4.2.4 Financial markets and monetary policy Flashcards
What are the functions of money?
- 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
What is a double coincidence of wants?
When both parties in an exchange have to want the good the other party offers
What are the characteristics of money?
- 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
What is the money supply?
The stock of currency and liquid assets in an economy, including cash and money held in savings accounts
What is narrow money?
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
What is broad money?
Consists of the entire money supply, including physical currency, deposits and liquid assets, as well as less liquid assets
What is a money market?
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
What is a capital market?
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
What are examples of bills traded in a money market and how liquid are they?
Commercial bills and treasury bills, which are both very liquid
What are commercial bills?
Unsecured short term debt instruments that private firms use to ensure they have enough cash to cover operating costs, and often mature overnight
What are treasury bills?
US government debt securities with a maturity of less than a year
What do money markets provide for banks?
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
What is an example of a capital market?
The London Stock Exchange
What enables a government to run a budget deficit?
Government bonds, gilts
How do PLC’s (public limited companies) raise medium to long term finance?
Shares or corporate bonds
What is maturity?
The period of time for which the financial asset is outstanding, so one that has matured has finished and been repaid
What is a coupon?
An annual interest payment to the bond holder between the date of issue and the date of maturity
How is yield calculated?
(Coupon) / (market price) x 100
What happens to the yield from a bond as its market price increases?
Yield decreases as bond price increases
What are primary markets?
Where bonds and shares are initially sold
How are bonds and shares initially sold in a primary market?
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
What are secondary markets?
Where existing financial securities, such as bonds and shares, are bought and sold, for example the London Stock Exchange
What is the purpose of secondary markets?
- 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
What are foreign exchange markets?
Where currencies are traded, mainly by international banks, and determines the relative value of different currencies will be
What is the difference between a spot rate and a forward rate in a foreign exchange market?
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
What is the role of financial markets in the wider economy?
- 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?)
What are dividends?
Returns on an investment, in the form of a share of the firm’s profits
What is the difference between debt and equity?
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.
Why is there an inverse relationship between market interest rates and bond prices?
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.
How can firms raise finance?
By issuing shares, corporate bonds, or borrowing from a bank
What are the advantages of the methods of firms raising finance?
- 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
What are the disadvantages of the methods of firms raising finance?
- 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
What are corporate bonds?
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
What is the difference between a commercial bank and an investment bank?
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.
What are the main functions of a commercial bank?
- 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
How do commercial banks accept deposits from the public?
Usually in the form of savings, which those on low incomes do for security, whilst firms do it for convenience.
What are the different types of deposits commercial banks offer, and how are they different?
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
What is the main source of income for commercial banks?
Interest, earned through providing loans
Why are some loans secured against an asset, such as a house?
To protect the bank’s funds if the loan is not repaid
What are the different types of loans offered by commercial banks, and how do they differ?
- 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
What is an overdraft?
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
How can commercial banks invest funds and why?
Surplus funds can be invested into securities such as government bonds and treasury bills, which could earn a return for the bank
What is a balance sheet?
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
What is a liability?
Something owed which must be paid, and is a claim on assets, so is used to buy assets
What is an asset?
Something owned that can be sold for value
What is a firm owner’s equity and what is it also known as?
It is what is left over when assets have been sold and liabilities have been paid, also called bank capital
What can be earned from assets?
Income
What are liabilities made up of?
Deposits, shareholder capital, borrowing and reserve funds (retained profit)
What are examples of assets?
Cash, securities and bills, loans and investments
What are examples of a bank’s assets in order of most liquid to least liquid?
- Cash - notes and coins
- Balance at the Bank of England
- Money at short call notice - overnight maturity
- Bills - commercial and treasury
- Investments - government and corporate bonds
- Advances - loans and mortgages
- Fixed assets - buildings
What are the objectives of a commercial bank?
- Liquidity
- Profitability
- Security
What is liquidity?
How easy it is to turn assets into cash without suffering a loss
What is profitability?
The ability to make revenue that exceeds the total cost
What is security?
How safe a bank’s assets are
What are the possible conflicts between the objectives of a commercial bank?
- 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.
How do banks create credit?
By using deposited funds as loans, with each loan resulting in the creation of an advance and a deposit
What is an advance?
An asset on a bank’s balance sheet
Why do banks need to earn profits?
To pay their depositors interest, shareholders dividends, as well as wages and general expenses
Why do banks need high liquidity?
Liabilities are payable on demand, so in order to be profitable banks must have cash and liquid assets
Why might banks aim for high security?
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.
Why is there a trade off between liquidity and profitability?
In general, assets which are liquid aren’t profitable, such as cash, and assets which are illiquid are very profitable, such as mortagages
What are banks likely to do if they can borrow easily and cheaply?
Keep fewer liquid assets
What are banks likely to do if it is expensive and difficult for them to get a loan?
Keep more liquid assets
What is a deposit to a bank?
A liability
What are the main functions of a central bank?
- 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
What is monetary policy?
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
What are the current objectives of monetary policy set by the government?
Price stability and a 2% inflation rate
What is the role of the Monetary Policy Committee of the Bank of England (MPC)?
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
What is the base rate?
The interest rate set by central banks for lending to other banks, used as a benchmark for interest rates set by commercial banks
How does increasing the base rate lead to price stability through decreasing demand-pull inflation?
- 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
How does increasing the base rate lead to price stability through decreasing cost-push inflation?
Exchange rate increases, decreasing the number of exports and cost of imports, therefore decreasing the costs for raw materials/ commodities, decreasing inflation
What does contractionary monetary policy involve?
Increasing the base rate and decreasing the money supply
What does expansionary monetary policy involve?
Decreasing the base rate and increasing the money supply
What factors are considered by the MPC when setting the bank rate?
- 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
Describe the demand-side monetary policy transmission mechanism if the base rate is decreased.
Domestic demand increases due to increased consumption, due to:
- 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.
Describe the supply-side monetary policy transmission mechanism if the base rate is decreased.
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.
What does the effect of lowering interest rates on inflation and growth depend on?
- 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
What is quantitative easing?
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
Why might quantitative easing be used?
When standard monetary policy is no longer effective, such as if interest rates cannot be lowered any further than their current rate
Explain the effects of quantitative easing.
- 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
What is a bond?
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
What is funding for lending?
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.
What is forward guidance?
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.
What is a liquidity trap?
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.
What is a central bank’s role to the government?
- 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
What is a central bank’s role to commercial banks?
- 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
What is financial regulation?
Setting limits or restrictions on what banks or financial institutions can do
Who regulates the UK banking industry?
The Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)
What is the role of the Financial Policy Committee (FPC)?
To ensure financial system stability through macro prudential regulation, regulating risk in banking, by clamping down on unregulated parts and loose credit
What are examples of actions the Financial Policy Committee (FPC) can take?
- Restrict the number of risky loans banks can issue
- Stress testing, determining if a bank has enough capital to withstand a negative economic shock
What is the role of the Prudential Regulation Authority (PRA)?
To promote the safety and stability of banks, building societies, investment firms and credit unions through micro prudential regulation
What are examples of actions the Prudential Regulation Authority (PRA) can take?
Set liquidity ratio and capital ratio policies
What is a liquidity ratio?
The ratio of a bank’s liquid assets to its short term liabilities, determining how able it is to pay off short-term obligations
What does a high liquidity ratio indicate?
The bank has a greater safety margin
Why might the PRA set a high liquidity ratio for banks?
The higher the ratio, the greater the safety margin of the bank, so it will be more able to pay off short-term obligations
Why is a bank’s liquidity ratio important?
It determines how able it is to pay off short-term obligations, so when creditors want payment, they look at liquidity ratios to decide whether the bank is a concern
What is a capital ratio?
The ratio of a bank’s equity capital to its risk-weighted assets, determining its financial strength
What is the role of the Financial Conduct Authority (FCA)?
- To protect consumer interests by regulating financial firms to ensure they are being honest to consumers
- To promote fair competition between banks in the interests of consumers
What are examples of actions the Financial Conduct Authority (FCA) can take?
- Regulate information failure, such as investigating PPI, which was mis-sold to consumers, resulting in large fines for banks involved
- They have made it easier to switch current accounts
What does the Global Financial Crisis refer to?
The decline in world GDP in 2008-2009
Describe the Global Financial Crisis.
- Before the crash, asset prices were high and rising, and there was a boom in economic demand
- There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages
- This meant borrowers had poor credit histories, and after house prices crashed in the US in 2006, homeowners defaulted on their mortgages in 2007
- Banks lost huge funds and required assistance from the government in the form of bailouts
Why might a bank fail?
- Subprime assets, such as the GFC where government securities were backed by subprime mortgages
- Long term lending
- Short term borrowing
Why are there risks involved with lending long term and borrowing short term?
They might lose money on investments, and if there are insufficient funds in a vault, banks might not be able to provide depositors with money when it is demanded
Why should financial markets be regulated?
- To prevent or mitigate systemic risk
- To protect consumers
What is a moral hazard?
A situation where there is a risk that the borrower does things that the lender would not deem desirable, as it makes the borrower less likely to repay a loan.
When does a moral hazard usually occur?
When there is some form of insurance for the mistake.
What is an example of a moral hazard?
If a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else.
Why might banks engage a moral hazard and take more risks?
If they know the Bank of England or the government can help them if things go wrong.
What is an example of a moral hazard in the financial system?
The Global Financial Crisis, due to the degree of risk taking taken by banks.
What is a systemic risk?
A risk of damage to the economy or the financial market.
What is an example of a systemic risk?
The risk of the collapse of a bank, which could result in a knock-on effect causing damage to the entire financial system.
What is a systemic risk an example of?
A negative externality.
Why can a systemic risk be seen as a negative externality?
It results in a cost for firms, consumers, the economy, and the market, which are considered third parties.
