Year 2 Monetary and Fiscal Policy, Bonds and Banking System Flashcards
What do monetarist economist believe
There is a strong connection between the rate of monetary growth and the rate of change of the price level
What has been the main way of controlling inflation
monetary policy
What are the characteristics of any asset to serve as money
Acceptable
Portable
Divisible
Durable
Homogeneous
Limited in supply
What is money
Money is defined by the functions that it does
Any asset that performs any jobs can claim to be money
What are the functions of money
A medium of exchange
A store of value/wealth
A measure of value/unit of account
What is a medium of exchange
A means of payment
It is an intermediary in an exchange that removes the need for a double coincident of wants
What is a store of value/wealth
When it can be earned and then spent later without significant loss in value
Modern currencies experience this with inflation as they have no intrinsic value
What is a measure of value/unit of account
It is when it expresses the relative value of goods and services
Acts as a standard of value and removes the need for separate exchange rates for every pair of goods
What is near money
Assets that fulfil some functions of money but not all
What is liquidity
The ease with which an asset can be converted into cash without significant loss of value
Notes and coins are the most liquid
What are the 2 measures of the money supply
Narrow Money
Broad Money
What is narrow money
Is all notes and coins in circulation including those held in tills, banks and building societies
What is broad money
It is all notes and coins
Deposits in current or saving accounts in banks or building societies
commercial bills
bonds that are within 5 years of maturity
What are the 2 types of asset classes
Physical assets
Financial Assets
Examples of physical assets
Houses
Land
Art
Antiques
Examples of financial assets
Cash
Bank Deposits
T-Bills
Shares
Bonds
What is the trade off with financial assets
Between liquidity and profitability of an asset
How are bonds and shares liquid
They can be converted into cash through resale in second hand markets
What is the purpose of financial markets
Is to channel funds from those who have surplus funds to those who have a shortage of funds
This takes place through financial intermediary e.g. bank or in a financial market e.g. bond market
What are the types of capital markets
Money markets
Capital markets
Foreign exchange market
What are money markets
Provide short term finance
Trade mainly short dated financial products
Main players are banks borrowing from and lending to each other covering day to day requirements
Also trade treasury bills and commercial bills
What are treasury bills
Short term loans to local and central governments that last 91 days
What are commercial bills
Short term loans to private businesses that need short term finance
What are capital markets
Provide medium and long term finance
Trade in bonds and shares
Secondary market where existing bonds and shares are sold by original buyers
This adds liquidity to capital markets
What is equity finance
Raising money through share sales
Businesses raise equity capital when selling shares
What is debt finance
Raising money through bond sales
Businesses raise debt capital when they borrow
What is a security
A commonly used term to describe a financial asset
As the asset secures a claim against the borrower
Whats the difference between bills and bonds
Bills are short term securities
Bonds are long term securities
What are Foreign exchange (forex) markets
They allow the trade of foreign currencies to allow international trade, investment and currency speculation
Spot markets
Forward markets
Largest markets in the world
What are spot markets
They are markets for trades that take place in the present at spot prices
What are forwards markets
They are markets that set prices for currency trades that will take place in the future
The forward market contracts are called futures
Futures remove some of the uncertainty of costs and revenue when currency values are volatile
What are the roles of financial markets in the world economy
Provide economic growth because resources can be allocated to its highest valued use at a global level
Offers credit facilities
Allows investment
Can offer finance to small firms in developing nations
What is a bond
It is a fixed interest security sold by firms and governments to raise money
Type of loan
Form of marketable debt capital
What are corporate bonds
Bonds issued by companies
What are gilt edged securities or gilts
Bonds issued by governments
What is the issue price of a bond
It is the nominal value of the bond when it is first sold (value of the loan)
Also the maturity price that is repaid to the bond holder
What is the coupon of a bond
It is the guaranteed fixed amount of interest which the bond holder will receive annually
What is the market price of a bond
It is the prevailing price of a bond sold in the second hand market
Depends on the demand and supply for bonds
What is the yield of a bond
It is the coupon expressed as a percentage of the current market price
What is the equation for yield of a bond
=Coupon/market price x100
What is the relationship between the price of a bond and its yield
inverse
What is yield maximisation assumption
When savers with surplus funds maximise the return they can earn by allocating their wealth into assets that offer the highest yield
What other things may assets do apart from a yield
Assets that have a capital gain (a rise in asset price)
Avoid a capital loss (a fall in the asset price)
What assets can investors hold for a yield
Bonds
Property/land
Shares (equities)
Savings account bank deposit
What is the measure of yields for property/land
Rent/Market price x100
What is the measure of yields for shares
Dividend/Market Price x100
What is the measure of yields for savings account bank deposits
Interest/Value of Savings x100
What does the high amount of competition in asset markets lead to
It will lead to equal rates of return that can be gained from investing in assets in close substitution
Similar to perfect competition
What happens when bonds approach their maturity date
It is more complicated as the bondholder receives the original value of the loan
Bondholders may forgo the higher yields to receive the loan sum
What is the interaction of fiscal and monetary policy
Governments aren’t able to operate fiscal policy without it having an impact on monetary policy
What is an example of the interaction of fiscal and monetary policy
Government operates a budget deficit as an expansionary fiscal policy
This is shown as an increase in demand for loans causing interest rates to rise (monetary policy)
This can also be shown as an increase in supply of bonds, causing the price to fall and the yield to rise, this will cause interest rates to rise
What is crowding out
It is the displacement of private sector activity by public sector spending because of higher interest rates
What is the argument for private sector spending
They are more allocatively efficient because they stand to lose or gain from their decisions
What is the argument for public sector spending
They will take into account externalities, so better at improving social welfare
Private sector investment is too focused on short term profit
Government is more likely to invest in a way that leads to economic re balancing
What is crowding in
Government borrowing less leads to lower interest rates and more funds for other borrowers
This will cause consumption and investment to rise
What is a transmission mechanism
The way in which a change in 1 policy variable feeds its way through intermediate variables to affect a final variable
What is the bank rate
It is the interest rate that the BOE charge commercial banks for loans
Know as official rate or base rate
What are the ways the government can affect inflation
Through market rates
Through asset prices
Through inflationary expectations
Through the exchange rate
How does the government affect inflation through market rates
The rise in bank rate causes commercial banks to rise interest rates to pass on the risk to the borrowers
Less borrowing decreases consumption and investment and government spending causing AD to fall
Reducing demand pull inflation
How does the government affect inflation through asset prices
Rising commercial bank interest rates will lower asset prices as investors will save instead of invest in assets due to the higher yield
This leads to a negative wealth affect and reduce consumer confidence and AD
Reducing demand pull inflation
How does the government affect inflation through inflationary expectations
A rise in bank rate should indicate the BOE is not tolerating higher inflation
This reduces the need for consumers and firms to bring forward consumption and investment
Lowering AD and demand pull inflation
How does the government affect inflation through exchange rates
A rise in Bank rate will lead to foreign investors moving hot money into UK Deposit accounts, attracted by higher rate of return
This causes the sterling to appreciate leading to a fall in net exports causing less demand pull inflation
The lower cost of imports also reduces cost push inflation
Why is there a lengthy time lag in the operation of monetary policy
There is a time between the bank rate change and commercial bank rate change
The banks then take time to notify customers who take time to change their behaviour
Asset prices may also take time
This change in AD takes time for firms to notice less demand and lower prices
This takes time to be measured for inflation
How does the exchange rate affect inflation
Realigning export and import prices
Change in imports affects costs of UK goods and foreign goods affect inflation in CPI basket of goods
Forces UK firms to be for productive and more price efficient
What is Quantitative Easing
Boosting the money supply through an Asset Purchase Programme
How does the Asset Purchase Programme work
The BOE creates new money and buys assets already in the financial system
This has been government bonds held by banks and other firms
This is an asset swap, it takes illiquid paper IOU’s out the system and replaces it with cash
This increases liquidity, boosting AD and preventing inflation
How does QE effect inflation
The increased in liquidity causes banks to have more liquid assets and try to lend it out
This will be spent on C+I and boost AD increasing demand pull inflation
QE causes a rise in demand for bonds and a rise in their prices, this lowers the yield
This causes investors to move to other assets driving their price up and causing a wealth effect boosting AD
Has QE worked
It helped boost GDP and inflation
However people are waiting until the extra money is removed after the government receive the payment from the bonds
If not the extra money supply will cause higher inflation
What are the 3 types of banks in the banking system
Commercial banks
Investment Banks
The Central Bank
What are commercial banks
They are retail or high street banks and have physical branches
Main customers are individuals and business
Profit-seeking financial intermediaries
What are the main functions of commercial banks
To accept Deposits
To act as lenders by creating deposits
To offer a means of payment (cheques, transfers)
What does a commercial banks balance sheet look like
They have assets and liabilities
What are assets
It is any claim that a bank has on another party
The asset side of the balance sheet shows what the bank is doing with their money
What are liabilities
It is any claim that can be made against the bank by another party
The liability side shows us where the bank’s money has come from
What are examples of assets
Cash (notes and coins)
Balances at the Bank of England
Money at call and short notice
Bills (Commercial and Treasury)
Investments (corporate and government bonds)
Advances (Loans and mortgages)
Fixed Assets (Building and Land)
What are examples of Liabilities
Share Capital
Reserves (retained profits)
Long term borrowing (bonds issued by the bank)
Short term borrowing from other banks
Customer Deposits (sight and time deposits)
What are sight and time deposits
Current accounts and savings accounts
When is a bank solvent
Total assets equals total liabilities
What happens to the balance sheet when the bank makes a loan
Their assets rise from owning the loan
Their liabilities rise as they have given that money away to the customer
What happens to the balance sheet when a customer makes a withdrawal
The value of the deposits falls (liabilities)
The cash balance of the bank falls (assets)
What can banks do
Lend out other customers deposits
Create money
How are assets on the balance sheet ordered
Decreasing liquidity and increasing profitability
Why do banks have to spread their assets
Conflicting interests
They need to hold liquid assets to meet customer’s daily cash requirements
They need to hold illiquid assets to meet the profit requirement of shareholders
Known as liquidity/profitability conflict
What are the roles of investments and advances
They provide the main earning opportunities for commercial banks as they bear higher interest rates
Bonds will become more liquid near maturity date
What is shareholder funds
The original value of shares issued plus any retained profits
The bank’s capital which acts as a cushion should there be a fall in bank assets
What are the 2 main parts of a banks liabilities
Shareholder funds
Customer deposits
How do banks normally operate
Borrow in the short term and lend in the long run
Borrowing is cheap and lending is rewarding
The bank earns its profits from the difference between theses interest rates
What are the 2 reasons banks fail
A fall in the value of its assets bigger than the value of its assets - called insolvency
It doesn’t have enough liquidity to meet demands of customers - normally caused by fear of insolvency
How do banks create credit
By giving loans to their customers which is classed as money as it can store value of a means of payment
What limits are there on how much credit a bank can create
The demand for credit and a profit incentive
The base rate of Interest
The amount of liquid assets a bank holds - a level of liquidity is needed to reduce risks
The BOE can stipulate a minimum capital to loans ratio
What are Investment Banks
They are banks that offer services to business, government and other financial institutions
Arrange new bond and share issues
Underwrite new share issues ( agree to buy up any unsold shares)
Trade bonds and shares
Buy and sell securities for clients
Help companies go public and with mergers
What are examples of investment banks
JP Morgan
Goldman Sachs
Morgan Stanley
What did investment banks do during the Financial Crisis
They practised high risk proprietary trading of securities
Causing systematic risk to the banking system
What changed for investment banks after the Financial Crisis
It was recommended that investment banks separate from commercial banks
This caused there to have to be separation between the 2 banks
The Banking Reform Act 2013 allowed the government to forcefully separate investment and commercial banks
What is a pension fund
An institution that collects people’s pension savings and invest them in securities
What are insurance companies
Companies that collect insurance premiums to provide cover against a range of risks
What is the shadow banking system
This the system of un-regulated operators in the financial system who are like banks but aren’t banks
What are hedge funds
An investment fund that pools money from individuals and businesses to invest in a variety of financial markets
What are private equity firms
Firms that provide finance for businesses by taking equity (shares) in return
What are examples of financial institutions
Commercial banks
Investment Banks
Pension Funds
Insurance Companies
The Shadow Banking System
Hedge Funds
Private Equity Firms
Pawnshops
Peer to peer lending websites
Crowd Funding
Asset management companies
What are the advantages and disadvantages of the shadow banking system
It acts as a useful secondary source of finance to individuals who aren’t accepted at normal banks
They are high risk operators who may contribute to systematic risk
What are the jobs of central banks
Maintain financial and macro-economic stability
Provides liquidity to banks (lender at last resort)
Provides regulations to banking sector
Acts as the governments bank
Controls note issue and money supply
Buys and sells currency to effect exchange rate and sets base rate of interest
Operates monetary policy for government
Pursues inflation rate of 2% and manages UK’s gold and foreign currency reserves
What is the Monetary Policy Commitee
They set interest rates to help reach inflation target
Made up of 9 members:
Governor, Deputy Governors, Chief Economist and external members
What is different about the financial sector
The high degree of interconnectedness
It has high levels of externalities
Moral Hazard in the sector
Can create and sustain asset market bubbles by providing loans that allow leveraged purchases of stocks and property
What is moral hazard
When there is an increased incentive to take risks because the cost of the risky action can be passed on and borne by someone else
What caused the financial crisis
Cheap starter loans were given to poor borrowers
When the sub-prime borrowers defaulted on their payments the banks gained the houses
But the housing bubble bursts and the value of theses houses fell
This left massive losses on balance sheets
What made the financial crisis worse
Banks started dealing with complex financial products
The banks couldn’t measure the risk of theses products which caused the level of risk taking by banks to rise
The deregulation of banking sector because of the belief that they were rational economic agents
Credit Crunch
What was the credit crunch
Banks stopped lending in the credit markets
Rise in interest rates
What are financial regulations
Rules and laws that govern the way banks and other financial institutions are allowed to behave
What are the 2 forms of financial regulation
Micro-prudential regulation
Macro-prudential regualtion
What is micro-prudential regulation
It is regulation aimed at ensuring individual banks and other financial institutions operate safely and fairly without taking excessive risk
What is macro-prudential regulation
Regulation designed to tackle systematic risk and avoid large scale financial crises
What are the 3 regulatory bodies in the UK
Financial Policy Committee
Prudential Regulation Authority
Financial Conduct Authority
What is the financial policy committee
It is part of the BOE
It has macro-prudential responsibility’s
What is the Prudential Regulation Authority
Part of the BOE
It has micro-prudential responsibility’s
It can specify capital and liquidity ratio’s for banks
What is the equation for capital ratio
Capital/Assets x100
What is the need for capital reserves
It acts as a buffer against any loan defaults
Means banks have to raise new capital to make new loans
Expected to be 8%
What is the equation for liquidity ratio
Liquidity assets/Deposits x100
What is the requirement for liquidity ratio’s for banks
Must hold sufficient liquid assets to cover 30 days of net liquidity outflows
What do the FPC and PRA carry out each year
annual stress tests
What is the financial Conduct Authority
Not part of the BOE
Involved in micro-prudential regulation
Job to protect consumers and increase confidence in the banking system
What are the different types of economy shocks
External
Domestic
Demand side
Supply side
What type of shocks are central banks best at controlling
Domestic demand side shocks
