4.2.4- Financial Markets And Monetary Policy

Question 1

Define the function of money

Answer 1

Is a benefit generated by the use of money

Question 2

Explain the key functions of money (4)

Answer 2

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.

Question 3

What are the key characteristics of money (6)

Answer 3

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

Question 4

Explain money markets

Answer 4

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.

Question 5

Explain capital markets

Answer 5

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.

Question 6

Explain currency markets

Answer 6

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.

Question 7

Define the money supply

Answer 7

Is the value of the stock of money that exists within an economy at a point in time.

Question 8

Explain the forms of money supply (4)

Answer 8

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Bank accounts- money kept in a bank current account , that can be withdrawn on request.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

Question 9

Define narrow money

Answer 9

Consists of cash and bank current accounts. Can be immediately drawn upon and fulfil the functions of money.

Question 10

Define broad money

Answer 10

Consists of all the components of money, used by central banks to indicate the willingness of consumers and firms to borrow and spend money.

Question 11

Explain the role of financial markets in the economy (4)

Answer 11

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.

Question 12

Define Equity

Answer 12

Refers to the value of share capital issued by firms, in order to fund business activities. Shareholders receive dividends.

Question 13

Define Bonds

Answer 13

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).

Question 14

Give the formula for the yield on Bonds

Answer 14

Coupon value / Current market price x 100%

Question 15

Explain the relationship between bonds and interest rates

Answer 15

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

Question 16

Explain the process of Quantitative Easing

Answer 16

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.

Question 17

How can Quantitative easing boost aggregate demand (4)

Answer 17

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.

Question 18

Explain the criticisms of Quantitative easing (5)

Answer 18

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.

Question 19

Define a Commercial bank

Answer 19

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

Question 20

State the functions of a commercial bank (4)

Answer 20

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

Question 21

Define a balance sheet

Answer 21

Financial document showing the assets and liabilities of an organisation

Question 22

Explain the assets on a commercial banks balance sheet (7)

Answer 22

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

Question 23

Explain the liabilities on a commercial bank’s balance sheet (5)

Answer 23

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

Question 24

Explain the objectives of a commercial bank (3)

Answer 24

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

Question 25

Define an investment bank

What services do they provide

Answer 25

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

Question 26

Explain fractional banking

Answer 26

Occurs where a commercial bank creates money by lending out customers deposits and holding a fraction of the deposit in liquid form

Question 27

Explain Liquidity as a form of bank failure

Explain the Liquidity ratio

Why is it done

Answer 27

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)

Question 28

Explain Insolvency as a form of business failure

How is it prevented

Answer 28

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

Question 29

Explain Bail out as a policy response to bank failure

Benefits and drawbacks

Answer 29

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

Question 30

Explain Nationalisation as a policy response to bank failure

Benefits and drawbacks

Answer 30

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

Question 31

Explain acquisition by a larger bank as a policy response to bank failure

Benefits and drawbacks

Answer 31

Acquired by a larger bank who clears debts and runs the firm

A
Prevents bank run
Increased efficiency

D
Potential for monopoly power

Question 32

Explain the free market solution as a policy response to bank failure

Benefits and drawbacks

Answer 32

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

Question 33

Define a Central Bank

Answer 33

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

Question 34

Explain the function of the central bank (4)

Answer 34

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

Question 35

Define monetary policy

Answer 35

Involves the manipulation of the price and availability of money within an economy to influence levels of consumer spending an aggregate demand

Question 36

Explain the aim of monetary policy (2)

Answer 36

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.

Question 37

Define the bank rate

Answer 37

Is the interest rate set by the Bank of England that affects interest rate set by banks in the economy

Question 38

Define the monetary policy committee

How does the MPC set interest rates

Answer 38

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

Question 39

Explain the effect interest rates have on other objectives

Answer 39

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

Question 40

Explain the limitations of using interest rates to control the economy (5)

Answer 40

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

Question 41

Explain the relationship between interest rates and exchange rates

Answer 41

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

Question 42

Explain the transmission mechanism

How will a change in the interest rate affect the transmission mechanism

Answer 42

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

Question 43

Explain the funding for lending scheme

Answer 43

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

Question 44

Define forward guidance

Answer 44

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

Question 45

Define macro prudential regulation

Answer 45

Involves identifying, monitoring and acting on risks which fits in the whole financial system of an economy

Question 46

Define Micro Prudential regulations

Answer 46

Involves identifying, monitoring and acting on risks to individual banks and firms

Question 47

Explain the Prudential Regulation Authority (PRA) in terms of regulating the financial system

Answer 47

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

Question 48

Explain the Financial Policy Committee (FPC) in terms of regulating the financial system

Answer 48

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

Question 49

Explain the Financial Conduct Authority (FCA) in terms of regulating the financial system

Answer 49

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

Question 50

Explain the issues with regulation (4)

Answer 50

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