4.2.4- Financial Markets And Monetary Policy Flashcards
Define the function of money
Is a benefit generated by the use of money
Explain the key functions of money (4)
Medium of exchange- money allows goods and services to be traded without the need for a barter system, which relies on a double coincidence of wants, separating the two sides of a barter transaction.
Store of value- assets value can be used now or in the future, people can save now to fund spending at a later date.
Unit of account- describes the way in which the value of something can be expressed in an understandable way, allowing the value of items to be compared.
Standard of deferred payment- money links different time periods when it comes to borrowing and saving, expressing the value of debt.
What are the key characteristics of money (6)
Durability (needs to last)
Portable (convenient and easy to carry around)
Divisible (can be broken down into smaller denominations)
Acceptable to all
Valuable (holds value over time)
Difficult to forge
Explain money markets
Are for short term loan finance for businesses and households, money is borrowed and lent for up to 12 months. This includes inter bank lending and short term government borrowing.
Explain capital markets
Are for long term loan finance, where shares and bonds are issued to raise long term financing. Includes raising finance by the government through the sale of long term government bonds.
Explain currency markets
Are ones where currencies are traded. Gains or losses are made from the movement of exchange rates, with spot exchange rates to be delivered now and forward exchange rates to be delivered in the future.
Define the money supply
Is the value of the stock of money that exists within an economy at a point in time.
Explain the forms of money supply (4)
Cash - notes and coins which are legally accepted as a means of payment, issued by the bank of England.
Bank accounts- money kept in a bank current account , that can be withdrawn on request.
Near Monies- are assets that can be converted into a medium of exchange quickly and at little cost, liquidity
Non-monetary financial assets- financial assets that can be converted into money, but comes with a long waiting time and considerable loss of money, impairing their function as units of account and stores of value
Define narrow money
Consists of cash and bank current accounts. Can be immediately drawn upon and fulfil the functions of money.
Define broad money
Consists of all the components of money, used by central banks to indicate the willingness of consumers and firms to borrow and spend money.
Explain the role of financial markets in the economy (4)
To facilitate saving by businesses and households- offering a secure place to hold money and earn interest.
To lend to businesses and individuals- banks provide an intermediary between savers and borrowers
To allocate funds to productive uses- financial markets allocate capital to where the rate of return is highest.
To provide a market for equities- allows businesses to raise finance to fund capital investment and expansion.
Define Equity
Refers to the value of share capital issued by firms, in order to fund business activities. Shareholders receive dividends.
Define Bonds
Are issued by governments that wish to borrow money, paying a fixed rate of interest (coupons) and have a fixed date when the original value of the bonds is to be repaid (maturity date).
Give the formula for the yield on Bonds
Coupon value / Current market price x 100%
Explain the relationship between bonds and interest rates
Interest rates determine whether people invest in bonds or save their money in bank accounts. There is an inverse relationship between bond prices and market interest rates, when the price of a bond increases the interest rate will fall ,leading to a lower yield
Explain the process of Quantitative Easing
The Bank of England creates new money which is used to buy government and commercial bonds. It is hoped that this will help to raise finance for firms without directly approaching banks and that it will stimulate spending and generate short run economic growth
Increases the money supply through the sale of government bonds to increase liquidity within the economy and therefore encourage borrowing.
How can Quantitative easing boost aggregate demand (4)
Improves the liquidity of commercial banks - during the 2008 recession commercial banks purchased illiquid government bonds, that there was no demand for, by printing money. The cash allowed banks to make loans, increasing AD.
Higher bond prices leading to a lower interest rate - central banks use QE to buy government bonds, raising bond prices. This causes bond yields to fall (making them less attractive), allowing banks to cut interest rates as they compete for saving with bonds. This increases borrowing and consumption.
Rising asset prices and wealth effects - QE causes the price of other assets to rise. For example, commercial banks used cash to make mortgage loans, increasing demand and causing house price inflation. Rising asset prices increases the wealth for households who hold assets, improving consumer confidence and consumption.
Currency depreciation - QE leads to inflation, weakening the demand for UK currency. A weak pound makes exports cheaper, increasing AD.
Explain the criticisms of Quantitative easing (5)
Rising income and wealth inequality - QE leads to increased asset prices, richer people are more likely to own assets. QE has also made the cost of living higher, pay increases have not been matched to the level of inflation leading to many seeing a decrease in real wages.
Effect on private pensions - pension firms use consumer received money to buy bonds. QE has led to very low interest rates, decimating the value of pension funds and leading to lower living standards in the future.
Lowered consumer confidence- loose monetary policy has led to uncertainty, reducing consumption and AD
Bursting of speculative bubbles - QE allows cheap and plentiful access to credit, meaning asset prices are being driven by increases in demand. A sudden drop in asset prices will lead to huge losses and a recession.
Zombie firms and households - QE has prevented creative destruction, allowing inefficient firms to survive, leading to lower economic growth. Has also lead to a high amount of debt undertaken by households, due to borrowing, leading to a large % of income spent on repayments, reducing consumption and AD.
Define a Commercial bank
Are the banks that most people use on a daily basis , they accept deposits from and lends money to customers, for personal and business loans
State the functions of a commercial bank (4)
Accept deposits from customers who wish to securely and conveniently store their money
Licensed to lend money to economic agents who wish to borrow
Are profit seeking so rely on achieving a higher interest rate on loans than they pay out in deposits
Provide an efficient means of payment
Define a balance sheet
Financial document showing the assets and liabilities of an organisation
Explain the assets on a commercial banks balance sheet (7)
Notes and coins- liquid assets held on premises
Balances held at the bank of england
Money at call and short notice - money borrowed from other banks on the interbank market to meet short term needs
Bills - assets than can be turned into cash quickly
Investments - bonds or shares held by the bank to generate income
Advances - loans made to customers who pay interest
Tangible fixed assets - physical assets a bank uses to perform it’s activities, premises
Explain the liabilities on a commercial bank’s balance sheet (5)
Share capital - issued to banks to finance activities when first formed or during major expansion
Reserves - profit generated to be put back into the business for growth rather than to shareholders
Long term borrowing - bonds a bank has issued to finance operations
Short term borrowing - money borrowed from the money markets for shortfalls in cash
Deposits - pay interest to customers for storing money in the bank
Explain the objectives of a commercial bank (3)
Liquidity - Banks need to manage assets effectively and be liquidable in order to meet the requirements of its customers, if not they will have to borrow money and pay interest from financial markets
Profitability - We want to make profit for each shareholders by lending out money to borrowers in order to earn interest
Security- Thanks take risks when lending money so charge higher interest rates to rescue loans to compensate
Define an investment bank
What services do they provide
Is one that does not accept customer deposits and normally provides financial services to businesses
Advise on security issues and capital raising
Advise on mergers, acquisitions and corporate restructuring
Trade on capital markets on a firm’s behalf
Corporate research and private equity investments
Explain fractional banking
Occurs where a commercial bank creates money by lending out customers deposits and holding a fraction of the deposit in liquid form
Explain Liquidity as a form of bank failure
Explain the Liquidity ratio
Why is it done
Is the ratio of liquid assets held by a bank on their balance sheet to their total assets. Banks need to hold enough to cover expected demand from depositors
Done to give confidence to consumers and prevent bank runs (where customers try to withdraw all their money)
Explain Insolvency as a form of business failure
How is it prevented
Occurs where a bank’s assets are worth less than their liabilities.
Capital ratio’s were introduced to ensure banks have more non risky assets than risky assets in order to be more solvent in the event of a banking crisis
Explain Bail out as a policy response to bank failure
Benefits and drawbacks
Involves the government clearing the debts of banks
A:
Prevents a bank run
Prevents customers losing their savings, preventing a recession
D:
Causes moral hazards where banks feel they can get away with failure cause they will get bailed out.
Leads to large national debt as the government have to borrow in order to bail out
Explain Nationalisation as a policy response to bank failure
Benefits and drawbacks
Involves the government taking control of ownership of the bank
A
Leads to more of an efficient service
Less likely to fail as they are not profit maximisers
D
Run for a political purpose rather than productive
Explain acquisition by a larger bank as a policy response to bank failure
Benefits and drawbacks
Acquired by a larger bank who clears debts and runs the firm
A
Prevents bank run
Increased efficiency
D
Potential for monopoly power
Explain the free market solution as a policy response to bank failure
Benefits and drawbacks
Leave the bank to fail in order to prevent inefficient banks from surviving
A
No national debt
D
Bank run
Customers lose all savings
No trust in banks and governments
Define a Central Bank
Is the bank of an economy, usually owned by the government, who are responsible for the issue of money and management of monetary policy, by printing money and ensuring the stability of the financial system
Explain the function of the central bank (4)
Financial stability- acts as a lender of last resort to the banking sector, providing money for short term needs and regulating the financial market
Issue money – has a responsibility for ensuring people have faith in notes which are printed and to control the rate of inflation
Lender of last resort to the government – can buy government bonds in shortages to avoid a falling confidence and allowing governments to borrow at a lower interest rate
Operate monetary policy - change interest rates in order to target low rates inflation and other macroeconomic targets
Define monetary policy
Involves the manipulation of the price and availability of money within an economy to influence levels of consumer spending an aggregate demand
Explain the aim of monetary policy (2)
Low Inflation - is considered an important factor in enabling higher investment in the long term, the UK target is 2%
Stable economic growth - want to maintain a sustainable rate of economic growth and keep unemployment low.
Define the bank rate
Is the interest rate set by the Bank of England that affects interest rate set by banks in the economy
Define the monetary policy committee
How does the MPC set interest rates
Is independent and is responsible for setting interest rates to try and meet the governments inflation target
Considers a range of economic factors that will impact the inflation rate – consumer confidence and consumption, business confidence and investment, fiscal policy, exchange rate, commodity prices and unemployment
If the MPC expect higher inflation and growth they will increase interest rates, leading to lower aggregate demand and less pressure on demand pull inflation
Explain the effect interest rates have on other objectives
There will be a policy conflict when increasing the interest rate in order to lower inflation – higher unemployment caused by a lack of spending, lower short-term economic growth, lack of supply-side growth, lower tax revenue collected and reduced exports due to a rise in the exchange rate
Explain the limitations of using interest rates to control the economy (5)
Not useful in controlling rises in cost push inflation due to its limited affect on aggregate supply
Have time lags in their effectiveness
Have uncertain effects
Further cuts in the interest rate may not be possible
Changes have to be large in order to have a significant effect
Explain the relationship between interest rates and exchange rates
Arise in the interest rate is likely to lead to a rise in the value of the pound, due to a high interest rate attracting flows of short-term money to save
The higher the value of currency put a downward pressure on cost push inflation as the price of imported goods will be lower
Explain the transmission mechanism
How will a change in the interest rate affect the transmission mechanism
Explains how a change in policy actually works through the economy to effect macro economic indicators
Financial institutions will react by changing their interest rates they charge to lenders, affecting those who wish to borrow, causing a change in asset prices and wealth affects.
The exchange rate will be affected, a higher interest rate would lead to a higher exchange rate as there becomes a demand for saving
Households with variable rate mortgages will see their monthly repayment change
Consumers who are looking to borrow money to finance consumption will be affected and the opportunity cost saving will be altered
Businesses planning for investment may change that approach
Explain the funding for lending scheme
Was introduced by the Bank of England and Treasury in order to boost bank lending to generate more loans and as a result more economic activity. Involves banks approaching the Bank of England to swap assets for Treasury bills, very liquid assets. This will increase lending for commercial banks
Define forward guidance
Are announcements made by the central bank as to the likely future direction of monetary policy in advance of actual changes, done to make it easier for households and businesses to plan their investment and spending decisions
Define macro prudential regulation
Involves identifying, monitoring and acting on risks which fits in the whole financial system of an economy
Define Micro Prudential regulations
Involves identifying, monitoring and acting on risks to individual banks and firms
Explain the Prudential Regulation Authority (PRA) in terms of regulating the financial system
Is responsible for the supervision of banks and building societies and set standards for these organisations to follow. They insure institutions will maintain certain capital and equity ratios and will allow institutions to fail, only if it does not affect the overall financial system
Explain the Financial Policy Committee (FPC) in terms of regulating the financial system
Identifies, monitors and takes action to remove systematic risks, risks that could affect the whole financial system, and take action to make it more robust. They make recommendations to banks if they feels they are at risk of failure
Explain the Financial Conduct Authority (FCA) in terms of regulating the financial system
Is funded by financial institutions at a fee, to protect consumers and ensure healthy competition between institutions. It has the power to regulate if institutions are not acting properly and investigate banks
Explain the issues with regulation (4)
Restricts economic activity
May divert financial institutions to other countries
Regulation requires time and money to plan and implement
Unintended consequences are likely - a shadow banking sector
