Theme 4: Financial Markets

Question 1

What finance is provided by financial markets?

Answer 1

• Short term finance
• Long term finance

Question 2

Types of financial markets

Answer 2

1. Money markets- short term finance
2. Capital markets- long term finance eg bonds and shares
3. Foreign exchange markets- where different currencies are traded

Question 3

What are the different purposes of financial markets?

Answer 3

1. Facilitate saving
2. Lend to businesses and individuals
3. Facilitate the exchange of goods and services- create payment systems for the exchange of goods and services
4. Provide forward markets in currencies and commodities- pre ordering goods and services
5. Provide a market for equities- equities are the shares of companies
6. Forward markets- transaction that will happen at an agreed time in the future

Question 4

Give 5 examples of market failure

Answer 4

1. Asymmetric information
2. Moral hazard
3. Externalities
4. Market rigging
5. Speculation and market bubbles

Question 5

What is market failure?

Answer 5

When free markets fail to deliver an efficient or socially optimum allocation of resources.

Question 6

Asymmetric information

Answer 6

When one party in a transaction has more information than the other. So they are able to exploit the information gap.

Question 7

Externalities

Answer 7

Externalities paid for by other individuals, firms or governments but not the financial markets creating the costs.

Question 8

Moral hazard

Answer 8

when someone is more willing to take risks because they understand that someone else will pay any costs if anything goes wrong.

Question 9

Speculation

Answer 9

Buying assets when the price is low and selling them at a later higher price, with the aim of making a profit.

Question 10

Market bubbles

Answer 10

When the price of an asset is forced excessively high, well beyond true value, then falling back. Speculators buy assets because others are doing so.

Question 11

Market rigging

Answer 11

When individuals or a group collude to fix prices or exchange information to help them gain for themselves at the expense of others.

Question 12

What was the LIBOR scandal?

Answer 12

From 2007 and involved a group of banks working together to fix the London interbank offered rate. This is an average interest rate which is used globally to fix other interest rates.

Question 13

4 functions of a central bank

Answer 13

1. Implementation of monetary policy
2. Banker to the government
3. Banker to the banks- lender of the last resort
4. Role of regulation of the banking industry

Question 14

What can the central bank do using monetary policy?

Answer 14

1. Manage availability of credit
2. Influence the amount of lending banks
3. Affect the exchange rates

Question 15

What does an increase in the availability of credit do?

Answer 15

• Increases aggregate demand
• Increases inflation

Question 16

What does an decrease in the availability of credit do?

Answer 16

decrease AD

Question 17

What does an increase in the amount of bank lending do?

Answer 17

• Increase AD
• Increase inflation

Question 18

What does an decrease in the amount of bank lending do?

Answer 18

• Decrease AD
• Decrease investment

Question 19

What does an increase in the exchange rate do?

Answer 19

• Decrease AD
• Decrease inflation

Question 20

What does an decrease in the exchange rate do?

Answer 20

• Increase AD
• Increase inflation

Question 21

How does the central bank regulate the banking industry?

Answer 21

• Reserve requirements
• Ensure competition
• Financial rules are adhered to by banks