Chapter Three

Question 1

What does the nominal interest rate compensate for?

Answer 1

The effect of expected inflation so where inflation is in line with expectations there is no wealth transfer between borrower and lender

Question 2

What happens when inflation is higher than expected?

Answer 2

The nominal interest rate will undercompensate for this leading to a redistribution of wealth from lender to borrower and consequently from the old to the young

Question 3

When can higher inflation disrupt investment planning?

Answer 3

If anticipated real returns fall and higher inflation tends to be more variable and uncertain

Question 4

What is true if unemployment was at its natural level?

Answer 4

Theory states that inflation would be stable and not accelerating

Question 5

What would reduce the size of the public sector net cash requirement?

Answer 5

Increased corporate tax will increase government revenue and other things being equal reduce the deficit of government expenditure and hence borrowing requirements

Question 6

A country is said to be in internal and external balance when?

Answer 6

AD is at full employment and the current account of the balance of payments balance.

Question 7

What do external and internal balances refer to?

Answer 7

International trade flows whereas internal balance refers to full employment

Question 8

If fixed investment is very sensitive to changes in interest rates, the most effective method of stimulating the economy would be to?

Answer 8

Increase the money supply as it would reduce interest rates, making private sector investment more attractive to UK firms

Question 9

Explain the fractional reserve banking system?

Answer 9

It gives rise to the potential money multiplier. The monetary base is the currency supplied by the bank to the commercial banks and private sector. The money multiplier is the extent to which the money supply is a multiple of the monetary base

Question 10

What are key determinants of the size of the multiplier?

Answer 10

The cash reserve ratio of commercial banks, and the private sector’s preferred ratio of cash to bank deposits. The lower these ratios are, the larger the money multiplier will be

Question 11

Why is it called fractional reserve banking?

Answer 11

As only a small proportion of the sterling liabilities are held as cash assets. Banks create money because of fractional reserve banking. If only a small proportion of new deposits have to be retained as cash reserves, this facilitates the expansion of more loans

Question 12

Describe the balanced budget multipler

Answer 12

It will generate an increase in overall national income even though government spending and revenue are balanced.

Question 13

Forward rate

Answer 13

Forward = spot x (1+rv)/(1+rf)

Question 14

Is a weakening currency good for exporters?

Answer 14

Yes as it makes their products cheaper in foreign currency terms

Question 15

How are spot and forward rates linked?

Answer 15

They are linked by interest rate parity

Question 16

What is M0?

Answer 16

It is the narrowest measure of the money supply. M0 was the BoE’s main narrow money measure and comprised sterling notes and coins in circulation outside the Bank, together with banks’ operation deposits with BoE.

Question 17

What is M2?

Answer 17

M2 is notes and coints plus all retail deposits held by the non-bank private sector

Question 18

What is M4?

Answer 18

Includes notes and coins, deposits, CDs, repos and securities with a maturity of less than five years held by the nonbank private sector

Question 19

What is the Taylor rule?

Answer 19

It suggests that a 1% change in inflation should be countered by a greater than 1% change in interest rates in the same direction.

Question 20

What does the Taylor rule specify?

Answer 20

The relationship between short-term interest rates, inflation relative to target inflation, and GDP relative to full employment output

Question 21

What is the aim of the Taylor rule?

Answer 21

To set rates that will stabilise the economy in the short term and still maintain long-term growth. It is intended to reduce uncertainty about economic policy and enhance policy credibility

Question 22

What does the debt deflation or credit cycle theory suggest?

Answer 22

That the financial sector causes cyclical changes in the economy as a result of its attitude towards credit availability

Question 23

What is an optimal currency area?

Answer 23

An optimal currency area is a geographical region in which overall economic efficiency will be maximised through the use of a single currency

Question 24

What is the minimum level of common equity Tier 1 capital permitted by Basel III?

Answer 24

4.5%. European regulators require a mnimum level of liquidity relative to total liabilites.

Question 25

What did Basel III introduce?

Answer 25

A new set of liquidity coverage rules that ensure a bank has adequate stock of high quality liquid assets that can be converted into cash easily and immediately in private markets

Question 26

What is common equity tier 1?

Answer 26

The highest quality of regulatory capital, as it absorbs losses immediately when they occur.

Question 27

What does CET1 measure?

Answer 27

The CET1 ratio measures a bank’s capital against its assets

Question 27

What is helicopter money?

Answer 27

The printing and distribution of money to the population, either directly or through infrastructure investments or tax cuts

Question 27

How does helicopter money work?

Answer 27

It is a form of monetary finance whereby the central bank finances fiscal stimulus through money creation.

Question 28

How do banks provide helicopter money?

Answer 28

The bank provides money to the government which can involve a direct transfer to the government’s account, buying government debt and direct payments to the general population.

Question 29

What socio-economic trends affect a country’s macroeconomic policy?

Answer 29

The role of an ageing population. This adds extra demands to the health service and pension provision in the UK

Question 30

What is another major macro consideration?

Answer 30

Climate change and sustainable development for poorer nations, with an integrated approach to a low-carbon, high-growth transformation of the economy