Section 1 - Economic Environment Flashcards

Question

MO - Narrow Money

Answer 1

The narrow money supply only contains the most liquid financial assets. These funds must be accessible on-demand, which limits the category to physical notes and coins and funds held in the most accessible deposit accounts.

Answer 2

Notes & coins in circulation plus all instant access and time deposits

Answer 3

* Rising prices reduces real value of future interest & dividend payments * RPI historically used but now CPIH - measures average change from month to month of prices of UK consumer goods and services. * CPIH is more comprehensive than CPI as includes owner occupiers’ housing costs (OOH) and council tax – otherwise CPIH is exactly the same as CPI.

Answer 4

* Decrease in rate of inflation (prices still rising but at a slowing rate)

Answer 5

* Prices declining over time and inflation becomes negative * Consumers defer purchases and manufacturers reduce output

Answer 6

* Combination of ‘stagnant growth’ and ‘inflation’ persistent high inflation combined with high unemployment and stagnant demand in a country's economy.

Answer 7

Variable rates tend to rise and fall in line with inflation ‘Real’ interest rate takes account of inflation

Answer 8

Inflation particularly significant Income is fixed whether prices rise or fall Index-linked gilts offer long term inflation protection

Answer 9

Seen as good hedge against inflation Efficient companies increase profits at least in line with inflation Leading to increased dividends and share price

Answer 10

* Cash -returns fluctuate broadly in line with interest rates * Fixed Interest - inverse relationship * Equities - generally benefit from low interest rates

Answer 11

* Foreign exchange market allows currency used by one country to be bought and paid for with another currency * Exchange rate is the price at which two currencies trade on foreign exchange market * Real exchange rate is adjusted to take account of inflation (good indicator of competitiveness) * Current account surplus - country exports more than it imports * Strong currency - beneficial effects, but if too strong then causes problems (e.g. exports too expensive) * Effect on foreign investments: higher overseas interest rates make overseas investments attractive * Effect on domestic shares: increasing value of £ increases profitability of exports

Answer 12

Made up of transactions in goods (visible trade) and services (invisible trade) - imports and exports A country’s current account balance = net balance of trade in both goods and services PLUS net receipts from income generating assets flowing into the UK from overseas Deficit means more goods and services have been imported into the UK than have been sold overseas Persistent deficit puts pressure on country’s currency

Answer 13

Records all movement of money into and out of the country for investment Real assets such as land and buildings or financial assets such as shares, bonds and loans Capital account surplus when overseas investors invest more money in the country than UK investors invest overseas If there is a net deficit on the combined current and capital accounts - official reserves of foreign currencies owned by Bank of England will be used to finance it

Answer 14

Transactions in goods (e.g. oil, agricultural products)

Answer 15

Transactions in services (e.g. transport, travel, tourism)

Answer 16

* Well-functioning financial institutions and markets (e.g. stock exchange) play central role in moving funds from where they are to where they are best used * Primary markets: Governments, companies & other organisations issue new securities * Secondary markets: Investors buy/sell securities in issue

Answer 17

* Types of unemployment: o Frictional o Structural o Cyclical

Answer 18

In a monopolistic market, there is only one firm that dictates the price and supply levels of goods and services, and that firm has total market control. In contrast to a monopolistic market, a perfectly competitive market is composed of many firms, where no one firm has market control.

Answer 19

o Producers have to operate efficiently and meet customers’ needs o Producers have an incentive to innovate and find lower cost methods of supply o Producers have to keep down costs per unit produced o Consumers receive better value through lower prices

Answer 20

* One producer * No clear substitute for the product or service * High entry barriers

Answer 21

* Two successive quarters of declining GPD means the economy is in recession

Answer 22

* Visible trade includes imports and exports of goods such as oil, raw materials, machinery, white goods and clothing

Answer 23

* Reduction of short-term interest rates

Answer 24

* Stagflation

Answer 25

* Frictional * Structural * Cyclical

Answer 26

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price. Zero-coupon bonds provide a clear example of how this mechanism works in practice.

Answer 27

The labor market, also known as the job market, refers to the supply of and demand for labor, in which employees provide the supply and employers provide the demand. It is a major component of any economy and is intricately linked to markets for capital, goods, and services.

Answer 28

A zero-coupon bond, also known as an accrual bond, is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value

Answer 29

The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households. What does the UK use to measure inflation? The Consumer Prices Index (CPI) is the main measure of inflation. It is produced in line with international standards and is the measure used for the Bank of England's 2% inflation target

Answer 30

The export definition in economics is any goods or services produced domestically but sold abroad. When a country exports goods or services, it engages in international trade. This is when countries or domestic firms purchase and sell goods to foreign firms and countries.

Answer 31

Is when the UK buys a product or service from another country Imports can be finished products, like cars, TV sets, computers, or sneakers, or they can be raw materials, such as zinc, oil, wood, or grains. They can also be services, like financial services, travel services, and insurance.

Answer 32

Gross domestic product (GDP) is the value of the finished domestic goods and services produced within a nation's borders. On the other hand, gross national product (GNP) is the value of all finished goods and services produced by a country's citizens, both domestically and abroad

Answer 33

* Interest payments increase * Profits will reduce * Dividends reduce / cease * Further finance may be required * Possibility of the share price falling

Answer 34

* Reduce dividends * Raise share capital / hold a rights issue * Renegotiate any finance

Answer 35

* Recession - Share prices begin to recover * Recovery - Share prices rise strongly * Boom - Share prices begin to falter * Slowdown - Share price falls

Answer 36

* Cyclical stocks are correlated to the economy will often perform well when the economy is doing well and badly when the economy is doing badly * Non cyclical stocks are not correlated to the economy and perform steadily regardless of the economic position

Answer 37

* Rising costs of raw materials * Increasing cost of labour * Increased demand * Lack of capacity * Growth / money supply * Rising demand * Fuelled by expanding money supply * War or shortages / decreasing supply * Currency devaluation * High wage demands and general increasing costs * Investor sentiment leading to investment bubbles.

Answer 38

* Interest rates rise * Loss of purchasing power as goods and services become more expensive.

Answer 39

* Exports to the UK would become cheaper with a likely increase in demand for companies goods * Profitability is likely to increase, share values are likely to go up for companies who export and thus will help to offset the currency conversion costs.

Answer 40

* Price elasticity of demand measures the extent to which demand responds to a given change in prices.

Answer 41

When a good has elastic demand, a small price decrease would lead to a large increase in demand, assuming an adequate supply for the product and a reasonable profit margin. Then profitability should increase substantially with a small price decrease or should decrease substantially with a small price increase.

Answer 42

Goods with elastic demand are usually frequently bought goods with many substitutes in competitive markets where consumers are price sensitive.

Answer 43

When the annual Retail Prices Index falls below 0%

Answer 44

* Demand for goods and services will fall as individuals / business will defer spending in the expectation that prices will be lower in the future

Answer 45

o Price o Costs of making and distribution o Supply of alternatives o Unexpected events that make supply easy or more difficult

Answer 46

equilibrium

Answer 47

Net cash requirement (NCR). This is fiscal policy governed by the UK elected government.

Answer 48

Inflation as the Government is spending large sums of money and injecting cash into the economy – as it loosens or tightens fiscal policy.

Answer 49

PSNDR (public sector net debt repayment).

Answer 50

Inflation is a general increase in prices and fall in the purchasing value of money

Answer 51

people are not spending and not consuming: no consumption (relative to output), means recession and lower GDP, lower next taxes and lower standards of living.

Answer 52

* Reduce interest rates: in order to stimulate consumer demand / business investment * Engage in a strategy of Quantitative Easing (ie. “QE”, see further): so increasing the money supply in order to stimulate bank lending to individuals and businesses * Increase government spending * Reduce taxes

Answer 53

* A rising cost of raw materials for businesses * Increasing cost of labour via wages * Increased consumer demand in the wider economy * A lack of capacity in business / industry * Growth in the money supply

Answer 54

* A reduction in the purchasing power of money held on deposit (negative for savers), * Increasing asset prices such as property (positive for property owners)

Answer 55

Retail Price Index (RPI).

Answer 56

It represents the average price of a basket of goods purchased by a typical household (+mortgage interest) and the current RPI series uses a base of January 1987.

Answer 57

The Monetary Policy Committee (MPC) of the Bank of England

Answer 58

The CPI took over from the RPI as the official measure of UK inflation in 2003 and many pension funds and others changed over in April 2011

Answer 59

the Harmonised Index of Consumer Prices (HICP) is the key inflation measure. The UK CPI is effectively the same as the HICP.

Answer 60

* Increasing interest rates so making borrowing more expensive * Increasing interest rates so providing higher interest on savings and cash deposits * Both consumers and companies will have less disposable income and profits to invest, and * Both consumers and companies will spend and invest less – thus, demand should fall

Answer 61

a lower cost of debt makes it easier to service that debt.

Answer 62

* A lower cost to public borrowing thus making more money available for public services, * In addition, low interest rates mean that (high) gilt values are maintained (QE implications)

Answer 63

* May be encouraged to borrow money to invest, * Low interest rates may lower the value of UK Sterling meaning that exports will be cheaper

Answer 64

* May be encouraged to borrow money to invest, * May stimulate the housing market (encourages people to take out mortgages), * The so-called “Wealth Effect”: encourages people to spend more money, * Encourages business start-ups and investment

Answer 65

If unemployment is too high it may indicate a fall in production and a fall in tax receipts; conversely, if unemployment is too low it may result in increased labour cost and increased inflation:

Answer 66

Frictional unemployment is caused by changes in the economy that lead to qualified jobseekers temporally unmatched with job openings

Answer 67

Structural unemployment caused by structural changes to the economy such as declines in particular industries and skills no longer being in demand.

Answer 68

Cyclical unemployment caused by changes in the overall level of economic activity and often associated with the business cycle.

Answer 69

Bond Prices fall (cost of purchase decreases) and increase the running yield on bond's which have fixed coupons, to correlate with increasing interest rates They have an inverse relationship to interest rates, meaning that when interest rates rise, bond prices generally fall and when interest rates fall, bond prices generally rise.

Answer 70

Bond yields can be a useful indicator of market expectations of future inflation and interest rates when you look at yield curves in future and compare the trend in movement of the 10 year bond price; many use it as an indicator of future market sentiment.

Answer 71

The theory is that the price of an index signals future economic expectations and that is why the FTSE is often used as a bell-weather of current economic activity (and is quoted daily). Although, 70%+ of earnings of FTSE 100 companies is derived from outside the UK and there is less and less resemblance to the UK economy.

Answer 72

This indicates the UK trade position: subtracting imports (M) from exports (X). It is split into visible (real tangible goods) and invisibles (services like financial services) and if the UK imports more goods than it exports, it is in deficit with the rest of the world.

Answer 73

A fall in the value of its currency may be needed to make imports more expensive and exports cheaper to balance the trade. When we buy imports from abroad we need foreign currency to pay for them. When foreign countries buy our exports they need our currency to pay for them.

Answer 74

When a country's goods are in demand, a demand is also created for their currency to buy these goods. When there is a strong demand for a currency it tends to appreciate in value. Unfortunately, this makes the goods in this country now more expensive and inflation starts going up. If no growth follows then stagnation could follow.

Answer 75

Measuring economic activity is important for a country to measure changes in living standards and to assist the central government in its economic planning.

Answer 76

GDP is the value of economic activity generated by factors of production from within the country's domain. GDP represents the total MARKET VALUE of all FINAL goods and services. The growth of an economy's GDP is used as a measure of its economic growth. GDP is the output of the UK of those firms (British and Foreign) based in the UK.

Answer 77

The Bank of England set interest rates in the UK. One of the purposes is to help adjust the money supply to stimulate growth. If the bank believes inflation caused by too much money in the economy will be a problem, it is likely to increase interest rates. The effect of this will be to encourage people to save due to the higher rates of return achievable on savings and discourage them from borrowing because financing costs have also increased.

Answer 78

during the last financial crisis 2008, the bank had reduced interest rates to record levels, and could not, with any expectation of a significant result, reduce them further. Despite this, the increase in consumption and particularly investment had not occurred as expected. In economics terms this is known as a “Liquidity Trap” because, with UK interest rates at historically low levels and approaching zero, they cannot fall any further.

Answer 79

As a supplement to dropping interest rates, the bank also set out on a large programme of quantitative easing (QE) to directly increase the amount of money in the economy through the purchase of mainly government but also corporate bonds from the financial institutions (gilt purchases by the BoE saw gilts yields fall from 3.63% to 2.92% in one particular week, demonstrating the increased demand/price).

Answer 80

* To act as “lender of last resort”, ie. in terms of Royal Bank of Scotland and the Financial Crisis of 2009 * To control the UK’s money supply to act as banker to the government and other banks * To act as a supervisor of other banks and major financial institutions

Answer 81

The government's fiscal policy is based on government spending and taxation and can run in deficit, surplus or as a balanced figure between income (tax) and outgoings (public services). If the government spends more than it receives in tax, it runs a budget deficit. The effect of a budget deficit is to increase the money supply within the economy, drive aggregate demand and is referred to as an expansionary policy.

Answer 82

the price of those goods will increase. This is called Inflation

Answer 83

Monetary Policy Committee of the Bank of England will advise the Bank to control inflation by raising interest rates. Typically this will discourage consumer borrowing and thereby reduce spending, forcing prices lower. It is therefore necessary to keep a measure of the money in the economy:

Answer 84

Narrow money Notes and coins in circulation + Operational deposits held by banks with the Bank of England This is the NARROWEST measure of money because it includes the fewest forms of money. The Bank of England discontinued measuring M0 in 2006.

Answer 85

Broad money Notes and coins in circulation plus Instant access and timed deposits of UK residents with UK banks and building societies M4 was introduced in 1987 and has become the measure that the government has shown the greater interest in over recent years. If you really want to know the detail, the Bank defines M4 as: Sterling notes and coins in circulation + Sterling deposits with UK-resident banks and building societies + Sterling holdings of certificates of deposit, commercial paper and debt securities of up to and including five years' original maturity issued by UK-resident banks and building societies; and Claims on UK-resident banks and building societies arising from sale and repurchase agreements in sterling M4 is now the only measure of money supply published by the Bank of England.

Answer 86

A “fixed exchange rate” is where a country’s currency is fixed (called “pegged”) against another country’s currency so that it moves in line / within a pre-defined range. This will be set by the country’s government or central bank.

Answer 87

A “floating exchange rate” is where a country’s exchange rate is not fixed and varies according to market supply and demand.

Answer 88

* A fall in UK interest rates when compared to other countries * Falling productivity or GDP is growing faster than the amount of money in circulation in the economy * The government / Bank of England increases the money supply at a faster rate than productivity in the UK economy * Higher UK inflation (rising prices) when compared to other countries * A UK current account deficit or negative balance of payments with other countries (ie. importing more than exporting) * A UK capital account surplus

Answer 89

this means that “more UK pounds would be needed to buy the same imports priced in another currency”. This makes these imports more expensive for people holding UK Sterling and would most likely cause a rise in UK inflation.

Answer 90

A company is said to be a “cyclical share” when its profits (and losses!) and ultimately, its share price, moves in line (is positively correlated) with the economic cycle. Examples would be luxury goods manufacturers, house-building companies and entertainment sector businesses (both would suffer falling demand in a recession and rising demand in boom times).

Answer 91

Likewise, a “non-cyclical share” is negatively correlated with the economic cycle. Examples would be utility companies and basic food manufacturers (people still need water and bread in both recessions and economic booms

Answer 92

Boom occurs when national output is rising strongly. In boom conditions, output and employment are both expanding: Strong and rising level of aggregate demand, driven by consumption Rising employment and real wages. High demand for imports Government tax revenues rise Company profits and investment increase Danger of inflation if the economy overheats Share prices begin to top-out and plateau.

Answer 93

A slowdown occurs when the rate of growth decelerates - but national output is still rising. Share prices fall.

Answer 94

A recession means a fall in the level of real national output when the rate of economic growth is negative in (at least) two successive quarters; national output declines, leading to a contraction in employment, incomes and profits (position of UK economy 2009-12): Declining aggregate demand for output Rising unemployment Fall in imports Decrease in tax receipts and increase in benefit payments Increased government borrowing Share prices begin to improve.

Answer 95

A recovery occurs when real national output picks up from the trough reached at the low point of the recession. Share prices rise strongly.

Answer 96

money supply will go up (M4).

Answer 97

the money supply will fall

Answer 98

Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.

Answer 99

12p/980p = 1.22%

Answer 100

980p/47p = 20.85

Answer 101

* £310m fixed assets + £160m current assets = £470m total assets * £50m preference shares = £50m * £50m long-term liabilities and £120m current liabilities = £170m * £470m total assets - £50m preference shares - £170m total liabilities = £250m net asset value of the company * £250m / 100m shares = 250p NAV per share * 980p share price / 250p NAV per share = 3.92

Answer 102

* Debt to equity ratio = £50m / £25m = 2.00. There are other ways this could be calculated.

Answer 103

OEIC Fund is a company Issues shares Open-ended Single price - initial charge separate Can issue different classes of shares, with differing charging structures or in different currencies Charges paid from fund Independent depositary protects shareholders’ assets Managed by an Authorised Corporate Director Unit Trust Fund is a trust Issues units Open-ended Dual price -Bid/offer spread, including initial charge Only difference between units is whether they are ‘distribution’ or ‘accumulation’. Charges included in managers’ fees Trustee oversees fund on unit holders’ behalf Fund Manager

Answer 104

Quantitative tightening (QT) refers to a monetary policy strategy implemented by central banks to reduce the money supply and withdraw liquidity from the financial system. It typically involves the central bank selling government bonds or other financial assets it holds in order to reduce the amount of money in circulation. When a period of quantitative tightening occurs in the UK, it can have several effects on commercial banks. Here are some key ways in which commercial banks in the UK may be affected: Liquidity reduction: Quantitative tightening reduces the liquidity available in the financial system as the central bank sells its assets. This can lead to a decrease in the amount of funds that commercial banks have available for lending and conducting their day-to-day operations. As a result, banks may face challenges in meeting their funding needs and may need to seek alternative sources of liquidity. Increased borrowing costs: With reduced liquidity, the demand for funds may exceed the available supply, leading to an increase in borrowing costs. Commercial banks may find it more expensive to obtain funding from other banks or the money markets, which can impact their profitability and ability to offer competitive lending rates to businesses and individuals. Impact on interest rates: The reduction in the money supply resulting from quantitative tightening can also have an impact on interest rates in the economy. As the central bank sells bonds and reduces liquidity, it puts upward pressure on interest rates. Higher interest rates can affect commercial banks in multiple ways. They may face increased borrowing costs for their own financing needs, and they may also see a decline in demand for loans from businesses and consumers who are deterred by higher borrowing costs. Asset prices and balance sheet effects: Quantitative tightening can have implications for asset prices. When the central bank sells its assets, it puts downward pressure on prices, particularly for bonds. This can lead to potential losses for commercial banks that hold these assets on their balance sheets. Banks may experience a decline in the value of their bond holdings, which can impact their capital positions and overall financial stability. Exchange rate impact: If the UK experiences quantitative tightening while other countries maintain loose monetary policies, it can lead to an appreciation of the domestic currency. A stronger currency can have both positive and negative effects on commercial banks. On the positive side, it can lower the cost of imported goods and services. However, it can also make exports more expensive and reduce the competitiveness of UK businesses operating in international markets. Overall, a period of quantitative tightening in the UK can have significant effects on commercial banks. It can reduce liquidity, increase borrowing costs, impact interest rates, affect asset prices and balance sheets, and potentially influence exchange rates. Commercial banks must closely monitor these developments and adjust their strategies and operations accordingly to navigate the changing economic conditions.

Answer 105

* Share capital * share premium capital account

Answer 106

* £75m - £24m - £4m = £47m * £47m / £760m = 6.18%

Answer 107

* £75m / * (£760m + £650m) = 5.31%

Answer 108

* Both ratios are measures of efficiency of profit generation. * ROE is better for comparing different investments/assets but is affected heavily by differences in company capital structure (i.e. the degree to which a company is funded by debt and/or equity) and is therefore not as suitable as ROCE when comparing companies.

Answer 109

* £75m / £24m = 3.125

Answer 110

* Not a concern about this level of interest cover * Can afford to repay interest on loans 3 x over; profits would have to fall significantly.

Answer 111

* A Cyclical share is where the share price is positively correlated with by ups & downs in the economic cycle. * Typically, companies that sell discretionary items, sell more in a booming economy but sell less in a slowing economy. * When the economy is slow, this results in less purchases, less demand from consumers who have had their real cost of debt increase through tighter monetary policy, which has resulted in less output, and fewer job – more slack in the economy. * Profits and share price will therefore rise and fall in-line with the economic cycle – thus in a slowing economy the profits will fall, so the dividend may be cut, which means that the share price could fall. Remember, it specifically asked you to describe the share price.