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Economics - Chapter 8 > Chapter 12 > Flashcards

Chapter 12 Flashcards

1
Q

What are the 6 characteristics of money?

A

Acceptable
Durable
Divisible
Portable
Scarce
Difficult to forge

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2
Q

What are the 4 functions of money?

A

Medium of exchange
Store of value
Unit of account
Standard of deferred payment

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3
Q

Define narrow money

A

The notes and coins in circulation + balances held at a central bank (very liquid). Are immediately accessible

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4
Q

Define broad money

A

The things making up narrow money + assets that are less liquid. Not always immediately accessible. Important measure of economic activity i.e. shows willingness of households to borrow and spend money

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5
Q

What are the 3 financial markets?

A

The money market
The capital market
The foreign exchange market

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6
Q

Explain the money market

A

Provides short term finance to banks, companies, govs and individuals
Deals with very short term loans.
Short term debt has a maturity of up to a year
Covers interbank lending and treasury bills

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7
Q

Explain the capital market

A

Deals with medium-to-long term lending to firms and govs.
Firms can raise finance by issuing bonds, shares or by borrowing from banks.
Capital market is split into:
- Primary market (for issue of new securities i.e. bonds and shares)
- Secondary market (trade in already issued bonds and shares i.e. stock markets)

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8
Q

Explain the foreign exchange market

A

Where different currencies are bought and sold
Is done to allow international trade and investment or as speculation (make profit from fluctuations in currency prices)
Market can be split into 2:
- Spot Market = immediate conversion between currencies
- Forward Market = agreement to buy foreign currency at a specified later date

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9
Q

What is the spectrum of liquidity, from most to least?

A

Notes and coins = approx. 2% of the UK money supply
Bank current accounts = Accessible through cash machines, cheques, debit cards etc
Bank savings accounts = Usually instant access but access may be limited
Building society accounts = Similar to banks but used more often for savings
Other financial assets = Shares, bonds, bills, which can be converted into cash but not necessarily at face value

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10
Q

Define the term money supply

A

The value of the stock of money in an economy

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11
Q

Define the term treasury bills

A

Short-term debt borrowed by govs, usually repaid within 3 months

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12
Q

What do financial markets do?

A

Move money from people with a surplus (savers) to those with a shortage (borrowers)

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13
Q

What do financial markets enable?

A

Individuals and firms to borrow
Gov to finance budget deficits
International trade to occur

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14
Q

What are the features of equity?

A

Is the share capital issued by firms.
Shares are sold to investors (shareholders) wishing to ‘own’ part of the business. Shares can be traded
Investors buy shares to make capital gains and to receive dividends
Shareholders can vote at business meetings
Share prices rise and fall depending on investors’ views on firm’s future performance (in terms of profits)

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15
Q

Define the term equity (in the financial sense)

A

Equity finance is raised by selling shares in a company. The person buying the shares becomes a shareholder and the shareholder gains profits in the form of dividends.

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16
Q

Define the term bonds

A

Debt issued by firms and govs that pays a fixed rate of interest and matures at a set date

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17
Q

What are the features of bonds (debt)?

A

Bonds are issued by firms and govs wishing to borrow
Bonds pay a fixed rate of interest (the coupon) and have a fixed date of repayment (the maturity date)
Have a lifespan of typically 10 years
Gov bonds are also called gilts
Business bonds are also called debentures

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18
Q

What are corporate (business) bonds?

A

Debt security issued by a company and sold to people who lend long term to the company. They can be resold second hand on the stock exchange

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19
Q

What are gov bonds?

A

Debt security issued by gov and sold to people who lend long term to the gov. They can be resold second hand on the stock exchange

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20
Q

What is the relationship between market interest rates and bond prices?

A

Bonds are traded in the (secondary) capital market.
Bond prices are closely connected with the level of current (market) interest rates
An inverse relationship exists between bond prices and current market interest rates

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21
Q

What is bond yield?

A

The interest paid on the bond ( this process is called the coupon), as a percentage of the current price of the bond.

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22
Q

How do you calculate bond yield?

A

Coupon/ Market price x 100

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23
Q

Define the term commercial bank

A

A bank that accepts deposits for the public and lends money to those wishing to borrow

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24
Q

Define the term investment bank

A

A bank that provides financial services for firms and govs but doesn’t accept deposits from the public

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25
Q

Explain the 2 features of a commercial bank

A

Used by public who open accounts with these.
Will lend to public as loans, overdrafts and mortgages

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26
Q

Explain the functions of commercial banks

A

They move money from those with surpluses to those with shortages by:
1. Accepting deposits from customers wishing to save
2. Lending to individuals and businesses wishing to borrow
3. Providing an efficient means of payments

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27
Q

What makes up the balance sheets of commercial banks?

A

Assets and Liabilities

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28
Q

Explain assets in terms of the balance sheets of commercial banks

A

Notes and coins
Balances are held at the Bank of England
Money at call/short notice - held for short periods of time (i.e. overnight)
Bills (commercial and Treasury) - short term debts issued by businesses/govs
Investments - shares and bonds issued by other companies/govs
Advances - amounts lent to businesses and individuals
Tangible non-current assets - physical assets of the bank (i.e. bank premises)

29
Q

Explain liabilities in terms of the balance sheets of commercial banks

A

Share capital - finance raised to start up or to expand
Reserves - profits reinvested into the bank
Long-term borrowings - bonds issued by the bank to raise finance
Short-term borrowings - amounts borrowed on the money markets to provide liquidity when the ban is short of money
Deposits - amounts placed in the bank by customers

30
Q

What are the objectives of commercial banks?

A

Banks aim to maximise profits to satisfy shareholders
Key objectives are divided into 3 areas -
1. Liquidity = Ensuring sufficient quantities of notes and coins to meet demand of customers
2. Profitability = Earning profits from lending money at a rate of interest
3. Security = Managing the risk of lending money out to minimise the chances of debts not being collected

31
Q

How are liquidity and profitability conflicting aims?

A

Holding notes and coins improves liquidity
Holding notes and coins is not a profitable activity
Lending money generates profits, but reduces liquidity

32
Q

Explain credit creation

A

Bank customers are unlikely to withdraw all the money.
Banks only need to hold a small amount of money deposited in liquid form (fractional banking)
Banks can create credit by lending money to customers wishing to borrow. Money lent out to customers is then redistributed in the banking system and then lent out again.
Credit creation is only limited by the amount banks wish to hold in liquid form.

33
Q

Explain the central banks and monetary policy

A

Central banks manage monetary policy for a country.
The UK’s central bank is the Bank of England.
It’s main functions are:
- to maintain financial stability
- to assist the gov in maintaining macroeconomic stability

34
Q

Explain financial stability

A

The Bank of England ensures financial stability by acting as a ‘lender of last resort’ - providing money for short-term needs to the banking sector if needed.
This helps ensure the banking system doesn’t run out of money and fail = became very important in the 2008 financial crisis

35
Q

Define the term central bank

A

A bank responsible for a currency and managing monetary policy in an economy

36
Q

Define monetary policy

A

Managing the price of money and the money supply for an economy

37
Q

Define the term bank rate

A

The interest rate set by the Bank of England which influences all other interest rates in the economy

38
Q

Explain macroeconomic stability

A

Main feature of the monetary policy is the setting of interest rates (the Bank rate)
Other aspects of monetary policy include:
Size of money supply
Availability of credit
Exchange rate

The bank of England sets interest rates independently of UK gov influence.

39
Q

What are the objectives of monetary policy?

A

Inflation target (measured by changes in CPI) of 2% per year (+- 1%)
Achieving the inflation target through changes in the bank rate, decided by the Monetary Policy Committee (MPC)
Full employment and steady economic growth

40
Q

What is the Monetary Policy Committee?

A

The MPC consists of the Bank of England employees and outside experts

41
Q

What are the factors affecting future inflation, that the MPC considers when setting interest rates?

A

Consumer spending/confidence
Business investment/confidence
Fiscal stance (i.e. current tax rates and gov spending)
Exchange rate
Commodity prices
House prices
Labour market and wage rates

NOTE: The MPC decide if interest rates need to change.

42
Q

How long is the time lag between interest rate changes and changes in inflation?

A

Up to 2 years

43
Q

What are interest rate decisions based on?

A

Expected increases in inflation mean interest rate rises are more likely.
Expected falls in inflation (or deflation) mean interest rate reductions are more likely)
Interest rate changes significantly affect AD (and have minor effects on AS)

44
Q

Explain interest rates and the exchange rate

A

Changes in interest rates can affect the exchange rate:
Higher interest rates attract speculative flows of hot money
Increased demand increases the currency’s value (and vice versa)
The link depends on expectation;
if interest rate changes are expected, then the exchange rate may not change when the interest rate changes.

45
Q

Define the term hot money

A

As people buy more pounds to save in British banks, raising its value.

46
Q

Define the transmission mechanism

A

The process of how a change in policy affects macroeconomic indicators and variables in the economy

47
Q

What affects does a rise in the Bank rate have?

A

Interest rates charged by banks and other lenders will rise, which has the following effects on AD;
- Consumers are more likely to save, and less likely to borrow and spend
- Households with mortgages are repaying more each month
- Business investment falls as the profitability of borrowing money to expand/invest will fall, given the higher cost of borrowing
- Asset prices are affected (bond prices will fall and this may also lead to falling share prices), which has a negative wealth effect on consumption
- The exchange rate will often rise, which leads to a fall in export volumes
- A rise in the exchange rate also leads to lower import prices, which increases imports
= all these effects will mean that AD falls

48
Q

How does increasing interest rates also affect other economic objectives?

A

Lower economic growth (due to lower AD)
Higher unemployment (due to lower AD)
Improved current account balance (due to lower AD and less spent on imports)
Higher budget deficit (due to lower tax revenue and higher welfare expenditure)

49
Q

What are the limitations of using interest rates?

A

Time lags (up to 2 years for full effect of change)
Uncertainty over size of their impact
Difficult to use if interest rates already at low levels
Size of changes in interest rates may be difficult to decide
Conflict with other objectives

50
Q

Define the term quantative easing

A

Increasing liquid funds available for banks so that they are more willing to lend to businesses

51
Q

Define the term forward guidance

A

Announcing the conditions for when policy is likely to change in the future

52
Q

What happens to the interest rate when it changes?

A

It affects the size of the money supply and the amount of credit in the economy

53
Q

Explain Quantative easing (QE) in relation to how the Bank of England can affect the money supply

A

Bank of England creates new money to buy bonds from financial institutions.
This money can be lent out to create credit and increase AD.
QE was introduced in the UK in 2009, when banks were reluctant to lend even with v.low interest rates

54
Q

Explain FLS (Funding for lending scheme) in relation to how the Bank of England can affect the money supply

A

Banks and lenders can swap assets (i.e. loans made) for Treasury bills - which are very liquid assets
Treasury bills enable the banks and lenders to borrow money from other money markets at very low interest rates
This encourages banks and lenders to borrow more and lend out more in order to increase their profits

55
Q

Explain Forward Guidance in relation to how the Bank of England can affect the money supply

A

Bank of England announces when policy changes are likely to occur, i.e. the likely data and size of future interest rate changes.
Used less due to the UK economy behaving less predictably than expected (unemployment fell far sooner and lower than most economists expected)
Forward guidance allows households and businesses to plan with greater confidence knowing when interest rates are likely to rise.

56
Q

What is the UK financial regulation for?

A

Until 2008 financial crisis, regulation of the financial system was limited.
Limited regulation was blamed for magnifying the financial crisis.
The 2012 Financial Services Act introduced regulatory instructions designed to improve financial stability.

57
Q

Explain the 3 parts of the 2012 Financial Services Act

A

PRA (Prudential Regulation Authority)
FCA (Financial Conduct Authority)
FPC (Financial Policy Committee)

58
Q

Explain the PRA

A

The Prudential Regulation Authority is responsible for supervision of banks and other financial institutions.
Takes actions to ensure these are managed properly and can make recommendations of actions
Allows banks to fail if it doesn’t disrupt whole financial system

59
Q

Explain the FCA

A

The Financial Conduct Authority (FCA)
Protects consumers by ensuring healthy competition between banks
Can intervene and set standards of behaviour if it feels institutions are not acting appropriately.
Independent of the gov

60
Q

Explain the FPC

A

The Financial Policy Committee
Monitors, identifies and takes action to remove systematic risk from financial system.
Stress tests are conducted to see how ‘healthy’ banking sector is.
Concerned with macroprudential regulation, whereas PRA and FCA are concerned with macroprudential regulation

61
Q

Why do banks fail and moral hazard?

A

Banks will face cash shortages if those it lends to fail to repay (by defaulting).
If customers think the bank is short of cash, then a ‘run’ on the bank may occur. Runs on banks become self-fulfilling - the fear of banks running out of cash encourages more to withdraw their cash.
The central bank can provide liquidity if the failure of a bank is against the public interest.
Knowing a bank can be ‘bailed out’ creates a moral hazard and banks take too many risks, knowing they will not be allowed to fail.
The 2012 Financial Services Act was designed to deal with the issue of moral hazard in the banking sector.

62
Q

Explain liquidity ratios

A

Limit bank lending by requiring banks to hold a percentage of their deposits in liquid form (i.e. as cash or as balances held at the Bank of England).
Increases in the liquidity ratio mean a bank can lend less - and cannot create as much credit.
Should ensure banks have sufficient liquidity in case of a shortage

63
Q

Explain capital ratios

A

Place a limit on bank lending to a percentage of the bank’s capital or equity issued.
Should limit lending by banks compared with bank’s own permanent capital.
In 2019, a capital ratio (also known as the liquidity coverage ratio) will be introduced for UK banks - capital must be equal to no less than 7% of their own lending

64
Q

Explain systematic risk

A

Financial crises often affect the whole banking sector (or spread from one bank to others)
After a crisis, banks often become unwilling to lend
Reduced bank lending has negative effects on the whole macroeconomy
Tighter regulation should reduce the chances of another crisis

65
Q

Define the term moral hazard

A

When an institution takes on too much risk due to not bearing the full costs of the risky behaviour

66
Q

Define liquidity ratios

A

Limiting how much lending a bank can make to a percentage of its deposits

67
Q

Define capital ratios

A

Limiting how much lending a bank can make to a percentage of its capital issued

68
Q

Define systematic risk

A

Risks that affect the whole banking system

69
Q

What are the issues with regulation in banks?

A

Tighter controls restrict people/businesses from borrowing
Regulation may divert financial activities that contribute to GDP in other countries
Regulation requires time and money to plan, implement and monitor
Penalties are needed to deter excessive risk-taking
Unintended consequences likely

Economics - Chapter 8 (10 decks)

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