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Economics Yr2 Macro > Financial Markets and Monetary Policy > Flashcards

Financial Markets and Monetary Policy Flashcards

1
Q

Explain 3 key functions of the bank of England

A
  • Help government meet economic objectives - especially price stability
    • Keep inflation at around 2%
  • Bring about financial stability in the financial system
    • As a lender of last resort to the banking system - Bankers bank - save a bank from failing if they deem it necessary to
    • Monitor/regulate banking system
  • Act as the Governments bank
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2
Q

What is a monetary policy objective

A

The target that the Bank of Enland aims to hit

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3
Q

What is a monetary policy instrument

A

The tool of control used to try to achieve the monetary policy objective

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4
Q

Name the 5 ways adjusting interest rates affects Aggregate demand

A
  • Through the exchange Rate
  • Level of burrowing
  • Mortgages
  • Level of saving
  • Level of business investment
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5
Q

How do interest rates affect the level of Aggregate Demand through the exchange rate

A

Higher interest rates give a higher incentive for foreign investors to save in UK banks, converting their currency to £

This increases demand for the £, strengthening the £

So exports will fall, decreasing AD

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6
Q

How do interest rates affect the level of Aggregate Demand through business investment

A

Interest rates are the cost of business investment

As firms usually will take out a loan to finance a loan, or due to the opportunity cost of investing profits rather than saving them.

So higher interest rates increase the cost of investment, so investment decreases, AD decreases

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7
Q

What is the transmission mechanism

A

The 5 different channels believed by the Bank of England that interest rates affects level of AD and therefore affect inflation, an objective of monetary polic

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8
Q

Define Conventional monetary policy

A

The Bank of England using the Bank rate to manage the level of AD in an attempt to control the rate of inflation

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9
Q

What is Unconventional Monetary Policy

A

Monetary policy instruments that support conventional monetary policy

  • Quantitative easing
  • Forward guidance
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10
Q

What is Quantitative easing

A

The bank of England ‘creating money’ to buy asset from private sector institutions

Through Asset prices or the amount of money in the economy, this eventually causes spending and income to increase, getting inflation back to its target

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11
Q

How does quantitative easing increase inflation through asset prices

A
  • Buying assets from private instritutions increases demand for them, so their asset prices increase
  • So higher asset prices making its owners richer(eg. through pension funds), and it lowers yields, lowering the cost of burrowing.
  • So spending and income goes up
  • AD goes up
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12
Q

How does Quantitative easing increase AD through money in the economy

A
  • Buying assets from private institutions gives them more cash which they can spend on goods/services/other financial assets and banks have larger reserves as more money will be deposited into them
  • Banks having larger reserves means they can increase their lending to households/businesses, making it easier for them to finance spending
  • So spending goes up
  • And AD goes up
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13
Q

What are QE1, QE2, QE3

A

The only three bouts of QE

The only three times when Quantitative Easing has been done in the UK

QE1 - March 2009 - £200 Billion

QE2 - Oct 2011 - £125 Billion

QE3 - July 2012 - £50 Billion

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14
Q

Using examples, describe the impact Quantitative Easing has had on the UK economy

A
  • QE1 prevented the recession from developing into a full depression, by propping up AD
  • Post recession, QE2 and QE3 seemed to have little impact, from 2010 onward UK growth had stayed close to 0%
  • Though due to QE, Inflation has stayed persistently above 2% in 2010-2013
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15
Q

What is Forward Guidance

A

Attempts to send signals to financial markets, businesses and individuals about the BofE’s interest rate policy in the future

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16
Q

What is the impact of Forward Guidance

A

Calms uncertainty in otherwise jittery financial markets

Allows BofE to engineer an outcome in which interest rates are of a certain level by signalling they will be at that level

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17
Q

What is the Financial Policy committee

A

Part of the Bank of England that identifies, monitors and takes action to reduce systemic risks

Operate on a more macro scale

Provide advice to the PRA and FCA and government

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18
Q

What is the Financial Conduct Authority

A

Protect consumers and increase trust in the financial system

Operate on a micro scale

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19
Q

What is the Prudential Regulation Authority

A

Part of the Bank of England responsible for the supervision of banks in the public interest

They specify ratios/requirements/industry standards and maintain stability in banks - monitor if the Basel Agreement regulations are being followed

Operate on a more micro scale - banks

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20
Q

What is liquidity ratio

A

The ration of a bank’s cash and other liquid assets to its deposits

Current Assets/Current Liabilities

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21
Q

Name 3 functions of the Financial Conduct Authority

A
  • Protect consumers by securing an appropriate degree of protection for them
  • Protect financial markets so as to enhance the integrity of the UK financial system
  • Promote effective competition in the interests of consumers
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22
Q

What is narrow money

A

The part of the stock of money made of cash and liquid bank and building society deposits

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23
Q

What is Broad Money

A

The part of the stock of money made of narrow money and some less liquid assets such as stocks, shares

Called M4 by BofE

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24
Q

Define liquidity

A

Measures the ease with which an asset can be converted into cash without loss of value. Cash is the most liquid of all the assets

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25
Q

Name the 4 characteristics of money

A

It’s a medium of exchange/means of payment

Store of value/wealth

A measure of value

A standard of deferred payment

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26
Q

What are assets

A

Anything that a business owns

Have value

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27
Q

What are liabilities

A

Anything that a business owes

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28
Q

What are money markets

A

Financial market where financial assets with a pay back date of within a yr are traded

Gov. bonds

Interbank lending

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29
Q

What is the LIBOR

A

The London Interbank offered rate

The interest rate charged in the London Interbank market

When banks lend to each other

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30
Q

What are capital markets

A

Where financial assets with a pay back date of over a yr are traded

Gov. bonds and shares

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31
Q

What is a foreign exchange market

A

Global, decentralised markets for trading currency

The biggest kind of market in the global economy

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32
Q

What are portfolio balance decisions

A

Decisions on the form of asset to keep their wealth

Physical assets such as houses/cars

Or financial assets such as shares/cash/gilts

33
Q

What relationship would one use to make a portfolio balance decision

Explain the relationship

A

The inverse relationship between Liquidity and profitablity.

A more liquid asset will yield less profit

As there is less risk seeing that you are committing money to it for less time

Banks will want your money for as long as possible so they can give out longer loans, so give more interest to longer deposits

34
Q

What are gilt edged securities

A

Government bonds

Corporate bonds

They are fixed interest bonds

35
Q

What is a commercial bank

A

A commercially run financial institution that accepts deposits from the general public and creates deposits that are lent to customers who wish to borrow from their bank

36
Q

What is an investment bank

A

A bank that doesn’t trade with members of the general public

They try to get more profit out of their own profit through prop trading

A place where bonds/shares can be bought/sold on behalf of lenders/burrowers

Advisory roles

37
Q

What is systemic risk

A

The risk of a breakdown of the entire banking system

A cascading failure due to inter-linkages in the financial system between commercial and investment banks which can result in a severe downturn in the whole economy

38
Q

What are intermediaries in financial markets and how do they work

A

Commercial/investment banks, pensions funds etc.

They make up financial markets aswell

Take funds from lenders (and pay a return on them) then from that money give out loans to lenders and charge an interest rate

Profit is made due to the difference between the money they get from the interest rate and what they pay out as the rate of return

39
Q

What the role of a financial market

A

To bring together lenders and burrowers to one place to meet and trade financial assets

40
Q

Who are Lenders

A

Those that have excess cash that they don’t need to spend

Savers

Investors

41
Q

Who are burrowers

A

Those who need cash but don’t currently have it

Individuals

Firms

Governments

42
Q

What is debt capital

A

A financial asset that pays back an interest rate

So it is a form of burrowing for the issuer

Bonds

43
Q

What is equity capital

A

Stake/share of the business

The return is a dividend from the profit

So it isn’t burrowing for the issuer, no interest is paid

Shares

44
Q

What is the difference between a primary and secondary financial market

A

Primary Financial market - Where brand new bonds/shares are traded

Secondary - Where second hand bonds/shares are traded - so not from the issuer

45
Q

What is the difference between a spot and futures currency market

A

Spot - Where you buy currency at the current exchange rate and it gets delivered to you immediately

Futures - Where you buy currency at the current exchange rate and it gets delivered to you in the future, so you don’t need to trade with the possibly weaker currency in the future

46
Q

What is a bond

A

An IOU

Paper that guarantees the holder:

Regular interest payments

The value of the bond back when it matures

47
Q

Who issues bonds

A

Governments, burrowing to fund spending

Corporations, burrowing to raise finance to spend

48
Q

Why do people buy government bonds

A

Low risk, as there is a very low chance that the government will go bankrupt

Might give them a higher return than alternatives

49
Q

What 4 things does a government bond specify when being issued

A

Maturity date

Coupon

Market price

Nominal Value

50
Q

What is a coupon

A

Fixed interest rate paid by the issuer of a bondover the period of time

A percentage of the nominal value

51
Q

What is a maturity date

A

When the issuer is meant to pay back the bond

52
Q

What is the difference between the nominal value and market price of a bond

A

Nominal value - The initial value of the bond, how much the issuer receives when it is first bought. The amount the issuer will pay back

Market Price - Price of the bond in the market due to demand and supply

53
Q

How to calculate Bond Yield

A

Coupon / Market Price x100

54
Q

What is Bond Yield

A

The rate of return on the bond, basically the interest on the bond

Proportion of the return that is being paid to them by the gov. (coupon) to how much they initially paid for it

So for a brand new bond, the bond yield is just the coupon

55
Q

What is the relationship between Bond yield and Market Price of a bond, why

A

As Market price goes up

Bond Yield goes down

Refer to equation, they are inversely linked

56
Q

How do the government set the coupon rate

A

Try to equalize bond yield with interest rates on other financial assets

Setting the coupon lower will mean no one buys it

Setting it higher will mean its easier for them to burrow as more people want to buy it

57
Q

Explain the relationship between market interest rates and bond prices

A

Inverse

They are both simply due to returns on financial assets

Higher market interest rates increase the return on other financial assets, so demand for bonds will decrease, so the market price of bonds will decrease

58
Q

Explain how banks create credit - create new money

A

Fractional reserve banking

  • If saver deposits £100 into the bank, the bank knows it’s unlikely they will come back and withdraw all the £100, instead they might assume they will only withdraw £10.
  • The reserve ratio is 10%
  • So the bank lends out the remaining £90
  • The £90 goes through the economy and will find its way back to the bank as another deposit by someone else
  • So when only £100 existed before, now £190 is in the money supply
  • So of the money supply, bank will keep £9 of it just incase, and lend out £81
  • And then this is repeated
59
Q

How to calculate Money Multplier

A

Money Multiplier = 1/ (Reserve Ratio as a decimal)

60
Q

What is the Money Multiplier

A

The total amount of money in the money supply as a factor of the initial deposit, due to credit creation

61
Q

What is a balance sheet

A

A financial record of all the assets, liabilities and capital at any given point in time

62
Q

What is capital on a balance sheet

A

Part of the liabilities owned by the shareholders

Shareholders funds - Can be taken out at anytime by shareholders

Retained profits - paid to shareholders as dividends

They are owed by the bank to the shareholders

63
Q

In what way must a balance sheet balance

A

Assets = Liabilities (Liabilities include capital)

64
Q

Give 5 examples of assets on a balance sheet, in order of liquidity, starting with the most liquid

A

Cash

Reserves at the BofE (In their ‘bank account at the BofE’)

Money lent to other banks

Investments

Loans

65
Q

Give 3 examples of Liabilities on a balance sheet

A

Deposits

Burrowing (Issuing corporate bonds, burrowing from other banks or the BofE)

Capital

66
Q

Explain the biggest objective of a commercial bank

How do they achieve this

A

Profit maximisation

Keep shareholders happy - principal-agent problem

Short term burrowing

Long term lending

Taking more risks to have more chances to charge a higher interest rate

67
Q

Explain 3 consequences of bank failure

A
  • Systemic risk
    • If one bank fails, the whole financial system can come crashing down
  • Recession (especially in the UK)
    • Lost incomes, jobs, output in many sectors due to failed financial system
  • Bank Bailouts
    • If BofE decide to bailout banks, it is with tax payer money
    • Oppurtunity cost of this
68
Q

What are the 2 ways in which a commercial bank can fail

A
  • Liquidity crisis
    • Not enough short term liquid assets to meet short term liabilities
    • Not enough liquidity
  • Can go insolvent
    • Not enough capital to offset loans that go bad, liabilities exceed assets
    • Not enough security
    • Less risks
69
Q

Explain the trade off between the objectives of a commercial bank

A

Being more profitable will reduce a banks liquidity and security

So a bank issuing more secure loans and keep more liquid assets will reduce profit

70
Q

Why is it important for a bank to keep a balanced Portfolio balance sheet

A

To reduce the risk of bank failure but make a profit still

As the difference between assets and liabilities won’t be too great

71
Q

What is Moral Hazard

A

When a firm pursues profit and takes on too much risk, knowing that if things go wrong, someone else will bear a significant portion of the cost

72
Q

How might the BofE save a bank in a liquidity crisis

A

Act as the bankers bank and loan them more liquidity with interest

Only if the BofE deem it necessary for the sake of society

73
Q

Why is it important for there to be stability in the financial system

A

To maintain confidence

  • Prevent panic and a run on the bank
  • Reduce financial instability and systemic risk
74
Q

What is capital ratio

A

Ratio of the amount of capital to the amount of loans issued

Proportion of each £ of loan that the bank needs to keep incase the loan goes bad or

75
Q

What is the Basel Agreement

A

Regulation/limits on bank lending to help prevent the 2008 the financial crisis

Just recommendations but many countries such as the UK have made them law

76
Q

What is the importance of a capital ratio

A

Prevents banks going insolvent - not having enough capital to fall back on and offset any losses due to loans

Prevent bank failure/systemic risk

77
Q

What would be the effect of the PRA imposing a liquidity ratio

A

Will prevent a liquidity crisis

Banks must now keep a certain quantity of assets to be able to pay back liabilities to avoid bank run

78
Q

What were the Basel recommendations for liquidity ratios as of 2017

A

100% liquidity ratio to be achieved by 2019

Liquidity coverage ratio - must have 100% liquidity to cover any liabilities owed in 30 days or less

79
Q

What is a loophole in the capital ratio regulation by the PRA

A

That it specified banks only had to follow this ratio on riskier loans, such as to firms/entrepeneurs

for ‘safer loans’ eg. mortgages, banks didn’t have to follow this ratio

Economics Yr2 Macro (5 decks)

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