4.2.4 Financial Markets And Monetary Policy Flashcards
Characteristics and functions of money
- medium of exchange
- measure of value
- store of value
- method of deferred payment
Money market
Liquid assets traded in short term
Capital market
Equity and debt instruments are traded. These can then be put into long term use by firms and governments
Foreign exchange market
Where currencies are traded mainly international banks
Broad money
Includes cash but also more illiquid forms of money such as bank deposits, treasury bills, gilts
Narrow money
Cash and short term deposits which can easily be turned into money
Role of financial markets
- to facilitate saving
- to lend to businesses and individuals
- to facilitate exchange of goods
- to provide forward markets in currencies and commodities
- to provide a market for equities
Debt
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
A stock or security which represents interest in owning something e.g. a firm
Why is there an inverse relationship between market interest rates and bond prices
Bonds have fixed interest rates. This means if the real interest rates drop the bond would be worth more since it carries higher interest than current market conditions. The opposite happens if interest rates rise
Coupon rate
The yield paid by a fixed income security
Maturity
The period of time for which the financial asset is outstanding
Yield
The % of the face value which paid each year
How do you calculate the yield
Coupon rate/ face value
Commercial bank
Manages deposits, cheques and savings accounts for individuals and firms
Investment bank
Facilitate the trade of stocks, bonds and other firms of investment. Government regulation is weaker and this combined with their business model gives them a higher risk tolerance
Functions of a commercial bank
- accept deposits
- provide loans
- overdraft
- investment of funds
- agency functions
Liability
Something which must be paid and I’d a claim on assets. They are made up of share capital, deposits, borrowing and reserve funds
Examples of assets
Cash Securities Bills Loans Investments
Objectives of a commercial bank
- liquidity
- profability
- security
Why do banks aim to be liquid but not too liquid?
So that they can quickly give people their money if they need to but holding too much liquid assets means lower profability
Why do banks aim to be profitable but not too profitable?
They need profit to pay their depositors. However if they aim to be too profitable they might not be liquid so safety of the bank is jeopardised
Why do banks aim to be secure but not too secure?
They must be secure to prevent uncertainty but if they are too secure they wont gain profits
Functions of a central bank
Implementation of monetary policy
Banker to the government
Banker to banks
What are the monetary policy instruments
Interest rates
Quantitative easing
Funding for lending
Forward guidance
What is funding for lending
The government introduced a ‘funding for lending scheme’ in the uk due to worsening conditions in the euro area and banks facing higher costs. This meant costs of production were lowered for banks so they could lend money out
What is forward guidance
Used by central bank to detail what the future monetary policy will be to reduce uncertainty
Factors to consider when setting the base rate
Unemployment rate
Savings rate
Commodity prices
Exchange rate
What should happen to interest rates if unemployment is growing
Interest rates should be dropped to encourage spending since spending will be low
What should happen to interest rates if the saving rate is high
Interest rates should drop to incentivise spending
What should happen to interest rates if oil prices suddenly rise?
They should rise because high oil prices will lead to cost push inflation and high interest rates combat this
What should happen to interest rates if the exchange rate depreciates
Should increase interest rates because there’s a net increase in exports
How does a reduction in exchange rate affect macro objectives?
Reduction in XR- weaker pound- cheaper exports- more expensive imports- exports rise- imports fall. Assuming imports and exports are price elastic, the current account deficit would increase. Cost push inflation occurs cos of expensive imports.
Why do governments use regulations and guidelines for banks
To ensure the behaviour of banks is clear to individuals and firms in business with the bank. If they failed it would be a catastrophe
Who regulates UK banking?
Prudential Regulation Authority (PRA)
Financial Conduct Authority (FCA)
Financial Policy Committee (FPC)
What do the PRA do?
Promote safety and stability of banks, building societies, investment firms and credit unions whilst ensuring policy holders are protected
What do the FCA do?
Checks firms are being honest to customers and aim to promote competition which benefits customers
What do the FPC do?
Regulate risk in banking and ensure the financial system is stable. It clamps down on unregulated parts and loose credit
What are reasons for a bank failing?
Moral hazard
Systemic risk
Liquidity and capital ratios
What is moral hazard and how do banks do it
Because banks know the central bank will help them if they fail, they are deliberately risky
What is a systemic risk
The risk of damage of the economy or financial market. It is effectively a negative externality
Liquidity ratio
A measure of how able a company is to pay off short term obligations. The higher the ratio the greater the safety margin of the bank
Capital ratio
A comparison between the equity, capital and risk weighted assets of a bank. A bank’s financial strength is determined using this
Summary of global financial crisis (2008-2009)
Asset prices were high and rising.
There were risky bank loans and mortgages where gov securities were packed with subprime mortgages.
This meant borrowers had poor credit history and after US housing market crashed, several homeowners defaulted in there mortgages. Banks lost huge funds and were reliant on the government
