Chapter 12 - Financial Markets & Monetary Policy Flashcards
12.1
To grasp the nature of financial markets, money & monetary systems, it’s key to know the defenition of ‘assets’ & ‘liabilities’.
Define the 2 terms. There are 2 forms of liabilities. Define both.
Money like a ‘£10 note’ acts as an assets since it gives the person who owns it £10 worth of spending power… Why is this a liability for the BoE?
a) ASSETS - These are resources (physical or otherwise) that can be SOLD for money.
b) LIABILITY - Is an amount owed to a business. Two types: current liability = short-term debt, non-current liability = long-term debt.
c) The BoE issues the bank note so they’re liable because they must provide the amount whenever the owner wishes to withdraw the £10 note.
12.1
a) From a commercial POV, a loan or credit granted to a customer is an interest-earning asset. Why is this?
b) Following on from ‘a’. The bank who creates the loan must therefore simultaneously create a bank deposit (i.e. transfer of money to an account - in this case the customer’s account) owned by the customer to whom the loan is made. Why is the bank deposit a liability for the bank?
a) It’s an interest earning asset because the person who takes the loan (an asset of the bank) must repay the amount with interest added on top! The borrow has the liability to pay the amount + the interest charged on top!
b) It’s a liability because they must now honour the withdrawls the customer makes and pay the amount to the customer (whenever they - the customer - wishes to withdraw the loan from the account the bank must have the amount ready for the customer… Therefore, it is a liability for them - the bank).
12.1
a) Define ‘Money’…
b) What are the 2 funcitons of MONEY? One of the functions is not like bartering. What is bartering?
a) Money is the primary medium of exhange, it’s also a means of payment, it’s also a store of VALUE.
b) Funtion 1. Money is a medium of exchange or a means of payment. Taking possession of goods and/or services requires the exchange of an intermediary, money. This is done as opposed to the barter system - whereby there is a swapping of goods or services.
Funtion 2. Money is a store of WEALTH or VALUE. It’s an asset. Inflation can erode money’s purchasing power over time.
12.1
a) What is ‘commodity money’? Examples?
b) What is ‘representative money’ (what forms of commodities replaced older forms and why (link it to the bottom question!)?
c) There are 5 key bits commodities need to be able excercise in order for them to FUNCTION like money. LIst all 5.
a) Commodity money: Commodity money consists of objects that hold intrinsic value to be able to be exchanged to essentially ‘buy’ goods and services. They can also hold value do to their use. E.g: Cattle, Shark Teeth, Gold, Silver etc…
b) Representative money: As money evolved gold and silver replaced older forms of money like sea shells. This is because gold and silver hold a greater degree of desirability key for a commodity to function as money.
c) 1. Relative scarcity - can’t be abundant/or easily copied
2. Uniformity - all units must be homogeneous
3. Durable - must last for a reasondable amount of time
4. Portable - Capable of being transported
5. Divisible - can be divided into smaller units
12.1
a) What is token money - all money now is ‘token’ money. There are 2 forms of ‘token’ money. Side note: must remeber that the BoE has a monopoly over the issue of cash.
b) Money does 1 thing we have NOT talked about. What is it? Think about how we measure things and their value…
a) Token money is money whose ‘face value’ has no relation to the value of which the money is composed of - i.e. the material of which it’s composed of. E.g: A £10 bank note, the face value of £10 is not related to the value of the material the £10 bank note is composed of…
The 2 forms of token money are CASH & BANK DEPOSITS.
b) Money allows us to determine the value or worth of goods and services. Therefore, we can compare the relative value/worth of goods by looking at the prices.
12.1
a) Define ‘narrow money’.
b) Define ‘broad money’.
c) What is ‘iquidity’?
a) Narrow money: All the real money held by the central bank. It’s all the cash and liquid bank and building society deposits.
b) Broad money: A category for measuring the amount of money circulating in an economy. It includes narrow money and illiquid assets.
c) Liquidity is the EASE with which an asset can be converted into cash without the loss of its value. By defenition the most liquid asset is cash…
12.1
Many people in the UK have possessions they own such as furniture, cars and houses. Some have SHARES and BONDS. Define both of these financial terms. Also, which shares are marketable and which shares aren’t?
c) What is equity?
d) What is debt?
a) A ‘share’ is a financial asset (which can be sold for money). The share is origionally sold by a company to allow the company to raise funds/investments. Shares sold by PLCs are marketable on the stock exchange, those shares that are sold by private limited companies are NOT marketable! The individual who owns a share of a company therefore owns a part of the enterprise (a project).
b) A ‘bond’ is a financial security - a security is a tradeable financial asset. It can be traded in financial markets - sold by governments which are a form of long-term borrowing. Bonds usually have a maturity date. The owner of a bond gains a FIXED interst on the bond until the bond’s maturity date has been reached.
c) ‘Equity’ is all of the physical and financial assets a person owns.
d) ‘Debt’ is what people owe. For adults, many are in debt to the bank due to having a mortgage on a house. Additional examples include credit card debt.
12.1
a) What is a ‘financial market’?
b) What are ‘treasury bills’? What’s the difference between this and ‘bonds’?
c) What are ‘commercial bills’?
d) The finacial market can be divided into 3 seperate markets. Name them.
a) This is a type of market in which financial assets or securities are able to be traded.
b) Treasury bills are short-dated government debt. The gov. pays the holder of the treasury bill a fixed rate of interest until the treasury bill’s maturity date. Treasury bills are the same as bonds apart from the fact that treasury bills are short-term gov. debt (usually 3 months) and bonds are long-term gov. debt (30 years).
c) Commercial bills are the same as treasury bills but instead of being sold by the gov. they’re sold by businesses which pay the holder a fixed rate of interest until the bill’s maturity date (usually after 3 months).
d) 1. The MONEY market, The CAPITAL market & The FOREIGN EXCHANGE market.
12.1
a) Define each of the 3 markets that make up the financial market.
b) What are ‘gilts’? Think of gov. bonds…
a) The MONEY market = a market in which lenders and borrowers can satisfy their short-term financial needs - this market covers several markets including treasury and commercial bills!
CAPITAL market = Where securities such as shares and bonds are issued to raise long-term financing (e.g. LONDON stock exchange).
The FOREIGN EXCHANGE market = global market for currency exchange.
b) Gilts are a type of loan the gov. borrows from INVESTORS and PROMISES to REPAY, with INTEREST!
12.1
a) What is a ‘coupon’?
b) What is ‘yield’?
c) Formula for calculating yield?
d) Why might the market price of a gov. bond decrease?
e) Explain the relationship between the market price of abond and its yield.
f) There are 2 types of capital markets. Name them.
a) The GUARANTEED FIXED annual INTEREST payment, payed by the issuer - corporations or the gov. They do this to raise finance.
b) Yield is the Annula interest earnt on a bond expressed as a % of the bond’s current market price.
c) Yield = coupon/market price of bond x 100%
d) If the yield on a bond is high (e.g. 4.35%) then people will demand more of the bond and as a resul the market price of the bond INCREASES (simple demand and supply). The opposite is true for a bond with a low yield and therefore low demand.
e) When the market price of a gov. bond goes UP, the YIELD on the bond decreases.. WHY? Simply because we know that the coupon is a FIXED value. If the market price increase then the coupon number (that does NOT chnage) is being divided further and further. A smaller number being divided by a bigger number means the yield goes DOWN!
f) New-issues market (primary market) and the second-hand market (second market). E.g the London Stock Exchange functions as the main secondary market in the UK.
12.3
a) We knwo that most banks are either commercial or investment banks. Their main aim is to make PROFITS. The most significant exception is the BoE (Bank of England) which is the UK’s central bank. What is a central bank? Give its functions - their are 2 major ones… Think about the gov. & the monetary system/nation’s macro economic health.
a) A central bank is a national bank that provides financial and banking services for its conutry’s government (e.g. the CBA Iraqi Cental Bank). The central bakn also impliments the government’s MONETARY policy and issues currency.
In summary, the central bank advises country’s gov. and maintains macroeconomic stability (key word) by delivering price stability in the monetary system.
12.3
a) Implementing monetary policy. To understand monetary policy it’s key to distinguish between policy objectives and policy instruments. What is a policy ‘objective’ and what is a policy ‘instrument’?
b) Control of inflation is the MAIN objective of the BoE. Gov. has to do this in order to achieve the ultimate policy objective which is widespread economic welfare. What is the MPC - monetary policy commitee? This is a policy instrument (another instrument is Quantative Easing - we’ll look at this later).
c) What is the aggregate demand equation? Explain each part of the equation.
a) A policy objective is the target the BoE AIMS to hit - for inflation it’s 2%. A policy instrument is the TOOL used to try and achieve the policy ojective.
b) The MPC are a group of individuals at the BoE who meet to set interest rates in the UK eight times a year. They set the interest rates with the aim to ‘hit’ the 2% inflation target! They may increase, decrease or not do anything at all in order to achieve the target level…
c) AD = C + I + G + X + M
C means CONSUMPTION
I means INVESTMENT
G means level of government spending
X Total exports
M total imports
Monetary policy impacts C,I and (X-M)
12.3
a) What factors do the members of the MPC take into consideration when deciding whether or not to increase, decrease or leave the interest rates unchanged? There are 4 this question looks for you to know…
b) What happens when the BoE stimulates AD? What does this lead to in the long-run?
c) In the 2008-09 recession, negative economic growth and growing unemployment led to the BoE chaniging its policy objective TEMPORARILY in order to stear us out into a recovery stage from the recession. What policy objective was put on the ‘back-burner’ temporarily?
a) The inflationary or defationary pressure
Consumer & Business confidence
Economy’s growth rate
Levels of unemployment and emplyment
b) Stimulation of AD leads to increased rate of inflation.
c) Controlling inflation rate.
12.3
a) What is contractionary monetary policy?
b) There are 3 main ways increased interest rates DECREASE AD. Explain each.
1. Reduced consumer consumption
2. Reduced business investment
3. Impact on exports and imports due to exchange rate
a) Contractionary monetary policy is a policy which uses higher interest rates to DECREASE aggregate demand and therefore shift AD curve to the LEFT. Interest rates are increased to take demadn OUT of the economy.
The extent to which price levels fall are determined by the AS curve. As a result real national income also falls from y1 to y2.
b)
1. HIgher interst rates reduce household CONSUMPTION - why? because it encourages people to SAVE their money. As a result of saving, household income reduces. Furthermore, the cost of borrowing increases since interest rates are high on big ticket items like cars and houses (mortgage rates go up). Additionally, assets like houses can reduce in value meaning reduced household wealth also reducing consumption.
IN summary:
a) people save –> causing incomes to reduce and therefore reduced disposable income = decreased consumption.
b) borrowing increases –> high rates on morgages for example this = decreased consumption.
c) asset value falls –> household wealth drops and therefore this = decreased consumption.
- Higher interest rates REDUCE BUSINESS INVESTMENT - why? becasue investment is the purchase of capital goods (e.g. machinery for goods production). Businesses cancel or temporarily postpone investment projects due to the high cost of borrowing - this makes these projects unprofitable.
- HIgher interst rates IMPACT EXPORTS & IMPORTS due to the exchange rate.
12.3
a) What is expansionary monetary policy? Also explain how the extent to which the AD curve shifts is determined… Describe the AS curve talking about the normal capacity level of output. Explain how steepness as AD rises leads to price __________….
a) Expansionary monetary policy is the reduction of interest rates to expand/increase aggregate demand leading to a shift in demand outwards (to the R-side). Bank DISCOURAGES saving!
The extent to which the AD curve shifts to the R-side depends on the slope/shape of the AS curve. Let’s dig deeper.
As the AD curve sits below the normal capacity level of output, the AS curve is relatively FLAT. As the normal capacity level of output arrives, the rising STEEPNESS of the AS curve means stimulation of real output by reducing interest rates gives way to price INFLATION. Price level RISES.
12.3
a) The transmission mechanism of interest rate policy. The BoE says changes in bank rate impact aggregate demand and inflation in a number of channels which form the transmission mechanism of bank rate policy. Draw the transmission mechanism.
b) What is demand-pull inflation?
c) It’s important to note one thing about all of monetary policy. This is….?
a) Look at pg. 447
b) Demand-pull inflation is a result of high AD. Due to high AD, prices begin to rise.
c) The time lags between the implimentation of the policy and the impact of the policy on the macroeonomic economy.
12.3
a) What is Quantitve Easing (QE)? What is the hope?
a) Quantitive Easing is when the BoE BUYS ASSETS, usually government bonds (remember, gov. bonds are sold to people in capital markets. The gov. sells the bonds for money and in return the individual gains annual interest on the amount the bond was sold for until the maturity date) with money the BoE has made electronically. QE is also called asset purchase scheme.
The hope is, is that the financial institutions (banks, pension funds and insurance companies) which sells the bonds to the BoE (remember the BoE buys the government bonds in this case from the second market of the capital market) will then lend the newly created money to businesses and individuals. The latter (individuals and houselholds) will then spend more as a result + invest more promoting economic growth!
12.3
a) We must remember that bank deposits (not cash) make up majority of the supply of money. QE does WHAT to those bank deposits that commercial banks hold? Having more of this increases the ability for commercial banks to then lend money to households and businesses.
b) What is the aim of ‘forward guidance’?
a) QE increases the bank deposits that commercial banks hold by. Having more bank deposits increases the ability of commercial banks to lend money to households and businesses.
Direct injections of money into the economy is primarlily done by the BoE buying gilts (bonds). The point of doing this is that it gives the seller (commercial banks) more money to then go out and spend. This shall boost growth. They may also buy more bonds or shares which shall increase the prices of those assets, making people who own them better off. Higher asset prices brings the cost of borrowing down for businesses and households. Why is this? This is because of the increased ‘collateral value’. When the prices of homes, stocks and business property e.t.c… increase, the value of these assets as collateral for loans also rises. This means lenders are more willing to offer out loans at lower interest rates. Collateral is an asset that a borrower offers to a lender as a SECURITY for a loan they take!
b) Forward guidance is the attempt to singal to financial markets, businesses and individuals about the BoE’s interest rate policy in the months and years ahead, so that economic agents are NOT surprised by a sudden and unexpected change in policy.
It aims to calm businesses and households about their future economic prospects.
12.4
The Regulation of the Financial System:
a) SImply, what is regulation all about?
b) What therefore is ‘financial regulation’?
c) How does the BoE maintain financial stability? What other committee is responsible?
d) Who are the PRA (Prudential Regulation Authority)
e) Who are the FCA (Financial Conduct Authority)
a) Regulation imposes rules and sometimes laws which limit the freedom of individuals and businesses to make decisions of their own free will.
b) Financial regulation is all about limiting the freedom of banks and other financial institutions/bodies, and of the people they employ, to behave as they otherwise might do.
c) The financial policy committee. They monitor the resiliance (ability to bounce back/adjust to change) of the UK’s financial system.
d) Prudential Regulation Authority (Prudential refers to cautious when making decisions or managng risks). They’re part of the BoE and are responsible in ensuring that financial institutions are following standards. They also monitor the risks posed by individuals financial firms and they are the ones who take action to ensure those risks are managed properly. The PRA demands financial firms maintain a SPECIFIED capital to liquidity ration. They do this to ensure that if a financial firm fails, the disruption to other essential financial firms is not significant!
e) The Financial Conduct Authority aim to ensure that financial markets are working well so that consumers get a fair deal, by ensuring that the financial industry is run with integirty and that consumers can trust that firms have their best interest at heart as well as providing consumer’s with key financial services and products.
12.4
a) How does a bank become insolvent (i.e. bankrupt)?
b) Illustrate the problem of ‘moral hazard’ using the 2007 subprime crisis.
c) Overtime banks have failed or required government assisstance either because they lacked _______, or becasue they had inadequate CAPITAL, or even a combination of both. Define the term in the gap.
Define the term capital ratio.
a) A bank becomes insolvent if the value of its assets falls so that they run out of capital and their liabilities exceed (debt) to a high level. Remember, a bank’s capital = assets - liabilities.
b) In 2007, banks showcased higher lending to those even on low credits. They took risks in the pursuit of profit maximisation. They did this beacuse they believe that banks are the lender of last resort, and the governement shall bailout them which means they won’t fail. This is the issue of moral hazard in which individuals have the tendency to pursue profits taking on high risks in the knowledge (i.e. knowing that…) if things go wrong, someone will bear a significant portion of the COSTS.
c) Overtime banks have failed or required gov. help either because they lacked liquidity, or because they had inadequate capital, or even a combination of both of these things.
The LIQUIDITY ratio = the ratio of a bank’s cash and other liquid assets in relation to its deposits!
The CAPITAL ratio = the ratio of a bank’s balance sheet as a proportion of its loans. 66
