Chapter 6: Economic Influences

Question 1

Main interests of the central bank

Answer 1

• Monetary, interest rate and inflation policy
• Banking regulation
• Implementation of government borrowing
• Performance and integrity of financial markets
• Intervention in currency markets
• Printing and minting of notes and coins
• Taxation

T-he P-rinting of M-oney F-or G-overnment I-n C-ountry

Tax
Print
Monetary
Financial markets
Gov borrowing
In banking
Currency

Question 2

Main economic variable controlled by the money supply

Answer 2

Inflation

Question 3

Open market operations (OMOs)

Answer 3

Central bank buying and selling of bills

Question 4

Non-market controls used by central banks

Answer 4

• Setting minimum liquid reserve ratios
• Setting interest rate ceilings for bank deposits
• Issuing directives regarding the types of lending to be undertaken

Question 5

Quantitative easing

Answer 5

Monetary policy used to increase the supply of money

Usually involves both a direct increase in money supply (by purchasing financial assets from banks and other financial institutions) and a knock-on effect from the fractional reserve system (e.g. changes to the reserve requirements for banks)

Question 6

The Quantitative Easing process:

Answer 6

1. QE is usually implemented by a central bank by first crediting its own account with money it creates out of nothing (‘ex nihilo’).
2. It then purchases financial assets, for example government bonds, quasi-government debt, MBS and corporate bonds, from banks and other financial institutions in a process referred to as ‘open market operations’ (OMO).
3. It can also involve changing the reserve requirements for banks which, through the fractional reserve system, would increase the money supply.

Question 7

Describe Quantitative Easing

Answer 7

it is a tool used to stimulate economic activity.

it involves the increases in money supply and the increase from the fractional reserve system.

Usually, the Central bank will credit its account with money and use it to buy financial assets.

Usually, the assets bought are gov bonds, quasi gov debt, MBS, and corporate bonds in OMO.

Central banks using QE may provide forward guidance to market regarding the anticipated levels of QE that they intend to conduct in the short to medium term.

Question 8

Fractional reserve system

Answer 8

Refers to funds being received by banks and loaned on to other customers

Bank reserves are only a fraction of the quantity of deposits in the banks

Question 9

Forward guidance

Answer 9

Guidance by central bank on how it believes monetary policy will change in the future

• not a guarantee - may deviate under unforesee conditions

Question 10

Describe Forward Guidance

Answer 10

it is a tool used by central banks to indicate (in the absence of unforeseen events) how it believes monetary policy will change in the future - usually of over the following 18 to 24 months.

It is designed to help people see how the central bank sets interest rates and to reduce the uncertainty about the future path of monetary policy.

it allows the CB to influence:
- long-term interest rates
- inflation expectations
- and economic activity

it is not a guarantee. The CB can depart from its guidance either as a consequence of unforeseen economic event or if the economic outlook changes.

Question 11

Main investor classes

Answer 11

1. Households - private individuals
2. Financial intermediaries - managers of savings products
3. Businesses - corporates
4. Foreign investor

Question 12

Investor classes mainly differ in respect to

Answer 12

• Time horizons : short vs long term
• Appetite for risk :level of risk tolernace
• Taxation position : tax rules that apply to them
• liability profile (nature,term , currency and uncertainty) and other features and circumstances

Question 13

List other features that might further differentiate categories of investors.

Answer 13

FORK - Factors,objectives, restrictions, knowledge

1. Investment Knowledge and Experience
   - Sophisticated vs. Retail Investors
   - Investment Focus (specific asset classes or investment styles)
2. Investment Objectives
   - Income vs. Growth
   - Liquidity Needs
3. Investment Restrictions
   - Investment Mandates
   - Regulatory Requirements
4. Demographic Factors
   - Age
   - Risk Tolerance

Question 14

Households

Answer 14

Diversification is a key consideration (leads to the need for financial intermediaries)

• Small amounts available to invest
• Much of wealth tied in house

Question 15

Household considerations when making investment decisions:

Answer 15

LACED SLUT

L- Liabilities
A - Attitude to risk
C- Characteristics of available assets (risk return)
E - Expertise (their level of investment expertise)
Diversification

S- Stability of asset values
L - Liquidity
U - Uncertainty over future income and outgo (cashflows)
T - Tax

Question 16

Financial intermediaries: Broad definition

Answer 16

Channels resources between lenders and borrowers

Add more from notes

Question 17

Financial intermediaries: Advantages and disadvantages

Answer 17

Advantages:

• Pooling of resources - from small investors enables lending to large borrowers
• Diversification - lending to many borrowers allows acceptance of loans which individuals might deem too risky
• Expertise - from large volumes of business
• Lower cost - economies of scale

Disadvantages:

• Additional layer of cost
• Products offered might need meet requirements of investors
• Products might be inflexible
• Loss of control over investment choice

Question 18

Businesses

Answer 18

Typically need to raise money to finance investment in real assets

Objectives in issuing securities:

• Get best possible price
• Market at lowest possible cost
• Issuing securities that best meet their requirements

Question 19

Foreign Investors don’t like:

Answer 19

Political risks

Currency risks

Different rules and regulations for them (compared to locals)

Question 20

Role of investment banks: (4)

Answer 20

1. Advise issuing firms on prices to charge
2. Handle marketing of securities
3. Verify the quality of the information supplied ( to keep investors happy and protect own reputation )
4. Innovate security design and packaging to stimulate demand

Question 21

Governments

Answer 21

Are not major investors.

Typically borrow to finance expenditure (By exploiting they creditworthiness)

Question 22

Main types of securities issued by governments (2)

Answer 22

• Treasury bills
• Government bonds

Question 23

Sources of finance for governments (other than borrowing)

Answer 23

Taxation

Also:

• Sale of public assets
• Profits from nationalised industries
• Printing of money

check the profits one

Question 24

The ways in which companies avoid tax (3)

Answer 24

1. financing subsidiaries in high-tax countries mainly with debt to reduce profits
2. reducing profits in high-tax areas through excessively high transfer pricing for intra-group transactions
3. transferring profits through the use of hybrid instruments that arbitrage between tax regimes.

Question 25

Describe the main forms of government policy: (5)

Answer 25

1. Monetary policy - the control of some measure of money supply and/or the level and structure interest rates.
2. Fiscal policy - decisions on the level and structure of taxation and government spending and hence, by implication, the public sector borrowing requirement (fiscal deficit).
3. National debt management policy - the manipulation of the outstanding stock of government debt instruments held by the domestic private sector.
4. Exchange rate policy - directed towards achieving some target for the exchange rate, perhaps with the objective of influencing the country’s international trading and investment patterns.
5. Prices and incomes policy - aimed at influencing the rates of wage and price inflation.

Question 26

Main forms of government policy

Answer 26

• Monetary Policy
• Fiscal Policy
• National debt management policy
• Exchange rate policy
• Price and incomes policy

Question 27

Monetary policy

Answer 27

The control of some measures of the money supply and/or the level and structure of interest rates

Question 28

Describe the role of the central bank in monetary policy and control.

Answer 28

Primarily concerned with monetary policy and control, including the following aspects:

• adjustment of banking sector liquidity
• control of money supply growth and short-term interest rates.

Question 29

Outline how the central bank may fulfil its roles in relation to the adjustment of banking sector liquidity and the control of money supply growth and interest rates.

Answer 29

It can fulfil its roles:

1. Directly through open money market operations
   - buying and selling of bills to influence level of liquidity within banking sector and ST interest rates
2. Indirectly through:
   - setting minimum liquid reserve ratios
   - setting discount rates and interest rate ceilings for bank deposits
   - issuing directives on types of lending

Question 30

Describe how the central influences money supply growth and interest rates indirectly through:
1. setting minimum liquid reserve ratios
2. setting discount rates and interest rate ceilings for bank deposits
3. issuing directives on types of lending

Answer 30

1. set minimum reserve ratios
   - This requires banks to hold a specific portion of customer deposits as reserves, limiting the amount available for lending.
   - While lending expands the money supply, these reserve requirements restrict a bank’s ability to lend, ultimately impacting overall money growth.
2. interest rate ceilings for bank deposits
   - restricts the ability of banks to compete for investor’s money
   - therefore, restricts amount coming into the system
   - thus, restricts extent bank lending is able to expand money supply
3. directives on types of lending
   - restricts expansion of money supply by directly restricting lending, e.g., restrict extent to which consumer credit is available

Question 31

Outline reasons why the central may be concerned with the control of money supply growth and short-term interest rates.

Answer 31

By controlling money supply growth and short-term interest rates, the central bank aims to achieve its primary objectives, which often include:

1. Price Stability: Maintaining low and stable inflation.
2. Economic Growth: Promoting sustainable economic growth and employment.
3. Financial Stability: Mitigating financial risks and maintaining a stable financial system.

Question 32

.

Outline reasons why the central bank may be concerned with the adjustment of banking sector liquidity

Answer 32

1. Smooth Functioning of Financial System: A healthy banking system relies on sufficient liquidity. This ensures banks have enough cash reserves to meet their daily obligations, like withdrawals and loan repayments.
2. Lending and Economic Growth: Adequate liquidity allows banks to lend money to businesses and individuals. This fuels economic activity and growth.
3. Financial Stability: Insufficient liquidity can lead to financial instability. Banks might become reluctant to lend, credit might dry up, and the economy could suffer.

Question 33

Fiscal policy

Answer 33

Decisions on the level and structure of taxation and government expenditure

and hence, by implication, the public sector borrowing requirement.

Question 34

National deb management policy

Answer 34

The manipulation of the outstanding stock of government debt instruments held by the domestic private sector

• in order to influence the level and structure of interest rates or the availability of liquid reserve assets to the banking sector.

Question 35

Exchange rate policy

Answer 35

Directed towards achieving some target for the exchange rate of the domestic currency in terms of foreign currencies

• perhaps with the objective of influencing the country’s international trading and investment patterns.

Question 36

Prices and incomes policy

Answer 36

Aimed at influencing the rates of wage and price inflation

Question 37

Other forms of government policy: Taxation

Answer 37

Policy regarding overall level and distribution of taxes

Question 38

Other forms of government policy: Labour policy

Answer 38

Sets the background for the flexibility of labour and the bargaining power of organised labour

Question 39

Major economic policy objectives

Answer 39

• Unemployment (low)
• Inflation (low and stable)
• Balance of payments (at a level that does not constrain the achievement of other objectives)
• Economic growth (high and stable)

Question 40

Interest rates affect: (4)

Answer 40

1. personal sector expenditure
2. business sector investment and economic growth prospects
3. corporate profitability
4. the balance of payments

Question 41

Effects of interest rates on the balance of payments

Answer 41

An increase in domestic interest rates is likely to attract an inflow of foreign investment funds and may also encourage the repatriation of domestic funds held overseas

Question 42

Effects of interest rates on corporate profitability

Question 43

c. the influences over the commercial and economic environment from main investor classes (Households).

List considerations for households when making investments.

Answer 43

LET WORDS Improve Life

1. Liabilities
2. Expertise
3. Tax
4. Wealth
5. Outgo and income uncertainty
6. Risk appetite
7. Diversification
8. Stability of Asset value
9. Investment and risk characteristics
10. Liquidity

Question 44

c. the influences over the commercial and economic environment from main investor classes (Financial intermediaries).

List the examples of FI.

Answer 44

Examples include:
- banks
- insurers
- pension funds
- CIS
They sell their own liabilities to raise funds that are used to purchase the liabilities of other corporations.

Question 45

List five other main forms of government policy.

Answer 45

1. Taxation policy regarding overall level and distribution of tax between personal direct, indirect, corporate and other - will affect prices and hence demand for goods and services, including labour.
2. Competition policy - affects oligopolistic industries, such as utilities.
3. Labour policy influences flexibility of labour and bargaining power of organised labour.
4. Social policy - determines costs of health services, welfare benefits and state pensions.
5. Investment policy - influences infrastructure and private sector Invesment

(All 10 could be arranged in the acronym MT FINE PLCS)

Question 46

c. the influences over the commercial and economic environment from Government policy.

Describe the main problem associated with tax policy in an environment where trade is truly global and where there is liberation of capital flows, and outline the three main ways in which the problem manifest itself.

Answer 46

Cross-border investors and international companies will seek to maximise profits net of tax, and therefore seek to move profits to countries with low tax rates. This produces competition pressure for countries to lower their tax rates.

How the problem manifests itself:

1. subsidiaries in high-tax countries are heavily leveraged, meaning that the profits after interest are very low
2. Intra-group transfer pricing rates are set, which are inconsistent with the market rates, leaving profits in high tax countries significantly lower
3. Hybrid instruments are used, that lead to a tax deduction in one country and a tax liability in another to transfer taxable profits.

may be related to how companies avoid tax. check

Question 47

c. the influences over the commercial and economic environment from Government policy (interest rates).

Describe the effects of higher interest rates on the:

• personal sector
• business sector

Answer 47

Personal sector:

Consumers’ expenditure reduced due to:

• Increase in mortgage interest payments, which reduce disposable income
• higher rates on credit facilities
• higher rates on interest on saving (encouraging higher levels of saving)

Business sector:
- Investment reduced due to increase cost of capital and reduce growth and profits prospects…
-… also increase opportunity cost of committing funds for investment and higher cost of borrowing…
- Current corporate profitability reduced, particularity if much floating rate corporate borrowing.
-…All of above result in reduce employment and lower sd of living
-

Check if not duplicate. use Ctrl + F

Question 48

Describe the effect of interest rates on the:
- exchange rate and the capital account of balance of payments
- current account of balance of payments

Answer 48

Exchange rate and capital account:
- Increase in interest rates attracts ‘hot money’, leading to increase in domestic currency’s exchange rate
- if it is believed that domestic activity likely to be depressed, then may be reduced inward flows of direct capital investment

Current account:
- if exchange rates rise, then likely to result in adverse movements in the volumes of trade. For example…
-…reduce exports and higher imports, i.e., reduction in value of net export.

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Question 49

Effects on the economy of an interest rate cut

Answer 49

The overall effect of an interest rate cut is likely to be an increase in economic activity.

The reasons for this include:

• Consumer expenditure would be expected to increase because:
  1. mortgage interest payments would fall resulting in more income being available for expenditure
  2. cheaper credit would reduce the effective cost of goods and services
  3. low interest rates may result in lower levels of saving (and so higher levels of spending!)
• Capital project investment by businesses is likely to increase, as the resulting lower cost of borrowing would reduce the opportunity cost of investing.
• Lower levels of interest on existing corporate debt will increase profits for those companies with (floating rate) debt finance.
• Lower interest rates are likely to lead to devaluation of the domestic currency. This will make domestically produced goods more attractive overseas, ie tend to increase exports. Similarly, volumes of imports are likely to be reduced.

Question 50

https://pse-journal.hr/en/archive/interactions-between-fiscal-and-monetary-policies-a-brief-history-of-a-long-relationship_7902/

Answer 50

the history part of the notes