Financial markets 2 Flashcards
what is a money market
where financial assets are bought and sold with IOU’s less than or equal to a year
why does the demand curve slope downwards on a money market diagram
- The interest rate represents the opportunity cost of holding money instead of investing it in interest-bearing assets like bonds or savings accounts. When interest rates are high, people are less inclined to hold money because they can earn more by investing it. ther than investing it.
- As interest rates fall, money becomes more attractive relative to other financial assets. People substitute away from bonds or savings accounts (which offer low returns) and hold more money instead, increasing the quantity of money demanded.
why is the money supply curve vertical
- : The central bank determines the money supply. Since the central bank sets the money supply, it does not change in response to the interest rate. Whether the interest rate is high or low, the central bank controls the quantity of money, so the supply of money remains fixed at a particular level in the short run.
when supply=demand on money market diagram, we get…
equilibrium interest rate
factors affecting the supply of money
- reserve requirements
- change in discount rate, repo rate, bank rates
- open market operations
what is reserve requirement
the amount of money commercial banks need to keep in the Bank of England (by law)
what is bank rate
the rate at which commercial banks borrow from the bank of England in order to meet their liquidity need
what are open market operations
the buying and selling of govt bonds
how can central banks alter money supply using reserve requirements
- When the central bank lowers reserve requirements, banks need to hold less money in reserve, freeing up more funds for lending
- Banks can lend out a greater proportion of their deposits. Since loans create deposits, the money supply in the economy increases through the money multiplier effect.
- As banks lend more, the total money supply (M) in the economy rises because more loans mean more deposits and, hence, more money in circulation.
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how can central banks alter the interest rate using discount/repo/ bank rates
BANK RATE
- When the central bank lowers the bank rate, long-term borrowing becomes cheaper for commercial banks
- Lower costs encourage banks to borrow more, increasing their capacity to lend to businesses and consumers
- With more lending capacity, banks may reduce the interest rates they charge to attract borrowers, leading to lower market interest rates.
- Lower interest rates stimulate investment and consumption, boosting economic growth
how do central banks use open market operations to alter interest rates
When the central bank buys government bonds from commercial banks or the public, it pays for these bonds by crediting the reserves of the banks. This increases the total reserves in the banking system.
- With more reserves, banks have more money to lend, which increases the supply of credit in the economy.
- The increased supply of credit leads to a decrease in the interest rates, particularly the short-term rates like the federal funds rate in the U.S. This is because banks now have more reserves and thus are more willing to lend at lower rates to attract borrowers.
- Lower interest rates make borrowing cheaper for businesses and consumers, encouraging investment and spending. This can lead to economic expansion, particularly when the economy is operating below its potential.
what is a bond
a piece of paper (IOU) that guarantees the holder of the bond 2 things:
- regular interest payments every year
- they get the value of the bond back once it matures
who issues bonds and why
government - need to raise finances to help them with their spending in the economy (if they havent got enough tax revenue), they will issue government bonds
firms looking to invest - if they dont have the retained profit, they will borrow to invest, corporate bonds
who can buy bonds and why
- anyone, individuals, firms,govt
why? - the return on the bond might be better than the retun on other financial assets
what would be on a bond
- name(treasury gilts)
- coupon(interest rate fixed over duration)
- maturity(when the bond expires/is paid back)
- market price -