Chapter 8: Economic, monetary and political influences

Question 1

State an equation that describes the ‘quantity theory of money’ and define the terms.

Answer 1

Quantity theory of money This theory states that
M x V = P x Q

where:
M = the amount of money in an economy
V = the velocity of money – the number of times money circulates around the economy over a specified period
P = the average price level of goods, services and assets
Q = the volume of goods, services and assets produced / transacted.

Question 2

Describe what is meant in economics by the ‘Malthusian trap’.

Explain why it is, at the present time, an important economic theory for the world economy.

Answer 2

Malthusian trap

This referred to a period up until the industrial revolution when income per head in most populations on the planet seemed to stagnate.

When incomes increased, population usually increased faster, resources became relatively scarce and incomes fell.

It is important at the present time because the world’s population has increased suddenly and sharply, and the world is consuming resources at a faster and faster rate.
The rate is far faster than the resources can replace themselves on earth.
As a result, continued technological advancement is crucial to maintaining wealth per head.

Many developing countries have been stuck in the Malthusian trap for a long time up to the present date.

Question 3

Outline six ways that Quantitative Easing (QE) can influence the domestic corporate bond market.

Answer 3

Influence of QE on corporate bond markets

1. QE may stimulate growth, which may increase spending and inflation. Higher inflation would be expected to reduce corporate bond prices
2. Higher growth may increase corporate profits and reduce default risk
3. If the Central Bank buys corporate bonds directly this would influence the price. If only government bonds are purchased this might reduce government bond yields and therefore also reduce corporate bond yields.
4. If institutions are not natural holders of cash, they might prefer to invest any cash from QE in asset categories such as corporate bonds.
5. If QE weakens the currency, this might create cost push inflation, which would increase corporate bond yields.
6. If QE undermines the trust in the Central Bank, overseas investors may sell all forms of assets in that currency, including corporate bonds.

Question 4

Outline six ways that QE could influence domestic equity markets.

Answer 4

Influence of QE on domestic equity markets

1. If QE is targeted directly at equity markets (via collective vehicles) it will push prices up.
2. If QE pushes government bond yields down, then on a dividend discount basis, the value of equities should rise.
3. If QE increases consumer spending, corporate profits may rise and equity prices rise.
4. If QE causes inflation, dividends may be expected to rise faster (in line with inflation). But if the Central Bank controls inflation by increasing short term rates or unwinding existing QE purchases, this may have a negative effect on prices.
5. If the currency weakens, this would be expected to benefit exporters, but create cost pressures for importers.
6. The effect on confidence in the currency could cause overseas investors to sell all assets in that currency, including equities.

Question 5

Describe the impact of the fractional reserve banking system on QE activity.

Answer 5

Fractional reserve banking system

Under QE a Central Bank may buy government bonds from banks using money created from nothing on its own balance sheet. This can result in commercial banks having larger cash deposits with the Central Bank itself.

Under the fractional reserve banking system, commercial banks are constrained from lending more than a certain factor of the amount they hold in cash with the central bank. This factor can be around 30 times, but can be higher.
If commercial banks hold more cash with the Central Bank as a result of QE, they could potentially lend a great deal more to companies and individuals and still not breach the limit.

Excessive commercial bank lending can cause demand pull inflation, and even hyperinflation.

Question 6

Outline the impact of QE on the commercial banking industry.

Answer 6

Impact of QE on the commercial banking industry

1. If the yield on medium-term government bonds is reduced, this can have a detrimental impact on banks’ lending margins (ie borrow in the money market and invest in the medium-or long-term corporate or government bond market).
2. QE may make companies keener to borrow to take advantage of low borrowing rates. This may give the banking industry more opportunities to lend.
3. It QE stimulates economic activity, it may temporarily reduce defaults by companies in the economy. This would be good for banks.
4. If companies borrow and invest in loss-making projects, there may be problems further down the road which will impact banks’ profitability.
5. QE raises the amount of money that banks have invested with the Central Bank, which in turn increases their capacity to lend.
6. Banks will lend only to those that they believe have the ability to repay, which will be those that have seen their assets increase in value under the QE programme (ie the wealthy).

Question 7

Outline four ways that QE can have an impact on the political environment in a country.

Answer 7

QE and its political impacts

1. QE makes the wealthy more wealthy.
   This can lead those people to spend more on luxury items and boost profits in those sectors.
   It can make the less wealthy even less wealthy as asset prices rise.
   This can lead to fractures in society and the appearance of political parties that built on these injustices. It can cause the appearance of demagogues.
2. Depending on the political reaction to the disparities in society, it can lead to protectionism if people feel that globalisation has caused their problems.
3. In other cases it can lead to nationalism if people migrating are the cause of their problems.
4. If the rich seem richer, there will be a drive by politicians to tax that visible wealth and redistribute it.
   This may lead to an increase in wealth taxes and a reduction in lower-band income taxes and an increase in allowances.

Question 8

Outline six impacts of QE on the pensions and insurance industry (building on the material in this chapter, but not directly repeating it).

Answer 8

Six impacts of QE on the pension & insurance industry

1. If bond prices rise and yields fall, valuations of liabilities will be greatly increased. This will lead to pension deficits and poor profits for insurers.
2. Pension deficits can in turn lead to increased company contributions which can act as a drain on company resources or expansion.
3. If deficits rise, there may be a backlash by regulators to force schemes and insurers to invest in less risky assets, for example highly-priced bonds.
4. Products offered by insurers will offer very low returns if they are bond-backed. This can lead to very low take-up by customers.
5. If the domestic currency weakens, overseas investment may give high returns and offer good diversification.
6. If bubbles appear in other asset categories such as equities and property, insurers and pension schemes invested here could see good asset returns.