4.4.3 Financial Markets and Monetary Policy

Question 1

Define Monetary Policy

Answer 1

Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.

Question 2

What does the central bank use to influence the monetary policy

Answer 2

The central bank takes action to influence the manipulation of:
➔ Interest rates
➔ The supply of money/credit
➔ The exchange rate

Question 3

Briefly describe the Monetary Policy Committee (MPC)

Answer 3

• In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and consist of 9 members who meet 8 times a year to discuss what the rate of interest should be.
• Interest rates are used to help meet the government target of price stability and a 2% inflation rate, since it alters the cost of borrowing and reward for saving. The objective of monetary policy, to achieve price stability

Question 4

Outline the base rate in relation to the MPC

Answer 4

The bank controls the base rate, defined as the interest rate set by central banks for lending to other banks. This is used as a benchmark for interest rates set by commercial banks.

Question 5

Outline the functions of the central bank

Answer 5

• The central bank manages the currency, money supply and interest rates in an economy. For example, the European Central Bank (ECB), the Bank of England (BoE) and the People’s Bank of China are all central banks.
• Central banks issue physical cash (notes and coins) securely and use methods to prevent forgery. This is so people trust the money. The central bank can regulate bank lending to ensure there is stability in the financial system

Question 6

Outline Banker to the government

Answer 6

• The central bank provides services to the Central Government. It collects payments to the governments and makes payments on behalf of the government. It maintains and operates deposit accounts of the government. The central bank also manages public debt and issues loans.
• The bank can also advise the government on finance, including the timing and terms of new loans.

Question 7

Outline Banker to the banks - lender of last resort

Answer 7

• The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the BoE will lend money to increase this supply.
• If an institution is risky or close to collapsing, the bank might lend to them. This is when they have no other way to borrow money.
• It can protect individuals who deposit funds in a bank and might otherwise lose them. It also aims to prevent a ‘run on the bank’, which is when consumers all withdraw their bank deposits at once in a panic, because they believe the bank will fail.
• Usually, banks will avoid borrowing from the lender of last resort, because it suggests to the government that the bank is experiencing financial difficulties and won’t display confidence to their depositors.

Question 8

Outline interest rates as an instrument of monetary policy

Answer 8

A reduction in interest rates (i.e. expansionary monetary policy) affects each determinant of Aggregate Demand (C+I+G+X-M), and ALL of these are covered in the A-level specification.

Question 9

Outline how consumer spending is affect by interest rates

Answer 9

• Low interest rates reduce the opportunity cost of saving, because it is cheaper for consumers to borrow from commercial banks.
• Households with variable rate mortgages benefit through lower repayments, which increases disposable income and, as a result, increases their marginal propensity to consume.
• Lower base rates (and therefore interest rates) also increases the number of mortgages taken out by households, so the demand for houses rises. Due to the supply of houses in the UK being PES inelastic, this results in a proportionately larger increase in house prices. This triggers a positive wealth effect, whereby people spend more as they feel richer, which boosts consumption.

Question 10

Outline how investment is affect by interest rates

Answer 10

• Low interest rates mean it is cheaper for firms to borrow from commercial banks, and use these cheap loans to fund R&D or other forms of investment.
• Investment will also increase if consumer spending does, according to Samuleson’s accelerator effect, as investment is a derived demand

Question 11

Outline how government spending is affected by interest rates

Answer 11

Low interest rates mean government debt repayments will be lower, and so will encourage the government to issue more bonds to contribute to higher levels of government spending.

Question 12

Outline how Exports minus imports (X-M) is affected by interest rates

Answer 12

Interest rates affect the amount of hot money flowing into an economy: this being money that flows from different countries in search of the highest interest rates to maximise short-term profits. So a low interest rate would reduce the flow of hot money into the economy, as the rate of return is lower than in other countries. This weakens the exchange rate, as it increases the supply of the £ on FOREX markets - or decreases the demand for
the £ This increases the price competitiveness of exports, as they become cheaper. However, imports become more expensive, and this could mean higher costs of production (and therefore prices), which would eliminate any increase in exports.

Question 13

Define quantitative easing

Answer 13

This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective, i.e. interest rates cannot be lowered any further than their
current rate. It is a non orthodox way of monetary policy

➔ Bank of England electronically creates more money.
➔ It uses this to buy government and bank bonds.

Question 14

Outline the process of quantitative easing

Answer 14

• As banks now have more money, they will naturally lend more to households and firms, thus increasing overall demand which will restimulate the economy. However, this assumes banks will simply not sit on the extra cash the BoE offers them, as they may be concerned about their clients’ abilities to repay loans, like we saw during the 2008 Great Financial Crisis (GFC).
• Now that the central bank has also bought up government bonds (often referred to as gilts), the government has the funds to spend more in the economy, for example on training and education (T&E) or other forms of capital spending, in the hopes of boosting the economy.
• Alternatively, if the BoE wants to initiate in contractionary monetary policy, they will stop the purchase of government and bank bonds. This means banks will hold back on lending to consumers and governments will delay spending on infrastructure, R&D, etc. This will overall reduce the rate of inflation to the BoE’s target of 2% CPI.

Question 15

Outline the limitations of quantitative easing

Answer 15

• As the supply of the £ increases, the UK experiences a depreciation of its currency on FOREX markets. Although this makes exports cheaper, imports become more expensive, and because the UK imports a lot of raw materials from overseas, it could trigger cost-push inflation.
• QE lowers long-term interest rates (i.e. interest rates on bonds), because the supply of money has increased. This makes bonds less attractive to potential investors, as the rate of return is lower, so without anyone buying government bonds, there is less investment in the country which prevents the productive capacity of an economy from expanding

Question 16

Outline funding for lending as unorthodox monetary policy

Answer 16

Moreover, worsening conditions in the Euro area meant that UK banks were faced with higher funding costs. In order to support them, the government introduced the Funding for Lending Scheme, which aimed to lower these costs and provide cheap funding to banks and building societies.

Question 17

Outline forward guidance as an unorthodox monetary policy

Answer 17

• This is used by central banks to detail what the future monetary policy will be to the general public. This is 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.
• For example, Janet Yellon, the former chair of the Federal Reserve, was a strong advocate of forward guidance, and always put it to practice in her years at the central bank. She supported the idea as it reduced the levels of uncertainty amongst investors.

Question 18

Factors considered by the MPC when setting bank rate

Answer 18

● Unemployment rate : if unemployment is high, consumer spending is likely to fall. This suggests the MPC will drop interest rates to encourage more spending.
● Savings rate : if there is a lot of saving, consumers are not spending as much. Interest rates might fall.
● Consumer spending : if there is a high level of spending in the economy, there could be inflationary pressures on the price level. This would cause the MPC to increase interest rates.
● High commodity prices : Since the UK is a net importer of oil, a high price could lead to cost-push inflation. This could push the MPC to increase interest rates to overcome this inflationary pressure.
● Exchange rate : A weak pound would cause the average price level to increase. This makes UK exports relatively cheap, so UK exports increase

Question 19

Define commercial banks

Answer 19

A commercial bank manages deposits, cheques and savings accounts for individuals and firms. They can make loans using the money saved with them.

Question 20

Define Investment banks

Answer 20

Investment banks facilitate the trade of stocks, bonds and other forms of investment. Government regulation is weaker in the investment bank industry, and this combined with their business model gives them a higher risk tolerance.

Question 21

Outline The main functions of a commercial bank

Answer 21

• Accept deposits- Commercial banks accept public deposits, often in the form of savings, for various reasons. They offer different accounts, such as Demand Deposits, Fixed Deposits, and Saving Deposits, to cater to different depositors’ needs. Demand Deposits allow immediate withdrawals, Fixed Deposits store money for long periods, and Saving Deposits offer lower interest rates.
• Provide loans - Commercial banks primarily generate income through interest through loans, which are created using deposited funds. Some loans are secured against assets, while others are cash credit, on demand, or short-term. Banks negotiate with customers, deposit money periodically, and charge interest upon payment. Short-term loans are typically personal or working capital.
• Overdraft - When a current account has no deposits, consumers can still borrow money from the bank in the form of an overdraft. These are at a high interest rate and the amount that can be borrowed is limited.
• Investment of Funds - Surplus funds could be invested into securities such as Government bonds and treasury bills. These could earn a return for the bank.
• Agency Functions - Banks represent their consumers. For example, they collect cheques and dividends, they pay and accept bills, such as through a direct debit, they deposit interest and income tax, buy and sell securities and arrange the transfer of money between places for consumers.

Question 22

The structure of a commercial bank’s balance sheet

Answer 22

Balance sheets show the value of a company’s assets, liabilities and owner’s equity during a period of time. It is usually at the end of a quarter or an annum. A liability is something which must be paid. It is a claim on assets.
An asset is something that can be sold for value. The owner’s equity is also called bank capital and it is what is left over when assets have been sold and liabilities have
been paid. Liabilities are used to buy assets, and income can be earned from these assets. Liabilities are made up of share capital, deposits, borrowing and reserve funds.
Assets are cash, securities and bills, loans and investments

Question 23

The objectives of a commercial bank and potential conflicts between Liquidity

Answer 23

The liquidity of assets is how easy it is to turn the assets into cash. Liabilities are payable on demand, so in order to be profitable banks must have cash and liquid
assets. If liquidity is prioritised, profits will be low, so banks need a balance between the two objectives.

Assets in commercial banks are liquid to different extents. Cash is the most liquid asset, whilst deposits are the next most liquid. Loans and long term bonds are the
least liquid assets in a commercial bank.

If banks can borrow easily and cheaply, they are likely to keep fewer liquid assets. The more expensive and difficult it is to get a loan, the more liquid assets are likely
to be kept.

Question 24

The objectives of a commercial bank and potential conflicts between Probability

Answer 24

Banks need to earn profits to pay their depositors interest, wages and general expenses. Holding a lot of funds in cash means profitability is limited. However,
liquidity and safety are generally prioritised over profitability, which is considered to be a supplementary for the bank’s survival.

Question 25

The objectives of a commercial bank and potential conflicts between Security

Answer 25

Banks face risks and uncertainties about how much cash they can get, and whether loans will be repaid or not. Banks therefore have to try and maintain the safety of
their assets. A bank has to keep high proportions of their liabilities with itself and the central bank. However, following these principles means banks only hold their safest assets, so more credit cannot be created.

This means that banks profits are lower and the bank might lose customers. The bank needs a balance between the risk level and their profits. Too much risk could be harmful.

Question 26

Outline money’s function as a medium of exchange

Answer 26

Without money, transactions were conducted through bartering. Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed. The goods and services exchanged were not always of the same value, which also posed a problem. Exchange could only take place if
there was a double coincidence of wants, i.e. both parties have to want the good the other
party offer. Using money eliminates this problem.

Question 27

Outline money’s function as a A measure of value (unit of account)

Answer 27

Money provides a means to measure the relative values of different goods and services. For example, a piece of jewellery might be considered more valuable than a table because of the relative price, measured by money. Money also puts a value on labour

Question 28

Outline money’s function as a store of value

Answer 28

Money has to hold its value to be used for payment. It can be kept for a long time without expiring. However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.

Question 29

Outline money’s function as a method of deferred payment

Answer 29

Money can allow for debts to be created. People can therefore pay for things without having money in the present, and can pay for it later. This relies on money storing its value.

Question 30

Define The money supply

Answer 30

The money supply is the stock of currency and liquid assets in an economy. It includes cash and money held in savings accounts.

Question 31

Define narrow money

Answer 31

Narrow money is physical currency (notes and coins), as well as deposits and liquid
assets in the central bank.

Question 32

Define Broad money

Answer 32

Broad money includes the entire money supply. Cash could be in restricted accounts, which makes it hard to calculate the money supply. It includes liquid and less liquid assets

Question 33

Define money market

Answer 33

In the money market, liquid assets are traded. It is used to borrow and lend money
in the short term.

Question 34

Define capital market

Answer 34

The capital market is where equity and debt instruments are bought and sold. These can then be put to long-term productive use by firms and governments.

Question 35

Define foreign exchange market

Answer 35

The foreign exchange market is a market where currencies are traded, mainly by international banks. It determines what the relative value of different currencies will be.

Question 36

Outline The role of financial markets in the wider economy

Answer 36

Financial liquid assets are exchanged in a financial market. For example, the stock market and the bond market are two examples of financial markets.

1. To facilitate saving- Financial markets provide somewhere for consumers and firms to store their funds. Savings are rewarded with interest payments from the bank.
2. To lend to businesses and individuals- The transfer of funds between agents is aided by financial markets. The funds can be used for investment or consumption.
3. To facilitate the exchange of goods and services- The transfer of real economic resources is facilitated in a financial market. Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds.
4. To provide forward markets in currencies and commodities- The currency market is another kind of financial market. They are used to trade one currency for another currency. Currencies can have speculative attacks taken on them, which can affect the value of the exchange rate. In commodity markets, investors trade primary products, such as wheat, gold and oil. Future contracts are a method for investing in commodities. This involves buying or selling an asset with an agreed price in the present, but a delivery and payment in the future. A forward market is an informal financial market where these contracts for future
5. To provide a market for equities- Equity markets involve the trade of shares. It is also called a stock market. Equity markets provide access to capital for firms, and allow investors to own part of a market. Returns on the investment, usually in the form of dividends, are based on future performance. A dividend is a share of the firm’s profits.

Question 37

Define debt

Answer 37

Debt is 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.

Question 38

Define equity

Answer 38

Equity is a stock or security which represents interest in owning e.g. a firm, a car or a house. It is when there is no outstanding debt, such as when a loan for a car or a
mortgage has been fully paid off. The owner’s equity is then the car or the house, which can be sold for cash.

Question 39

Regulation of the financial system in the UK

Answer 39

Governments might regulate banks with regulation and guidelines. This helps to ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank. Some economists argue that the banks have a huge influence in the economy; if they
failed it would have huge consequences. Therefore, it is important to regulate the banking industry.

Question 40

Outline different regulatory bodies in the Uk

Answer 40

The UK banking industry is regulated by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The FCA regulates financial firms to
ensure they are being honest to consumers and they seek to protect consumer interests. The FCA also aims to promote competition which is in the interests of consumers. The PRA promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policyholders are protected.

Question 41

Outline the Financial Policy Committee (FPC) as a regulatory body

Answer 41

The Financial Policy Committee (FPC) regulates risk in banking and ensures the financial system is stable. It clamps down on unregulated parts and loose credit. The
committee monitors overall risks to the financial system as well as regulating individual groups.

Question 42

Using the exam of the 2008/2009 Fiancial crash explain why a bank might fail

Answer 42

The Global Financial Crisis is sometimes called The Great Recession, and it refers to the decline in world GDP in 2008-2009. 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 means the borrowers had poor credit histories, and after house prices crashed in the US in
2006, several homeowners defaulted on their mortgages in 2007. Banks had lost huge funds, and required assistance from the government in the form of bailouts.

There are 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.

Question 43

Outline and define Moral hazards

Answer 43

A moral hazard is a situation where there is a risk that the borrower does things that the lender would not deem desirable, because it makes the borrower less likely to
repay a loan. It usually occurs when there is some form of insurance for the mistake.

For example, if a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else. Banks might take more risks if they know the Bank of England or the government can help them if things go wrong. The financial crisis has been regarded as a moral hazard, due to the degree of risk taking.

Question 44

Define and outline systematic risks

Answer 44

Systematic risk in financial markets can be seen as a negative externality. Systematic risks are the risk of damage of the economy or the financial market. For example, it could be the risk of the collapse of a bank. Since this costs firms, consumers, the economy and the market, it is akin to a negative externality.

Question 45

Outline Liquidity ratios and capital ratios and how they affect the stability of a financial institution

Answer 45

• A liquidity ratio is used to determine how able a company is to pay off short-term obligations. The higher the ratio, the greater the safety margin of the bank. When creditors want payment, they look at liquidity ratios to decide whether the bank is a concern.
• A capital ratio is a comparison between the equity capital and risk-weighted assets of a bank. A bank’s financial strength is determined using this. Assets have different weightings, where physical cash has zero risk and credit carries more risk.
• The recent financial crisis showed how having insufficient finance, in either capital or liquidity, can be dangerous. Another risk that comes with this is that investors might assume other banks will fail as well, which reduces confidence.