Macro 20: Financial Markets and Monetary Policy Flashcards
Explain the characteristics and functions of money
Functions of money:
Medium of exchange
Unit of account
Store of value
Standard of deferred payment
Characteristics of money:
-Acceptable by the population to serve as a medium of exchange
-Durable
-Portable
-Divisible
-Scarce
-Difficult to forge
Explain where different forms of money lie on the spectrum of liquidity and the difference between narrow and broad money
Narrow money is a measure of the money supply that includes balances that can be used immediately as a medium of exchange and accessible bank balances
Broad money is a measure of the money supply that includes notes and coins, as well as most balances held by banks and other financial institutions
Liquidity spectrum from most to least liquid:
cash in hand, sight deposit, treasury bill, gold bar, 2 year corporate bond, 10 year guilt, house, infrastructure
Distinguish between the money market, capital market and foreign exchange market
The money market deals in short-term finance between firms, individuals and governments- focusing on debts due to be repaid in the near future
The capital market deals with medium-term and long-term finance such as share and bond issues between individuals, firms and governments- focusing on debts due for repayment more than a few months ahead
The foreign exchange market deals with transactions requiring conversion from one currency into another currency
Explain the difference between debt and equity
Debt is money which has been borrowed from a lender, which is usually a bank. There is little flexibility, and the loan is later repaid with interest. Equity is 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 owner’s equity is then the car or the house, which can be sold for cash.
Outline the differences between commercial and investment banks and their respective functions
Commercial banks (high street banks) are the banks most people use on a daily basis. They access deposits from the general public and lend money to those who wish to borrow money- often in the form of bank overdrafts and mortgages for homebuyers.
Investment banks are banks that provide financial services to other businesses, such as arranging share. They help companies raise finance by assisting with the issue of new capital (in the form of a share issue or a bond issue). They don’t allow the general public to open up bank accounts. They also assist governments with share issues for the privatisation of state-owned enterprises (eg. the Royal Mail in 2013). They earn income from charging a fee for the service of advising and organising the raising of finance.
Explain the role of a central bank in managing the economy.
The UK’s central bank is the Bank of England and is based in London.
It ensures financial stability by acting as the ‘lender of last resort’ to the banking sector- providing money for short-term needs to the sector and providing liquidity insurance, which means the central bank will make available liquid assets for banks that need access to those funds. They also monitor and regulate the UK’s financial institutions.
They also have a role to achieve macroeconomic stability measured by the 2% inflation rate target. This is set by the government. They only provide input on monetary policy and don’t directly influence the government’s fiscal or supply-side policies, but it’s believed that by achieving price stability it will be easier for the government to achieve other macroeconomic objectives.
Explain the objectives of a commercial bank, including liquidity, profitability and security
Banks are public limited companies owned by shareholders- they appoint directors to supervise the running of the company. Shareholders/managers will want to see their returns/effort rewarded and will look for profit/market share to be maximised.
Liquidity- banks have to manage their assets carefully and ensure they have sufficient notes and coins to meets the needs of customers withdrawing cash. If a bank has insufficient amounts to meet the requirements of its customers, it will have to borrow money (and pay interest) from the financial markets
Profitability- holding notes and coins doesn’t generate a return so it’s not profitable. Banks will want to make profit for their shareholders by lending out money to their borrowers and charging interest on any money lent.
Security- banks take risks when lending money as borrowers may fail to repay. Normally, the interest on the riskiest types of loans is higher to compensate for the higher risk. Therefore, greater profits can be made on riskier lending by the bank.
Explain how the objectives of a commercial bank may conflict
-Banks generally borrow short term and lend long term
-This means that if people wish to withdraw money from their accounts, the bank risks being unable to access money from those it has lent to for long-term use
-This means banks can be unstable so the BofE might step in to maintain stability
-Although a bank has a need for liquidity, it can make higher profits by lending out on risky, long-term ventures, meaning money is tied up elsewhere when the bank might need it
Explain how banks create credit
They do this by extending loans to households and firms. They don’t need to attract deposits from savers but make loans to attract them. When a bank makes a loan, it credits their bank account with a bank deposit of the size of the loan/mortgage. At that moment, new money is created. Banks can borrow from other financial institutions or sell shares to gain the funds to make the loans.
Explain how bonds are used to raise funds and the meaning of ‘coupon’, maturity and yield
Maturity date- the date upon which the borrower will repay the lender (most are fixed)
Coupon- annual amount of interest paid to the bond-holder as a percentage of the face value of the bond
Yield- the annual amount of interest paid on the bond (the coupon) expressed as a percentage of the current market price of the bond
Calculate the yield on a government bond
Yield (%)= coupon/market price x 100
Explain why there’s an inverse relationship between market interest rates and bond prices
Government bonds and savings in banks are substitute investments with similar levels of risks attached. They’re both very safe so consumers are happy to switch between the 2 forms of investment to maximise their return. A rise in interest rates will make savings in banks more attractive than purchasing bonds. The demand for, and hence price of, bonds will therefore fall, hence, the market price of bonds and interest rates have an inverse relationship.
The price of the bond will continue to rise/fall until the yield equates to the interest rate that can be earned on the high street.
Explain how the monetary policy committee apply changes to the base rate of interest, QE, funding for lending and forward guidance
The MPC decide what monetary policy action the BofE will take to keep inflation low and stable (qe) set bank rate and other monetary policy eight times a year through public announcements.
Members vote on monetary policy actions, majority carry the vote on what to do to the bank rate and support the government in macroeconomic objectives
Forward guidance- communication from a central bank about the state of the economy and the likely future course of monetary policy, try to influence financial decisions by providing a guidepost for the expected path of interest rates, trues to prevent surprises that disrupt markets to increase security and certainty of future borrowing cost and promote private sector investment for short run and long run growth and less risk
Funding for lending- Scheme launched by BofE and HM Treasury in 2012, designed to incentivise banks and building societies to increase lending to UK households and private non-financial corporations by providing funding to banks and building societies for an extended period, at below market rates with both pound and quantity of funding linked to performance in lending. Introduced to provide more economic growth when more conventional monetary policy like reducing base rates was in effective
Outline who the PRA, FPC and FCA are
Prudential Regulation Authority- they’re responsible for the provision of banks, building socieities, credit unions, insurers and major investment firms. It supervises individual financial institutions and sets standards for these financial organisations to follow. It aims to improve financial stability by taking action to ensure financial institutions are managed properly and can specify that individual institutions maintain certain capital and liquidity ratios. The PRA will allow banks and other financial institutions to fail as businesses, but only if their failure does not disrupt the overall financial system
Financial Policy Committee- its main purpose is to remove systematic risks to the whole financial system and take action to make it more robust. It can make recommendations to banks and other institutions if it feels they are at risk of failure and these risks are judged by stress tests
Financial conduct authority- it’s separate from the government and is funded by charging fees to financial institutions. Its aim is to protect consumers and ensure healthy competition between financial institutions. They can also regulate and set standards and rules for behaviour.
Explain the risks of lending long term and borrowing short term
Banks do this as it’s cheap to borrow money for a short time like 6 months at 2% and they can charge more when they lend money for a long period (5% for 25 years) which leads to more bank profitability but also more risk.
Problems occur when the bank has difficulty in borrowing due to a credit crunch, and/or it becomes expensive for them to borrow from the money markets, and can lend banks to run into difficulties on their balance sheet.
