to borrow money, as banks usually avoid this as it suggests to the government they have financial difficulties, so do not display confidence to their depositors
• Can protect individuals who deposit finds in a bank and might otherwise lose them
• Aims to prevent a ‘run on the bank’, which is when consumers all withdraw their bank deposits at once in a panic, as they think the bank will fail

Question 87

What is financial regulation?

Answer 87

Setting limits or restrictions on what banks or financial institutions can do

Question 88

Who regulates the UK banking industry?

Answer 88

The Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)

Question 89

What is the aim of the Financial Policy Committee (FPC)?

Answer 89

To maintain financial stability through macro prudential regulation, by reducing or removing risks that could impact the financial system.

Question 90

What are examples of actions the Financial Policy Committee (FPC) can take?

Answer 90

Restrict the number of risky loans banks can issue, and stress testing