The Financial Sector and the real economy

Question 1

Name the four roles of money

Answer 1

A medium of exchange
A store of value
A unit of account
A standard of deferred payment

Question 2

What are the characteristics that money must have in order to fulfil its functions?

Answer 2

Portability- Money must be easy to carry
Divisibility- Money must be easily divided into small parts in order to undertake transactions
Durability- Money needs to be able to withstand wear and tear in use.
Acceptability- Money must be generally accepted if it is to act as a medium of exchange.
Scarcity- Money should not be unlimited or easily counterfeited
Stability in value- The value of money must be reasonably stable overtime

Question 3

What characteristics does money need to have to be able to carry out its function as a medium of exchange?

Answer 3

Acceptability- If money is not seen as an acceptable method of payment, transactions through money will not take place and instead a barter system would have to be used.
Portability- easy to carry around so when shopping money can be used
Divisibility- Money must be easily split into small sections otherwise it will be hard to buy things of low cost if change is not available.
Durability

Question 4

What characteristics does money need to have to be able to carry out its function as a store of value?

Answer 4

Acceptability by the population
Durability- It must be able to last wear and tear
Scarcity- Money must not be unlimited or easily counterfeited as this would cause its value to decrease and people may reject money in transactions and default to a barter system
Stability- The value of money must be stable overtime

Question 5

What characteristics does money need to have to be able to carry out its function as a of unit of account?

Answer 5

acceptability by the population

Stability in value

Question 6

What characteristics does money need to have to be able to carry out its function as a standard of deferred payment?

Answer 6

Acceptability
Stability in value overtime
Durability- withstand wear and tear

Question 7

Liquidity

Answer 7

How easily and quickly an asset can be converted in the short term : Cash and banknotes are the most liquid assets, current accounts are almost as liquid, savings accounts are less liquid as although they can be converted into cash there may be a time delay or cost incurred.
Government bonds and shares are far less liquid although, it is still regarded as near-money.

Question 8

What is credit?

Answer 8

A borrower is given an amount of money based on the agreement that it will be paid back with interest to the lender.

Question 9

Define the term credit multiplier

Answer 9

An increase in the money supply has a multiplied effect on the amount of credit created by banks.

Question 10

Explain the credit multiplier

Answer 10

If a saver deposits £100 in a commercial bank, the bank know that it is unlikely that the saver will withdraw all the £100 in one transaction as they want to gain return.
Henceforth, the bank use a proportion of this deposit as loans to others and the difference between the rate of return on a savers deposit and the rate of interest paid on a loan is profit for the bank.
Once people get a loan the loaner will use this money for expenditure purposes meaning the loan essentially became income for someone else. Depending on MPS the person may decide to deposit some of it in the bank. The bank then uses a fraction of the deposit as money to loan.
process continues….
This causes the amount of credit in an economy to increase, and in turn the money supply increases

Question 11

What is the equation for the credit multiplier?

Answer 11

1/cash ratio held by banks (percentage of deposits that they hold in liquid form)

Question 12

What are the main reasons why people hold money?

Answer 12

To use later for transactions (medium of exchange), for precaution in case an emergency happens and they need cash immediately, for speculative reasons.

Question 13

What is the opportunity cost of a firm or individual choosing to hold money as cash?

Answer 13

The person misses out on the opportunity to use the money as a financial asset e.g. a bond and gain return (current accounts are liquid but not as liquid as cash).

Question 14

Why is the interest rate essentially the opportunity cost of holding money as cash?

Answer 14

It shows how much the individual or firm could have gained in return if they used the money as a financial asset.
At a high rate of interest people will hold less money.

Question 15

What is the demand for money?

Answer 15

The amount of money that people are willing to hold as cash rather than as a financial asset. It is determined by, the amount of money that is used for transactions, precautionary demand for money and speculative demand.

Question 16

What will impact the amount that people demand money for transactions?

Answer 16

The income level will impact the amount of transactions that people undertake.

Question 17

What is precautionary demand for money

Answer 17

People may want to guard themselves and have money in a liquid form in case for some reason an emergency payment is needed.

Question 18

What is speculative demand for money?

Answer 18

If share prices are unreasonably high and people expect them to fall, they may sell bonds and hold money so they have money to buy these bonds back in the future at a lower price.
The interest rate (opportunity cost of holding money) does effect speculative demand for money a high interest rate also means a high rate of return on bonds incentivizing people to buy shares.

Question 19

What is the liquidity Preference theory?

Answer 19

The idea that people want to use money as a financial asset rather than more liquid cash.

Question 20

Why is the Money demand curve downward sloping? (Price of money (Interest rates) on the y axis money holdings on the x)

Answer 20

Since the interest rate is the opportunity cost for holding money, than a high interest rate will result in a then the demand for money will be low as the cost of holding money is high.
A low interest rate means the cost of holding money si slow so demand for money will be high.

Question 21

Why is the Supply of money curve fixed ?

Answer 21

The central bank control the money supply in theory, regardless of the interest rate.

Question 22

In practice, why is it hard for the central bank to control the money supply?

Answer 22

Commercial banks can increase the money supply through lending through the credit multiplier.

Question 23

Why can the interest rate be viewed as the cost of borrowing as well as the cost of holding money, in a firms point of view?

Answer 23

A firm may want to take out a loan to finance an investment project, but a high interest rate means that loans are more expensive and the investment is less profitable than if the interest rate had been lower.

Question 24

Will the interest rate effect a firms likelihood to invest if they’re going to finance their project from past profits?

Answer 24

Yes as a high interest rate means the firm could of gained a large rate of return if they used this profit as a financial asset rather than to fund the project.

Question 25

How is the importance of the rate and interest to firms and households tie in together.

Answer 25

The interest rate shows the return of saving while for firms it impacts whether or not they will invest. Saving from consumers helps firms fund their investment expenditure as a fraction of money that is deposited by savers is lent to firms and individuals (credit multiplier).

Question 26

Define the market for loanable funds?

Answer 26

That when making saving decisions households are influenced by the rate of interest, which determines the quantity of loanable funds that are available for firms to borrow to fund investment.

Question 27

What is the market for loanable funds?

Answer 27

That when households make decisions on whether to save money (rather than hold money for transaction, precautionary or precautionary purposes) they are influenced by the interest rate as it is the opportunity cost of holding money. Firms are also influenced by the interest rate when making investment decisions as it shows the cost of borrowing money to fund projects. These two flows can be linked together as firms investment is where the main demand for loans comes from firms borrowing for investment . Households saving and firms saving is the main way that the supply of loanable funds is increased.

Question 28

When interest rates are high how does this affect the loanable funds market?

Answer 28

Saving is high, so the supply of loanable funds is high, but the quantity demanded of loanable funds is low and so is investment.

Question 29

When interest rates are low how does this affect the loanable funds market?

Answer 29

Saving is low, so the supply of loanable funds is low, but the demand for loanable funds is high as more firms want to invest when interest rates are low as projects are more profitable.

Question 30

What is the equation for the real interest rate?

Answer 30

Nominal interest rate - inflation rate = real interest rate.

Question 31

What are financial intermediaries?

Answer 31

Financial institutions that provide a link between borrowers (taking out loans to finance investment and spending) and lenders e.g. banks and building societies.

Question 32

What are retail banks?

Answer 32

The banking sector is often seen as being divided into two sections, the retail banks and the wholesale banks.

Retail banks include the high street banks that provide financial services for small business’ and households, they accept deposits and make loans on a relatively small scale.

Question 33

What are wholesale banks?

Answer 33

The other section of the banking sector are wholesale banks who operate on a large scale, taking deposits and making loans to companies and other banks. E.g. investment banks and other specialist financial institutions.

Question 34

Universal Banks

Answer 34

Banks that operate in both retail and wholesale markets. Operating in large scale lending and investment as well as traditional high street functions.
Online banking has allowed universal banks to reduce costs.

Question 35

What is the liquidity ratio?

Answer 35

The ratio of liquid assets to total assets in a bank.

Question 36

Why is the liquidity ratio important?

Answer 36

Banks make profit through the difference between the interest paid by borrowers on loans and the interest they pay to savers on their financial assets.
Therefore, the more loans a bank provides the more profit it makes, since banks give loans through savers deposits it is important that they keep enough liquid asset for when a saver wants to withdraw some of their deposit. The liquidity ratio helps a bank keep track on the proportion of their assets that are liquid.

Question 37

What is interbank lending?

Answer 37

When banks lend liquid money to each other in the SHORT RUN to maintain a desirable liquid ratio.

Question 38

How is the rate of interest that banks have to pay on loans from eachother determined?

Answer 38

The rate of interest on loans that banks lend to each other is determined by the amount of liquidity in the market over the time when the loan is borrowed.

Question 39

What is LIBOR?

Answer 39

The average rate of interest paid on interbank lending in the London Interbank market, it is set everyday.

Question 40

What is a way that banks can attain a desirable amount of liquid assets in the short run other than interbank lending?

Answer 40

Repos

Question 41

What is a repos?

Answer 41

A sale and repurchase agreement.
A bank sells financial assets to the central bank , or another bank.
They gain liquid funds and then repurchase these financial assets at an agreed later date.

Question 42

What is a mortgage?

Answer 42

It is a long-term loan taken out for house purchase. (Secure loan)

Question 43

What influences the size of mortgage that a borrower is given?

Answer 43

-The lenders assessment of how able the borrower will be to pay the loan back.
Income and expected income
The expectation that house prices will rise in the future
Whether or not there is collateral to cover a default. If there is no collateral this is unsecured borrowing and the interest rate on the loan will be higher.

Question 44

What is collateral?

Answer 44

An object of the borrower that will be forfeited to cover a default if the borrower fails to repay the loan in time

Question 45

What is an unsecured loan?

Answer 45

A loan where there is no collateral, so if a borrower defaults there is no object of there’s that the bank can repossess to avoid them from making a loss.
E.g. Credit cards, overdrafts, payday

Question 46

What Is pay day lending?

Answer 46

Very short term loans to give households enough money to tide them over until their next pay day, these have a very high level of interest rate. (A type of unsecure loan)

Question 47

What is an overdraft?

Answer 47

Where a bank customer can spend more than what is covered by current deposits (beyond their current account) at a pre-determined interest rate. This borrowing is limited to an agreed amount in advance. (Unsecure loan)

Question 48

What is a credit card?

Answer 48

It allows borrowers to incur debt in order to pay for everyday transactions (Unsecure loan)

Question 49

Name the 5 types of borrowing

Answer 49

Mortgages
Unsecured loan
Credit Cards 
Pay-day Lending
Overdraft

Question 50

Why is the interest rate higher in unsecured loans?

Answer 50

Since there is no collateral, a default would be a high cost for the borrower

Question 51

What determines the interest rate attached to a loan?

Answer 51

The security of a loan-
Lending with no collateral means the borrower faces a higher interest as the cost of default is high. Therefore a risk premium is included.

A long term loan is more risky and so would have a higher interest rate as well since there is uncertainty to the future.

Question 52

Why may the interest rate paid on mortgages decrease?

Answer 52

A long term loan may be balanced out by collateral.
Since the collateral for a default in mortgage repayments is the house, if house prices rise, the value of the collateral has appreciated .

Question 53

What is a share?

Answer 53

It allows someone to become a part owner of the company once they buy the share. (Think of dragons den)

Question 54

What is the benefit of buying a share?

Answer 54

Shareholders may receive dividends from the profits made by the firm.

Question 55

What is a government bond?

Answer 55

A financial asset that carries a fixed value that the government will pay when the bond matures as well as paying interest annually for the loan that the financial institution has lent to the government. Bonds can be bought and sold.

Question 56

What is a Certificate of Deposit?

Answer 56

A certificate issued by the bank given to the customer in return for a deposit for a fixed term. CD’s can be bought and sold so if the customer wants a liquid asset they can sell their CD.

Question 57

What is Securitisation?

Answer 57

When a bank sells a stock of assets that have a future cash flow to other financial institutions. For example if a bank sold a bundle of mortgages to investors. The bank often sells the mortgages for a greater amount that what they leant.

Question 58

What is a potential drawback of securitization?

Answer 58

It can involve highly risky assets such as mortgages. This is risky for the investor as the household may default on their mortgage, meaning the investor looses out as they have already paid the bank for these mortgages.

Question 59

What are the benefits of securitization?

Answer 59

They allow a bank to increase their liquidity.

Question 60

What is a banks “capital”

Answer 60

It is the value of a banks assets, including cash, loans, securities

Question 61

What is the capital adequacy ratio?

Answer 61

It is a banks capital relative to its current liabilities and risk-weighted assets .
Essentially the capital adequacy ratio shows whether the bank has enough money to cover loan defaults as well as meet demands of depositors that want to withdraw their deposit.

Question 62

Why has the growth of internet banking (a form of financial innovation) spurred on the transition of banks from retail to universal?

Answer 62

Banks have started to increasingly offer high-street services to households and small firms as well as large scale lending and investment to companies and other banks. The growth of internet banking has meant that banks have a reduced need to have more branch banking networks as they can provide financial services to consumers online.