Financial markets and Monetary policy

Question 1

Functions of Money

Answer 1

Unit of account - Relative value of goods and services can be compared, the cost of all goods can be expressed in a common pricing system.
Means of deferred payment - Widely accepted way to pay in the future for goods and services acquired now.
Medium of exchange - Money acts as a medium of exchange. This allows goods and services to be traded without the need for a barter system.
Store of value - Maintains value over time

Question 2

Characteristics of money

Answer 2

• Portable
• Limited in supply
• Acceptable
• Durable
• Difficult to forge
• Divisible

Question 3

Narrow Money and Broad Money

Answer 3

Narrow includes notes. coins and reserves held by the BofE. Broad includes anything that has a redemption date less than 5 years away.

Question 4

Quantity theory of money

Answer 4

One of the primary research areas for the branch of economics referred to as monetary economics is called the quantity theory of money.
According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy—assuming the level of real output is constant and the velocity of money is constant.
The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money, ceteris paribus, decreases the marginal value of money so that the buying capacity of one unit of currency decreases.
Many Keynesian economists remain critical of the basic tenets of the quantity theory of money and monetarism, and challenge the assertion that economic policies that attempt to influence the money supply are the best way to address economic growth.

Question 5

Quantitative easing

Answer 5

Quantitative easing is a form of monetary policy used by central banks to increase the domestic money supply and spur economic activity.
Central banks create new money electronically to buy financial assets such as corporate government bonds from financial such as pension funds as well as commercial banks. This process means that commercial banks and other financial institutions will have greater liquidity, which should increase lending and lead to a rise in private sector spending in the economy.

Question 6

Money demand

Answer 6

• Rate of interest
• amount of transactions we expect to undertake
• speculative motives
• changes in GDP
• Precautionary motive
• The rate of anticipated inflation on real interest rates

Question 7

Financial markets

Answer 7

Money market - Market for short-term loan finance, primary for firms and households.
Capital market - Medium to long-term finance.
Foreign exchange market - Where currencies are traded.

Question 8

Bonds

Answer 8

In the world of finance, bonds are basically IOUs that allow companies or governments to borrow money from investors. When you buy a bond, you’re lending money to the issuer in exchange for regular interest payments and the promise of getting your principal back at a set time in the future.
Interest rates and bonds are inversley related.

Question 9

Yield equation

Answer 9

(coupon/current market price) X100

Question 10

Commercial bank

Answer 10

Commercial banks are an important part of the economy. They not only provide consumers with an essential service but also help create capital and liquidity in the market. Commercial banks ensure liquidity by taking the funds that their customers deposit in their accounts and lending them out to others.

Question 11

Investment banks

Answer 11

In essence, investment banks are a bridge between large enterprises and the investor. Their primary roles are to advise businesses and governments on how to meet their financial challenges and to help them procure financing, whether it be from stock offerings, bond issues, or derivative products.

Question 12

money supply (M4)

Answer 12

The money supply measures the total amount of money in the economy at a particular time.

Question 13

Micro and Macro Prudential Policies

Answer 13

Micro-prudential - involves regulation of individual financial firms such as commercial banks, payday lenders and insurance companies.
Macro-prudential - regulation is designed to safeguard the financial system as a whole. Includes counter-cyclical capital buffers.

Question 14

Minsky’s ‘financial instability hypothesis’

Answer 14

To conclude, Minsky argues that periods of prolonged prosperity, the ‘tranquil period’, incentivise financial institutions to invest in riskier assets. However, riskier assets result in greater market exposure, making the system more vulnerable to defaults.

Question 15

House/Asset price ‘bubble’

Answer 15

A housing bubble, or real estate bubble, is a run-up in housing prices fuelled by demand, speculation, and exuberant spending to the point of collapse.

Question 16

Subprime mortgages

Answer 16

“Subprime” refers to the below-average credit score of the individual taking out the mortgage, indicating that they might be a credit risk.

Question 17

Bank rate

Answer 17

The bank rate is the interest rated charged by a nation’s central bank for borrowed funds.

Question 18

coupon

Answer 18

the interest you receive back annually

Question 19

par value

Answer 19

the amount you pay for the bond determined by demand/supply.

Question 20

market value

Answer 20

the price a bond rises/falls to

Question 21

yield

Answer 21

percentage of the market you receive back

Question 22

holding a bond to maturity

Answer 22

waiting until the bond reaches its end date and the original loan date is repaid.

Question 23

investment bank

Answer 23

An investment bank is a financial services company that acts as an intermediary in large and complex financial transactions. An investment bank is usually involved when a start-up company prepares for its launch of an initial public offering (IPO) and when a corporation merges with a competitor. It also has a role as a broker or financial adviser for large institutional clients such as pension funds

Question 24

balance sheet

Answer 24

The term balance sheet refers to a financial statement that reports a company’s assets, liabilities, and shareholder equity at a specific point in time. Balance sheets provide the basis for computing rates of return for investors and evaluating a company’s capital structure.

Question 25

interest rates

Answer 25

Interest rates are the cost of borrowing money. Interest rates are normally expressed as a % of the total borrowed, e.g. for a 30-year mortgage, a bank may charge 5% interest per year.
Interest rates also show the return received on saving money in the bank or from an asset like a government bond.

Question 26

liquidity trap

Answer 26

a condition that can occur when interest rates fall so low that most people prefer to let cash sit rather than put money into bonds and other debt instruments. The effect, Keynes said, is to leave monetary policymakers powerless to stimulate growth by increasing the money supply or lowering the interest rate further.

Question 27

Financial policy committee

Answer 27

The FPC’s main role in the UK is to identify, monitor, and take action to remove or reduce risks that threaten the resilience of the UK financial system as a whole.

Question 28

UK Prudential regulation authority

Answer 28

The PRA is part of the Bank of England and is responsible for the prudential regulation and supervision of around 1,700 banks, building societies, credit unions, insurers and major investment firms. The PRA has a particular focus on the solvency of specific financial markets such as: Insurance providers, Buy-to-let mortgage lenders, Credit unions and other specialist lenders.

Question 29

Financial conduct authority

Answer 29

The Financial Conduct Authority (FCA) replaced the Financial Services Authority (FSA) on 1 April 2013. It is funded entirely by the firms it regulates. The FCA has three main objectives:
(1) Secure an appropriate degree of protection for consumers
(2) Protect and enhance the integrity of the UK financial system
(3) Promote effective competition in the interests of consumers.

Question 30

Systemic risk

Answer 30

Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called “too big to fail.”

Question 31

Liquidity

Answer 31

Liquidity means the ease and cost with which assets can be turned into cash and used immediately as a means of exchange. Cash is very liquid whereas a life assurance policy is less so.

Question 32

Debt and Equity

Answer 32

Debt is a way of raising money by borrowing. It can be done via a direct loan or by issuing a bond. Equity is a financial term for stocks/shares. It means ownership of a company.
If you finance by issuing debt, you do not have to give up any ownership of the company but you have to pay interest payments without fail.
If a company lists the company on a stock exchange, it’s called an initial public offering to by equity of the company. If you raise finance by issuing equity you give up some ownership of the company.

Question 33

Central Bank

Answer 33

Functions:
- Implementation of Monetary policy
- Act as a banker to the government
- Act as a banker to the banks (lender of last resort).
- Regulation of the banking industry
e.g. Bank of England.

Question 34

Monetary Policy committee

Answer 34

The body within the BofE that is in charge of achieving price stability. Normally meet once a month to vote on whether there will be a change to monetary levers or not.
They set the ‘base rate’ of interest for the economy. This is used by banks and other such institutions as a guide for what interest rate to pay consumers on their savings and to charge corporates for borrowing.

Question 35

London Inter-bank offered rate (LIBOR)

Answer 35

The rate at which commercial banks lend/borrow from each other.

Question 36

Moral Hazard

Answer 36

Happens when people engage in riskier behaviour with insurance than they would without insurance. Caused by imperfect information.

Question 37

Stress test

Answer 37

Allows the FPC and the PRC to assess banks’ resilience and make sure they have enough capital to withstand shocks, and to support the economy if a stress does materialise.