Financial Framework

Question 1

What is money?

Answer 1

Anything generally accepted in exchange for goods and services

• A store of wealth
• Divisible into different units of value thereby facilitating trade

Question 2

What is liquidity?

Answer 2

The ease and speed with which an asset can be turned into cash

Money assets usually classified by degrees of liquidity

Question 3

What is narrow money?

Answer 3

Most liquid e.g notes, coins and current bank accounts

Question 4

What is broad money?

Answer 4

Narrow money + less liquid deposit accounts and deposits held by government and other financial institutions

Question 5

What is confidence?

Answer 5

• Confidence is the willingness to accept money in exchange for goods and services
• Money has no intrinsic worth - its values derive from a willingness to accept and recognise it (making it extrinsic)
• Collapse in confidence causes a breakdown in the financial system

Question 6

How did Chile face money crises?

Answer 6

Salvador’s Marxist policies, nationalisation and expansionary monetary policy led to inflation of 600% in 1972 and 1200% in 1973

Salvador was then overthrown by Augusto Pinochet in 1973 and the Chilean Escudo replaced in 1975 with new peso

Question 7

What is inflation?

Answer 7

• An increase in the general price level over a certain time period
• Reduces the value of money
• Affects international competitiveness of business
• Calculated as a price indices (RPI, CPI)

Question 8

What types of inflation are there?

Answer 8

Cost push inflation

Demand pull inflation

Question 9

What is cost push inflation?

Answer 9

Rising input prices increase the cost of production - production declines, demand falls, GDP falls

Negative relationship between cost push inflation and GDP

Question 10

What is demand pull inflation?

Answer 10

Increase in demand leads to increasing price levels - demand outstrips production, increased production to meet demand reduces unemployment and increases demand

Positive relationship between demand pull inflation and GDP growth

Question 11

What is negative inflation/deflation?

Answer 11

• Inflation less than 0%

Caused by:

• Reduction in cost/price of goods
• Increase in production/excess capacity
• Reduced supply of money
• Cash building (hoarding)

Question 12

What consequences does negative inflation have?

Answer 12

It increases the value of money but could have negative consequences

• Associated with recession
• Redistributes wealth between lenders and borrowers

Question 13

How do interest rates affect business?

Answer 13

• Interest rate = price paid to borrow money
• Cost to borrowers and income to lenders
• Interest rates can influence the cost of financing a business, the lending behaviour of financial institutions and inflation

Question 14

Why are lending rates important?

Answer 14

A multinational firm can decide to borrow in countries where the rates are cheaper and those the funds to finance its operations in other countries where rates are high

Question 15

How do interest rates, recession and inflation work in a cycle?

Answer 15

Inflation - worry about increase in price levels

–> Interest rate - increase to reduce borrowing and inflation

–> Recession - worry about fall in consumption and GDP

–> Interest rate - reduce to boost economy

Question 16

What are exchange rates?

Answer 16

• The price of money in terms of another currency
• Determines how much is needed to buy another currency
• Has significant impact on firms with international operations
• Increase or decrease in exchange rates creates winners and losers

Question 17

What are the choices of exchange rate regimes?

Answer 17

• Fixed exchange rate
• Floating exchange rate = set by supply and demand
• Managed float - interventions when necessary (CHINA)

Question 18

Why do countries use fixed exchange rate regimes?

Answer 18

• Avoid competitive depreciation e.g trade wars
• Provide stability e.g avoid speculative bubbles
• Facilitate long term planning

Question 19

What is imported inflation?

Answer 19

Can be caused by a declining home currency or an increase in foreign prices

Question 20

Which important institutions exist in international finance?

Answer 20

• International Monetary Fund (IMF)
• World Bank
• Bank for International Settlements
• European Central Bank

Question 21

What do private financial institutions include?

Answer 21

• Banks
• Microfinance institutions
• Private Equity firms
• Ventrue capital firms
• Insurance companies

Question 22

Why are private financial institutions important?

Answer 22

• They mobilise savings and provide credit at home and abroad
• Provide domestic and international payments systems
• Reconcile ST requirements of savers with LT needs of business
• Spread risk across projects and countries
• Protection from shocks

Question 23

What do trends in the financial environment include?

Answer 23

• Decline in the umber of banks
• Growth in the average size of banks
• Increase in market concentration

Question 24

What are trends in the financial services industry caused by?

Answer 24

• Domestic mergers
• International mergers
• Some mergers are due to financial crisis
• Bank strategies

Question 25

What are the motives for bank mergers?

Answer 25

• EOS (market share)
• Economies of scope - offer bundles of products and services
• Government regulation (e.g Nigeria, Spain)
• Rechannelling savings to borrowers in other countries
• Avoidance of regulation - go to places with lax rules

Question 26

What are examples of bank mergers?

Answer 26

Lloyds bank bought credit card company MBNA in 2016

Clydesdale, Yorkshire and Virgin money consolidated in June 2018

Question 27

What are financial markets?

Answer 27

• Financial markets are mechanisms/intermediaries that bring lenders and borrowers together to transact
• Financial institutions usually operate through financial markets: capital markets, foreign trading exchange markets
• The strength of financial markets differs from country to country
• Emerging and developing markets usually have weak capital markets

Question 28

What can lead to financial crisis?

Answer 28

Over engineering and new product development in advanced financial markets can lead to financial crises

Question 29

What are the characteristics of financial crisis?

Answer 29

• Speculation, market euphoria, rising asset prices
• Turning point - panic, facing asset prices, pessimism
• Contagion - spread of the crisis internationally

Question 30

How did the global financial crisis occur in 2007?

Answer 30

Low interest rates and weak regulation

–> Ferocious search for profits by financial institutions

–> Subprime mortgage lending in US to risky borrowers

–> Repackaging of high risk subprime mortgages with other less risky financial products

Question 31

What were the outcomes on banks from the recession?

Answer 31

• Lehman bros went bankrupt
• Banks forced by gov to merge
• Massive bail out of banks in US and Europe
• Banks taken into public ownership e.g RBS

Question 32

How did advanced economies go into recession after the financial crisis in 2007?

Answer 32

• Low interest rates in US, UK, Eurozone and Japan
• High levels of public and private debt
• Fiscal deficits ballooned
• Quantitative easing to stimulate the economies
• Tighter bank regulation

Question 33

What makes financial regulation attractive?

Answer 33

• Tight regulation reduces attractiveness
• Little regulation scares customers
• A good balance required

Question 34

How can effective financial regulations be helpful?

Answer 34

• Protects consumers against fraud
• Ensures that payments systems operate smoothly
• Maintain liquidity in the system
• Avoid financial crises

Question 35

What regulatory challenges are there?

Answer 35

• Fierce bank resistance to tighter regulation

Financial institutions difficult to regulate because:

• They operate internationally
• Some countries have little regulation
• Corruption especially in developing countries
• The development of new financial products