Macroeconomics: Financial markets and monetary policy

Question 1

What are financial markets?

Answer 1

Places where buyers and sellers come together to trade financial assets, such as stocks, bonds, currencies, and derivatives. These markets serve as intermediaries between those who need capital (borrowers) and those who have capital (investors).

Question 2

What are the roles of financial markets?

Answer 2

Allocation of capital: efficiently allocate capital to its most productive uses. Investors allocate funds to projects with the highest expected returns (some projects are riskier than others.)
Risk management: offer a platform for risk transfer. Participants can hedge against risks, such as interest rate risks and foreign exchange risks.
Price discovery: determines the price of financial assets, reflecting available information and market expectations.
Economic growth: well-functioning financial markets can spur growth by providing firms with access to capital for investment and innovation.
The main role is to match buyers and sellers to efficiently allocate financial capital to its productive uses.

Question 3

How do businesses use financial markets?

Answer 3

Finance a business start-up
Finance a merger or a takeover
Finance capital investment

Question 4

What is the money market?

Answer 4

Market for short term loan finance for businesses and households. Includes inter-bank lending i.e. commercial banks providing liquidity for each other.

Question 5

What is the capital market?

Answer 5

Market where securities such as shares, and bonds are issued to raise medium to long-term finance for businesses and the government.

Question 6

What is the foreign exchange market?

Answer 6

Where currencies are bought and sold.
Facilitates international trade and investment by enabling the exchange of one currency for another.

Question 7

What are the characteristics of money?

Answer 7

Medium of exchange- facilitating transactions, making trade more efficient.
Unit of account- valuing goods and services, enabling price comparisons.
Store of value- money retains its value over time, allowing individuals to save wealth for future uses.
Standard of deferred payment- settle debts and obligations in the future.

Question 8

What is money supply?

Answer 8

Total quantity that is available for transaction. It is typically categorised into different monetary aggregates based on liquidity and accessibility.
Narrow money (M1)- represents the most liquid components of the money supply. it includes physical currency (coins and notes) and checking deposits in banks. M1 is used for day-to-day transactions.
Broad money (M2, M3, etc.)- broader monetary aggregates which incorporate illiquid assets. These aggregates encompass a wider range of savings and time deposits, as well as other near-money substitutes.
Broad money includes savings accounts, time deposits, and other forms of near-money assets.

Question 9

What is digital money?

Answer 9

Refers to a form of currency that exists solely in electronic or digital form.
Has become increasingly prevalent with the growth of e-commerce, digital banking, and the development of new financial technologies.

Question 10

What is the difference between debt and equity?

Answer 10

Equity finance is finance from shareholders through the issue of new shares/stock that carry voting rights. It represents ownership in a business or an asset. Equity security includes common stock and preferred stock.
Debt finance requires paying interest (on loans) and may also need security. It represents borrowing by individuals or organisations.

Question 11

What are bondholders?

Answer 11

Creditors with a claim on the issuer’s assets but no ownership stake.

Question 12

What are leveraged loans?

Answer 12

Loans provided to companies with a high level of debt compared to their equity. These loans are typically used by companies with lower credit ratings and are issued by private equity firms or hedge funds rather than traditional banks.

Question 13

What are the key characteristics of leverage loans?

Answer 13

High debt-to-equity ratio: the company borrowing the loan has a high amount of debt compared to its equity, making it riskier for lenders.
Floating interest rates: interest rates are often variable in leverage loans which means they can change over time.
High risk: higher risk of default, so they often have higher interest rates and fees than traditional loans.

Question 14

Why are financial markets complex?

Answer 14

Derivatives market- derivatives are financial instruments whose value is derived from an underlying asset, such as stock, bond, commodity, or currency. e.g. options, futures, and swaps.
Credit derivatives market- credit derivatives are financial contracts that allow investors to transfer credit risk from one party to another.
Cryptocurrency market- crypto assets or digital currencies e.g. Bitcoin, are decentralised digital assets that operate on a blockchain, which is a decentralised public ledger that records all transactions.

Question 15

What are bonds?

Answer 15

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.

Question 16

What is the relationship between bond prices and bond yields?

Answer 16

Bonds have fixed coupon payments, and their prices are inversely related to market interest rates.
When market interest rates rise above a bond’s coupon rate, the bond’s price falls because its fixed interest payments are less attractive compared to newer bonds with higher yields.
Conversely, when market interest rates decline, bond prices rise because their fixed payments become more appealing compared to new bonds with lower yields.
The yield on a bond is the coupon as a % of its current market price.

Question 17

What was the credit crunch 2007-2008?

Answer 17

A period of tight credit conditions characterised by a decrease in the availability of credit or loans, often accompanied by an increase in the cost of borrowing.

Question 18

What are the impacts of the credit crunch on the financial sector and the broader economy?

Answer 18

Banking crisis- faced liquidity problems as interbank lending froze.
Credit contraction- sharp contraction in lending by banks and other financial institutions.
Economic recession- tightening of credit conditions has led to falling consumer confidence and declining house prices, contributing to a deep recession in the UK economy. GDP contracted, unemployment rose, and businesses struggled to access the financing they needed to operate and expand.
Government response- bank bailouts, interest rate cuts by BoE, quantitative easing, and fiscal stimulus packages aimed at boosting demand and supporting struggling industries.

Question 19

What are the key roles of financial markets?

Answer 19

To facilitate saving by businesses and households- offering a secure place to store money and earn interest.
To lend to businesses and individuals- provide an intermediary between savers and borrowers.
To allocate funds to productive uses- allocate capital to where the risk-adjusted rate of return is highest.
To facilitate the final exchange of goods and services such as contactless payment systems, foreign exchange etc.
To provide forward markets in currencies and commodities- forward markets allow agents to insure against price volatility.
To provide a market for equities- allowing businesses to raise fresh equity to fund their capital investment and expansion.

Question 20

What is the importance of financial markets for economic development?

Answer 20

Having a trusted banking system to promote household saving.
Mobile payment systems to facilitate spending and business growth/cash flow.
Micro-finance schemes to encourage local entrepreneurship.
Insurance to protect farmers and other primary sector producers.
Foreign currency exchange helps enable firms to import materials and sell goods and services overseas.
Capital markets for developing governments and corporations to raise fresh debt and equity.

Question 21

Why does the inverse relationship between market interest rates and bond prices occur?

Answer 21

When interest rates increase, the prices of bonds decrease.
New bonds with high interest rates make existing bonds with lower rates less attractive.
Higher interest rates cause existing bonds to lose market value.
This relationship affects both individual investors and financial institutions.

Question 22

What are investment banks?

Answer 22

Specialise in activities related to capital markets, such as underwriting securities, facilitating mergers and acquisitions, and providing advisory services to corporations.

Question 23

What is the distinction between narrow money and broad money?

Answer 23

Narrow money refers to the most liquid forms of money, which are readily accessible for transactions e.g. physical cash. Broad money encompasses narrow money (M1) and other forms of money that are less liquid, meaning they cannot be quickly converted to cash without some delay or potential loss of value e.g. foreign currencies.

Question 24

What are commercial banks?

Answer 24

Licensed deposit-takers providing a range of savings accounts.
They are licensed to lend money and thereby create money via new bank loans, overdrafts and mortgages.

Question 25

What are the main functions of commercial banks?

Answer 25

Accepting deposits
Providing loans
Payment services
Safekeeping of valuables
Currency exchange- foreign exchange services to facilitate international trade and travel.

Question 26

What is the structure of a commercial bank’s balance sheet

Answer 26

Assets:
cash and reserves = funds held in the central bank or as cash on hand.
Loans and advances = the money lent out to borrowers.
Investments = securities held by the bank, such as government bonds or corporate bonds.

Liabilities:
Deposits = funds held in customer accounts.
Borrowing
Capital = the bank’s equity, including shares and retained earnings.

Question 27

How do banks create credit?

Answer 27

Banks create credit by agreeing on loans to businesses and households.
When a bank makes a loan, it credits their bank account with a deposit of the size of the loan.
At that moment, new money is created.
They do not need to attract deposits from savers initially.

Question 28

Why do commercial banks aim to maintain sufficient liquidity?

Answer 28

To meet deposit withdrawal demands and fund lending activities, which ensures customers can access their funds when needed.

Question 29

How do banks generate profits?

Answer 29

Earning more than their assets (e.g. interest on loans) than they pay on their liabilities (e.g. interest offered on deposits)

Question 30

What are the potential trade-offs between commercial bank objectives?

Answer 30

Liquidity vs profitability = while maintaining high liquidity ensures safety, it may reduce potential profits.
Profitability vs security = pursuing high profitability often involves talking on more risk, which can jeopardise the security of customer deposits.

Question 31

What is a central bank?

Answer 31

Monetary authority and major regulatory bank in a country.
Responsible for monetary policy and maintaining financial stability.

Question 32

What are the main roles of a central bank?

Answer 32

Setting interest rates- control inflation and promote economic growth.
Regulating banks- to ensure they are financially sound and to protect depositors.
Maintaining financial stability- act as a lender of last resort, providing liquidity to financial institutions in times of crisis.
Issuing currency
Conducting research and providing advice to policymakers.

Question 33

What are the factors considered when setting bank rates?

Answer 33

Rate of growth of real GDP and the estimated size of the output gap.
Forecasts for price inflation.
Rate of growth of wages and other business costs.
Movements in a country’s exchange rate.
Rate of growth of asset prices such as house prices.
Movements in consumer and business confidence.
External factors such as global energy prices and inflation in other countries.
Financial market conditions including the rate of growth of credit/money.

Question 34

What are the macro effects of currency depreciation?

Answer 34

Increased import prices feed into increased consumer prices- may help a country to avoid deflation. But increased inflation threatens real living standards.
Weaker currency is usually a stimulus to GDP growth from increased net exports but much depends on the PED for exports.
More competitive currency will help to increase domestic production and create a positive multiplier effect which will further stimulate AD and jobs.

Question 35

What is monetary policy?

Answer 35

Changes in interest rates, the supply of money and credit, and exchange rates by the central bank to influence the macro-economy and achieve target outcomes.

Question 36

What factors need to be considered when setting bank rate?

Answer 36

Rate of growth and estimated size of the output gap
Forecasts for price inflation
Rate of growth of wages and other business costs
Movements in a country’s exchange rate
Rate of growth of asset prices such as house prices
Movements in consumer and business confidence

Question 37

What are negative interest rates?

Answer 37

Countries like Japan like to save, so banks offer negative interest rates to encourage people to take loans.

Question 38

How can higher interest rates affect AS?

Answer 38

When interest rates increase, it becomes more expensive for firms to borrow money for capital investment, causing a fall in investment and hence a possible decrease in LRAS.

A fall in investment means that an economy’s capital stock will age possibly leading to a fall in productivity/efficiency.

Increased interest rates can reduce businesses’ profitability. If profits decrease, businesses may have to reduce spending on R&D and innovation, which might reduce labour productivity.

Question 39

What are the evaluation points for monetary policy?

Answer 39

It depends if fiscal and monetary policy in harmony.
MPC and MPS may not work in the way the BoE wants it to be.
It depends on consumer confidence.
It depends on the magnitude (how much will they go up by).
It depends on the duration of the change.
It will impact more in the long run because it takes time for peoples behaviour to change.
It depends on what consumers spend on (foreign or domestic products).

Question 40

Why do governments regulate banks with regulation and guidelines?

Answer 40

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

Banks have a huge influence in the economy; if they failed it would have huge consequences.

Question 41

What is the banking industry regulated by?

Answer 41

PRA - promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policymakers are protected.
FCA - ensures financial firms are honest to consumers and they seek to protect consumers. Promotes competition.

Question 42

What is the FPC?

Answer 42

Regulates risk in banking and ensures the financial system is stable.

Question 43

What is a moral hazard?

Answer 43

A situation where there is a risk that the borrower does things that the lender would not deem desirable, because the borrower is less likely to repay a loan.
e.g. Financial crisis.

Question 44

Why might a bank take more risks?

Answer 44

If they know the BoE or the government can help them if things go wrong.

Question 45

What are systematic risks?

Answer 45

The risk of damage of the economy or the financial market. e.g. it could be the risk of the collapse of a bank. Since this costs firms, consumers, the economy and the market, it is akin to a negative externality.