Chapter 6: Economic influences

Question 1

What determines the influence of central banks

Answer 1

Influence of central banks vary according to the division of power between related government ministries, central banks and other regulatory bodies. Degree of independence of the central bank from the political echelon determines the bank’s importance.

Question 2

The interests of the central bank

Answer 2

• 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

Question 3

Central bank’s primary concerns

Answer 3

Monetary policy and control, including the following aspects:

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

Question 4

Adjustment of banking sector liquidity

What are some direct controls the central bank can use?

Answer 4

Buying and selling bills to influence level of liquidity within the banking sector and short-term interest rates. Includes activity to stabilise rates

Central bank may use non-market (direct) controls such as:

• setting minimum liquidity reserves ratios
• setting interest rate ceilings for bank deposits
• issuing directives regarding the types of lending to be undertaken

Question 5

Quantitative Easing (QE)

Answer 5

Monetary policy tool used by central banks to increase the supply of money.

Usually involves direct increase in money supply or and a knock-on effect from the fractioning reserve system, increasing the money supply further, although it can involve only making changes to the fractional reserve system.

Question 6

Fractional reserve system

Answer 6

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

Question 7

How does QE work?

Answer 7

1. Central bank credits its own account wit money it creates out of nothing.
2. Purchases financial assets from banks and other financial institutions in process refered to as ‘open market operations’.
3. Can involve changing the reserve requirements for banks which through the fractional reserve system would increase the money supply.

Question 8

Forward guidance

Answer 8

Enables central banks to indicate, in the absense of any unforeseen events, how the central bank believes monetary policy will change in the future - usually over the following 18-24 months

Question 9

What does forward guidance help the central bank do?

Answer 9

• Helps people see how the central bank sets interest rates and should reduce the uncertainty about the future path of monetary policy
• Controls short-term interest rates through setting the base rate
• Allows central bank to influence long term interest rates
• Allows central bank to influence inflation expectations

Question 10

Main investor classifications

Answer 10

• private individuals (‘households’)
• managers of short-term and long-term savings products (‘financial intermediaries’)
• corporates (‘businesses’)
• foreign investors

Question 11

Different categories, and investors within each category, will vary in their:

Answer 11

• time horizons
• appetite for risk
• taxation position
• liabilities (nature, term, currency and certainty)

Question 12

Household considerations when making investment decisions

Answer 12

LACED SLUT

• Liabilities (generally real in nature)
• Attitude to risk
• Characteristics of available assets (investment and risk characteristics)
• Expertise (level of investment expertise)
• Diversification (NB)
• Stability of asset values
• Liquidity
• Uncertainty over future income and outgo
• Tax

Question 13

Financial intermediaries

Answer 13

Sell their own liabilities to raise funds that are used to purchase the liabilities of other corporations.

Channels resources between lenders (investors) and borrowers.

Question 14

Advatages financial intermediaries offer

Answer 14

• Pooling of resources of many small investors and therefore can lend considerable sums to large borrowers
• Significant diversification achieved by lending to many borrowers = can accept loans that individuals may regard as too risky
• Build expertise through the volumes of business they conduct
• Economies of scale = lower dealing, admin and management costs

Question 15

Disadvantages of financial intermediaries

Answer 15

• additional layer of cost to investor
• products offered by intermediaries may not meet exact requirements of the investor
• products offered by intermediaries may be inflexible
• investor loses an element of control over their investment choice

Question 16

Objectives of businesses in issuing securities to the public

Answer 16

• get the best possible price for their securties
• market the issue at the lowest possible cost
• issue securities that best meet their requirements with regards to term, pattern and flexibility of funding

Question 17

Role of the investment bank in helping businesses achieve their fund raising objectives

Answer 17

• advise issuing firms on prices they can charge
• handle the marketing of the security issue to the public
• uphold their reputation for honesty by checking and certifying the quality of information offered
• innovate security design and packaging to simulate demand.

Question 18

Why do foreign investors’ preferences differ from those of local investors?

Answer 18

Due to:

• the impact of currency movements
• the different rules and regulations to which they’re subject in the countries in which they are based

Question 19

Main forms of government policy

Answer 19

• Monetary policy
• Fiscal policy
• National debt management policy
• Exchange rate policy
• Prices and incomes policy

Question 20

Other forms of government policy

Answer 20

• Taxation
• Competition policy
• Labour policy
• Government incentives for investment

Question 21

Monetary policy

Answer 21

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

Question 22

Fiscal policy

Answer 22

Decisions on the level and structure of taxation and government expenditure and hence, by implication, the public sector borrowing requirement (or debt repayment)

Question 23

National debt management policy

Answer 23

The manipulation of the outstanding stock of government debt instruments held by the domestic private sector, to influence the level and structure of interest rates or the availability of liquid reserve assets to the banking sector.

Question 24

Exchange rate policy

Answer 24

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 25

Prices and incomes policy

Answer 25

Aimed at influencing the rates of wage and price inflation.

Question 26

Taxation

Answer 26

Policy regarding taxation, its overall level and distribution between personal direct, indirect, corporate and other will affect demand for goods and services, including labour, because of the impact on prices.

Question 27

Competition policy

Answer 27

Competition policy will be a crucial element of the operating environment, especially for naturally oligopolistic industries, such as utilities.

Question 28

Labour policy

Answer 28

Labour policy will set the background for the flexibility of labour and the bargaining power of organised labour. The related domain of social policies will determine the cost of health services, welfare benefits and state pensions.

Question 29

Government incentives for investment

Answer 29

Incentives for investment will vary largely and will be important for suppliers of investment goods and to companies making investment decisions.

Government funded, or otherwise encouraged, investment infrastructure will help determine how easy it is for an organisation to put in place the physical requirements of its business within a territory.

Question 30

Effectiveness of government economic policy in practice

Answer 30

Early post-war period

• monetary policy played a subsidiary supportive role to fiscal policy.
• use of demand management techniques to ‘fine-tune’ the economy
• money supply was allowed to accomodate money demand, with little attention paid to inflationary implications

From 1970s onwards

• more positive role adopted for monetary policy with explicit recognition given to the control of money supply as an important element in fight against inflation
• medium term financial strategies aimed at reducing inflation while reducing the proportion of national resources taken for public sector use and the burden of taxation on the working population.
• aim to encourage long-term economic growth
• globalisation of businesses = liberalisation of trade and capital markets

Question 31

Examples of cross-border tax schemes

Answer 31

• moving earnings to a country with a lower tax rate
• profit shifting through transfer mispricing, ie setting prices for intra-group transactions which are inconsistent with market rates or by leveraging high charges for the use of intellectual property such as trademarks.
• taking advantage of differences between tax regimes

Question 32

Major economic policy objectives

Answer 32

• unemployment
• inflation
• balance of payments
• economic growth

Question 33

Effects of interest rates on the domestic economy

Answer 33

Major effects of higher interest rates:

On the personal sector

• increase in mortgage loan interest payments
• consumers’ expenditure may also be discouraged by higher rates on credit facilities and higher interest rates may encourage higher levels of saving

On the business sector:

• capital investment and economic growth prospects will be reduced
• increased opportunity cost of committing funds for investment and higher cost of borrowing
• reduction in expected levels of economic activity and higher domestic exchange rates will reduce viability of capital investment projects.
• higher levels of interest payments on outstanding debt will reduce corporate profitability

All features are likely to result in reduced employment prospects and slower rate of improvement in living standards

Question 34

Effects of interest rates on balance of payments

Answer 34

Increase in domestic interest rates likely to attract inflow of foreign investment funds and may encourage repatriation of domestic funds held overseas. Thus, a likley upward pressure on the domestic currency’s exchange.

May ultimately lead to a reduction in the value of net exports.

Question 35

Define monetary policy and its principal objectives

Answer 35

Monetary policy is the process by which the central bank controls the supply of money or the availability and price of money, i.e. interest rates.
Primary objectives:

• Growth and stability of the economy
• Price stability is a major objective
• Some monetary policies target inflation exclusively, while others have economic growth or employment as a secondary or additional objective.