Financial Markets and Monetary Policy

Question 1

what are the characteristics and functions of money

Answer 1

a medium of exchange

a measure of value

a store of value

a method of deferred payment -> money can allow for debts to be created -> people can therefore pay for things without debt being created

Question 2

what is the money supply

Answer 2

The money supply is the stock of currency and liquid assets in an economy. It
includes cash and money held in savings accounts.

Question 3

what is narrow money

Answer 3

Narrow money is physical currency (notes and coins), as well as deposits and liquid
assets in the central bank.

Question 4

what is broad money

Answer 4

Broad money includes the entire money supply. Cash could be in restricted accounts,
which makes it hard to calculate the money supply. It includes liquid and less liquid
assets.

Question 5

what is the money market

Answer 5

In the money market, liquid assets are traded. It is used to borrow and lend money
in the short term.

Question 6

what is the capital market

Answer 6

The capital market is where equity and debt instruments are bought and sold.

These
can then be put to long-term productive use by firms and governments

Question 7

what is the foreign exchange market

Answer 7

The foreign exchange market is a market where currencies are traded, mainly by
international banks.

It determines what the relative value of different currencies will
be.

Question 8

what is the role of financial markets in the wider economy

Answer 8

Financial liquid assets are exchanged in a financial market.

For example, the stock
market and the bond market are two examples of financial markets.

To facilitate saving -> provide somewhere for consumers and firms to store their funds -> savings are rewarded with interest payments from the bank

to lend to businesses and individuals -> the transfer of funds between agents is aided by financial markets. The funds can then be used for investment or consumption

To facilitate the exchange of goods and services

to provide a market for equities

Question 9

what is the difference between debt and equity

Answer 9

debt is money which has been borrowed from a lender, usually a bank. There is little flexibility, the loan is later repaid with interest

Equity -> a stock or security which represents interest in owning e.g. a firm, a car or a house. It is when there is no outstanding debt, such as when a loan for a car or a mortgage has been fully paid off. The owners equity is then the car or the house, which can then be sold for cash

Question 10

why is there an inverse relationship between market interest rates and bond prices

Answer 10

There is an inverse relationship between market interest rates and bond prices.
When a bond is bought, money is lent to the issuer. The issuer agrees to pay the
value of the bond back when it matures, in addition to periodic interest payments.
The rate of interest is fixed when the bond is issued.

New bonds have rates close to the market interest rate. If the market interest rate
falls, for example, the bond would be worth more, since it carries a higher interest
rate than current market conditions. Similarly, the bond is worth less if the rate
increases. This is because the bond has a lower interest rate than the current
market

Firms can raise finance by issuing shares, issuing corporate bonds and borrowing
from a bank. Raising finance through shares is relatively cheap for firms. Although
firms are legally obliged to pay their shareholders dividends, a proportion of their
profits as a reward for investing in them, they only pay dividends when there are
distributable profits and it is voted for by shareholders.

Borrowing could involve paying back loans with high interest rates, which could be
expensive. This might be unaffordable for new, smaller firms. However, it is flexible
and the funds can be increased or decreased by borrowing more or paying back the
loan.

Corporate bonds are issued to raise funding for large projects, such as to expand the
firm, develop a product, move to a new premise, or takeover another firm. Bonds could be traded in a similar way to shares, and they are partially protected against
variable interest rates or economic changes. However, the firm will have to pay the
investors who buy the bonds interest.

In relation to government bonds, the term coupon is an interest payment to the
bondholder between the date of issue and the date of maturity. Maturity is the
period of time for which the financial asset is outstanding. When it finishes and has
been repaid, it has matured.

Question 11

what is a commercial bank

Answer 11

A commercial bank manages deposits, cheques and savings accounts for individuals
and firms. They can make loans using the money saved with them

Question 12

what is an investment bank

Answer 12

Investment banks facilitate the trade of stocks, bonds and other forms of
investment.

Government regulation is weaker in the investment bank industry, and
this combined with their business model gives them a higher risk tolerance.

Question 13

what is the difference between commercial and investment banks

Answer 13

Commercial banks - manage deposits, cheques and savings accounts for individuals and firms

investment bank - facilitate the trade of stocks, bonds and other forms of investment

Question 14

what are the main functions of a commercial bank

Answer 14

-accept deposits

-provide loans (their main source of income as they can get paid back the loans with interest)

some loans are secured against an asset -> protects the banks funds if the loan is not repaid

-overdraft

when a current account has no deposits -> consumers can still borrow money from the bank in the form of an overdraft

-investment of funds

-agency functions

Question 15

what are the objectives of a commercial bank

Answer 15

-Liquidity

e.g. how easy it is to turn assets into cash -> liabilities are payable on demand so in order to be profitable banks must have cash and liquid assets

if liquidity is prioritised -> profits will be low -> banks need to balance between the two objectives

-Profitability

-Security

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Question 16

what is monetary policy used for and how is it done, who is it conducted by

Answer 16

used to control the money flow of the economy

done by:

interest rates

quantitative easing

conducted by the bank of England

Question 17

what are the functions of a central bank

Answer 17

the central bank manages the currency, money supply and interest rates in an economy

central banks issue physical cash securely and using methods to prevent forgery, so people can trust the money

the central bank can regulate bank lending to ensure there is stability in the financial system

Question 18

how is monetary policy implemented

Answer 18

the central bank influences interest rates, the supply of money and credit, and the exchange rate

the bank controls the base rate, which ultimately controls the interest rate across the economy

Question 19

define banker to the government

Answer 19

the central bank provides services to the central government

collects payments to the governments and makes payments on behalf of the government

The central bank also manages public debt and issues loans

The Bank can also advise the government on finance, including the timing and terms
of new loans.

Question 20

lender of last resort meaning

Answer 20

The Bank of England is considered to be a lender of last resort

if there is no other method to increase the supply of liquidity when it is low -> the bank of England will lend money to increase the supply

if an institution is risky or close to collapsing, the bank might lend to help them

usually banks will avoid borrowing from the lender of last -> suggests that the bank is experiencing a financial disaster

Question 21

what are the different instruments in monetary policy

Answer 21

interest rates

asset purchases to increase the money supply (Quantitative easing)

Question 22

what is quantitative easing

Answer 22

a method to pump money directly into the economy.

has been used
by the European Central Bank to help stimulate the economy

Since the
interest rates are already very low, it is not possible to lower them much more.

The bank bought assets in the form of government bonds using the
money they have created.

This is then used to buy bonds from investors,
which increases the amount of cash flowing in the financial system.

encourages more lending to firms and individuals -> as cost of borrowing is lower

in theory, it encourages more investment + more spending + hopefully higher growth

Question 23

Factors considered by the MPC (monetary policy committee) when setting the bank rate (interest rate)

Answer 23

Unemployment rate: If high -> consumer spending likely to fall -> suggests MPC will drop interest rates to encourage more spending

Savings rate -> if there is a lot of saving -> consumers are not spending as much -> interest rates might fall

consumer spending -> if there is a high level of spending in economy -> there could be inflationary pressures on price level (demand-pull) -> cause the MPC to increase interest rates

high commodity prices -> increased cost of production for firms -> cost push inflation -> higher prices of goods -> increase interest rates to increase the strength of the pound so factor inputs aren’t as expensive

exchange rate -> a weak pound would cause the average price level to increase -> makes UK exports relatively cheap -> so UK exports increase -> since imports become relatively more expensive there would be an increase in net exports -> the MPC might consider increasing interest rate

Question 24

How does changes in the exchange rate affect AD

Answer 24

a reduction in the exchange rate -> exports become cheaper + causes imports to become expensive -> means the current account deficit will improve

this inflationary pressure due to the increase in the price of imported raw materials -> increase costs of production for firms -> cost-push inflation

an increase in interest rates -> relative to other countries makes it more attractive to invest in the country because the rate of return on investment is higher -> increases demand for the currency -> causing appreciation (hot money)

Question 25

what is hot money

Answer 25

an increase in interest rates relative to other countries makes it more attractive to invest in the country because the rate of return on investment is higher -> increases demand for the currency -> causing appreciation

Question 26

why might governments regulate banks with regulations and guidelines

Answer 26

helps to ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank

Question 27

what is a moral hazard

Answer 27

when the borrower does things that the lender doesn’t see as desirable, because they will be less likely to repay the loan

e.g. usually occurs because there will be some form of insurance for the mistake

Question 28

why might a bank fail

Answer 28

Before the crash, asset prices were high and rising, and there was a boom in
economic demand.

There were risky bank loans and mortgages, especially in the US
where government securities were backed by subprime mortgages.

This means the
borrowers had poor credit histories, and after house prices crashed in the US in
2006, several homeowners defaulted on their mortgages in 2007.

Banks had lost
huge funds, and required assistance from the government in the form of bailouts.

There are risks involved with lending long term and borrowing short term.

They
might lose money on investments, and if there are insufficient funds in a vault, banks
might not be able to provide depositors with money when it is demanded.

Question 29

what is a liquidity ratio

Answer 29

A liquidity ratio is used to determine how able a company is to pay off short-term
obligations.

The higher the ratio, the greater the safety margin of the bank.

When
creditors want payment, they look at liquidity ratios to decide whether the bank is a
concern

Question 30

what is a capital ratio

Answer 30

A capital ratio is a comparison between the equity capital and risk-weighted assets of
a bank.

A bank’s financial strength is determined using this.

Assets have different
weightings, where physical cash has zero risk and credit carries more risk

Question 31

systematic risks

Answer 31

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