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Economic A Level > Year 2 Monetary and Fiscal Policy, Bonds and Banking System > Flashcards

Year 2 Monetary and Fiscal Policy, Bonds and Banking System Flashcards

1
Q

What do monetarist economist believe

A

There is a strong connection between the rate of monetary growth and the rate of change of the price level

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2
Q

What has been the main way of controlling inflation

A

monetary policy

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3
Q

What are the characteristics of any asset to serve as money

A

Acceptable
Portable
Divisible
Durable
Homogeneous
Limited in supply

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4
Q

What is money

A

Money is defined by the functions that it does
Any asset that performs any jobs can claim to be money

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5
Q

What are the functions of money

A

A medium of exchange
A store of value/wealth
A measure of value/unit of account

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6
Q

What is a medium of exchange

A

A means of payment
It is an intermediary in an exchange that removes the need for a double coincident of wants

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7
Q

What is a store of value/wealth

A

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

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8
Q

What is a measure of value/unit of account

A

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

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9
Q

What is near money

A

Assets that fulfil some functions of money but not all

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10
Q

What is liquidity

A

The ease with which an asset can be converted into cash without significant loss of value
Notes and coins are the most liquid

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11
Q

What are the 2 measures of the money supply

A

Narrow Money
Broad Money

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12
Q

What is narrow money

A

Is all notes and coins in circulation including those held in tills, banks and building societies

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13
Q

What is broad money

A

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

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14
Q

What are the 2 types of asset classes

A

Physical assets
Financial Assets

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15
Q

Examples of physical assets

A

Houses
Land
Art
Antiques

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16
Q

Examples of financial assets

A

Cash
Bank Deposits
T-Bills
Shares
Bonds

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17
Q

What is the trade off with financial assets

A

Between liquidity and profitability of an asset

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18
Q

How are bonds and shares liquid

A

They can be converted into cash through resale in second hand markets

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19
Q

What is the purpose of financial markets

A

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

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20
Q

What are the types of capital markets

A

Money markets
Capital markets
Foreign exchange market

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21
Q

What are money markets

A

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

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22
Q

What are treasury bills

A

Short term loans to local and central governments that last 91 days

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23
Q

What are commercial bills

A

Short term loans to private businesses that need short term finance

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24
Q

What are capital markets

A

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

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25
Q

What is equity finance

A

Raising money through share sales
Businesses raise equity capital when selling shares

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26
Q

What is debt finance

A

Raising money through bond sales
Businesses raise debt capital when they borrow

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27
Q

What is a security

A

A commonly used term to describe a financial asset
As the asset secures a claim against the borrower

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28
Q

Whats the difference between bills and bonds

A

Bills are short term securities
Bonds are long term securities

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29
Q

What are Foreign exchange (forex) markets

A

They allow the trade of foreign currencies to allow international trade, investment and currency speculation
Spot markets
Forward markets
Largest markets in the world

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30
Q

What are spot markets

A

They are markets for trades that take place in the present at spot prices

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31
Q

What are forwards markets

A

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

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32
Q

What are the roles of financial markets in the world economy

A

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

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33
Q

What is a bond

A

It is a fixed interest security sold by firms and governments to raise money
Type of loan
Form of marketable debt capital

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34
Q

What are corporate bonds

A

Bonds issued by companies

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35
Q

What are gilt edged securities or gilts

A

Bonds issued by governments

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36
Q

What is the issue price of a bond

A

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

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37
Q

What is the coupon of a bond

A

It is the guaranteed fixed amount of interest which the bond holder will receive annually

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38
Q

What is the market price of a bond

A

It is the prevailing price of a bond sold in the second hand market
Depends on the demand and supply for bonds

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39
Q

What is the yield of a bond

A

It is the coupon expressed as a percentage of the current market price

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40
Q

What is the equation for yield of a bond

A

=Coupon/market price x100

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41
Q

What is the relationship between the price of a bond and its yield

A

inverse

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42
Q

What is yield maximisation assumption

A

When savers with surplus funds maximise the return they can earn by allocating their wealth into assets that offer the highest yield

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43
Q

What other things may assets do apart from a yield

A

Assets that have a capital gain (a rise in asset price)
Avoid a capital loss (a fall in the asset price)

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44
Q

What assets can investors hold for a yield

A

Bonds
Property/land
Shares (equities)
Savings account bank deposit

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45
Q

What is the measure of yields for property/land

A

Rent/Market price x100

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46
Q

What is the measure of yields for shares

A

Dividend/Market Price x100

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47
Q

What is the measure of yields for savings account bank deposits

A

Interest/Value of Savings x100

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48
Q

What does the high amount of competition in asset markets lead to

A

It will lead to equal rates of return that can be gained from investing in assets in close substitution
Similar to perfect competition

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49
Q

What happens when bonds approach their maturity date

A

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

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50
Q

What is the interaction of fiscal and monetary policy

A

Governments aren’t able to operate fiscal policy without it having an impact on monetary policy

51
Q

What is an example of the interaction of fiscal and monetary policy

A

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

52
Q

What is crowding out

A

It is the displacement of private sector activity by public sector spending because of higher interest rates

53
Q

What is the argument for private sector spending

A

They are more allocatively efficient because they stand to lose or gain from their decisions

54
Q

What is the argument for public sector spending

A

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

55
Q

What is crowding in

A

Government borrowing less leads to lower interest rates and more funds for other borrowers
This will cause consumption and investment to rise

56
Q

What is a transmission mechanism

A

The way in which a change in 1 policy variable feeds its way through intermediate variables to affect a final variable

57
Q

What is the bank rate

A

It is the interest rate that the BOE charge commercial banks for loans
Know as official rate or base rate

58
Q

What are the ways the government can affect inflation

A

Through market rates
Through asset prices
Through inflationary expectations
Through the exchange rate

59
Q

How does the government affect inflation through market rates

A

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

60
Q

How does the government affect inflation through asset prices

A

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

61
Q

How does the government affect inflation through inflationary expectations

A

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

62
Q

How does the government affect inflation through exchange rates

A

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

63
Q

Why is there a lengthy time lag in the operation of monetary policy

A

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

64
Q

How does the exchange rate affect inflation

A

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

65
Q

What is Quantitative Easing

A

Boosting the money supply through an Asset Purchase Programme

66
Q

How does the Asset Purchase Programme work

A

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

67
Q

How does QE effect inflation

A

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

68
Q

Has QE worked

A

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

69
Q

What are the 3 types of banks in the banking system

A

Commercial banks
Investment Banks
The Central Bank

70
Q

What are commercial banks

A

They are retail or high street banks and have physical branches
Main customers are individuals and business
Profit-seeking financial intermediaries

71
Q

What are the main functions of commercial banks

A

To accept Deposits
To act as lenders by creating deposits
To offer a means of payment (cheques, transfers)

72
Q

What does a commercial banks balance sheet look like

A

They have assets and liabilities

73
Q

What are assets

A

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

74
Q

What are liabilities

A

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

75
Q

What are examples of assets

A

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)

76
Q

What are examples of Liabilities

A

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)

77
Q

What are sight and time deposits

A

Current accounts and savings accounts

78
Q

When is a bank solvent

A

Total assets equals total liabilities

79
Q

What happens to the balance sheet when the bank makes a loan

A

Their assets rise from owning the loan
Their liabilities rise as they have given that money away to the customer

80
Q

What happens to the balance sheet when a customer makes a withdrawal

A

The value of the deposits falls (liabilities)
The cash balance of the bank falls (assets)

81
Q

What can banks do

A

Lend out other customers deposits
Create money

82
Q

How are assets on the balance sheet ordered

A

Decreasing liquidity and increasing profitability

83
Q

Why do banks have to spread their assets

A

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

84
Q

What are the roles of investments and advances

A

They provide the main earning opportunities for commercial banks as they bear higher interest rates
Bonds will become more liquid near maturity date

85
Q

What is shareholder funds

A

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

86
Q

What are the 2 main parts of a banks liabilities

A

Shareholder funds
Customer deposits

87
Q

How do banks normally operate

A

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

88
Q

What are the 2 reasons banks fail

A

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

89
Q

How do banks create credit

A

By giving loans to their customers which is classed as money as it can store value of a means of payment

90
Q

What limits are there on how much credit a bank can create

A

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

91
Q

What are Investment Banks

A

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

92
Q

What are examples of investment banks

A

JP Morgan
Goldman Sachs
Morgan Stanley

93
Q

What did investment banks do during the Financial Crisis

A

They practised high risk proprietary trading of securities
Causing systematic risk to the banking system

94
Q

What changed for investment banks after the Financial Crisis

A

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

95
Q

What is a pension fund

A

An institution that collects people’s pension savings and invest them in securities

96
Q

What are insurance companies

A

Companies that collect insurance premiums to provide cover against a range of risks

97
Q

What is the shadow banking system

A

This the system of un-regulated operators in the financial system who are like banks but aren’t banks

98
Q

What are hedge funds

A

An investment fund that pools money from individuals and businesses to invest in a variety of financial markets

99
Q

What are private equity firms

A

Firms that provide finance for businesses by taking equity (shares) in return

100
Q

What are examples of financial institutions

A

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

101
Q

What are the advantages and disadvantages of the shadow banking system

A

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

102
Q

What are the jobs of central banks

A

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

103
Q

What is the Monetary Policy Commitee

A

They set interest rates to help reach inflation target
Made up of 9 members:
Governor, Deputy Governors, Chief Economist and external members

104
Q

What is different about the financial sector

A

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

105
Q

What is moral hazard

A

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

106
Q

What caused the financial crisis

A

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

107
Q

What made the financial crisis worse

A

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

108
Q

What was the credit crunch

A

Banks stopped lending in the credit markets
Rise in interest rates

109
Q

What are financial regulations

A

Rules and laws that govern the way banks and other financial institutions are allowed to behave

110
Q

What are the 2 forms of financial regulation

A

Micro-prudential regulation
Macro-prudential regualtion

111
Q

What is micro-prudential regulation

A

It is regulation aimed at ensuring individual banks and other financial institutions operate safely and fairly without taking excessive risk

112
Q

What is macro-prudential regulation

A

Regulation designed to tackle systematic risk and avoid large scale financial crises

113
Q

What are the 3 regulatory bodies in the UK

A

Financial Policy Committee
Prudential Regulation Authority
Financial Conduct Authority

114
Q

What is the financial policy committee

A

It is part of the BOE
It has macro-prudential responsibility’s

115
Q

What is the Prudential Regulation Authority

A

Part of the BOE
It has micro-prudential responsibility’s
It can specify capital and liquidity ratio’s for banks

116
Q

What is the equation for capital ratio

A

Capital/Assets x100

117
Q

What is the need for capital reserves

A

It acts as a buffer against any loan defaults
Means banks have to raise new capital to make new loans
Expected to be 8%

118
Q

What is the equation for liquidity ratio

A

Liquidity assets/Deposits x100

119
Q

What is the requirement for liquidity ratio’s for banks

A

Must hold sufficient liquid assets to cover 30 days of net liquidity outflows

120
Q

What do the FPC and PRA carry out each year

A

annual stress tests

121
Q

What is the financial Conduct Authority

A

Not part of the BOE
Involved in micro-prudential regulation
Job to protect consumers and increase confidence in the banking system

122
Q

What are the different types of economy shocks

A

External
Domestic
Demand side
Supply side

123
Q

What type of shocks are central banks best at controlling

A

Domestic demand side shocks

Economic A Level (22 decks)

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