Chapter 2

Question 1

Difference between fiscal and monetary policy

Answer 1

Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs. Monetary policy involves influencing the supply and demand for money through interest rates and other monetary tools. Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy.

Question 2

Macroeconomic policy

Answer 2

concerned with issues that affect the economy as a whole

Question 3

Macroeconomic objectives

Answer 3

full employment;
economic growth and thereby improved living standards;
an acceptable distribution of wealth;
price stability and therefore limited inflation; and
a solid balance of payments because a continual external deficit, where a country is importing more goods and services than it is exporting, is unsustainable and is likely to lead to an exchange rate crisis.

Question 4

How can macroeconomic policy objectives be in conflict

Answer 4

The above objectives can often be in conflict (e.g. economic growth can lead to excess demand for resources and lead to an increase in inflation).

Question 5

Monetary policy

Answer 5

influence variables such as interest rates and money supply in order to manage demand

Question 6

What do monetary policy actions do

Answer 6

directly control the amount of money in circulation (the money supply); or
attempt to reduce the demand for money through its price (interest rates). For example, increasing interest rates increases the cost of borrowing which decreases the demand for goods and so tends to decrease the rate of inflation

Question 7

Monetarists

Answer 7

Those who see the use of monetary policies as crucial in the control of macroeconomic activity are known as monetarists.

Question 8

Financial instrument

Answer 8

A contract for monetary asset

Question 9

Financial instrument

Answer 9

A contract for monetary asset

Question 10

How to directly control money supply

Answer 10

Open market operations
If the central bank sells government securities, the money supply is contracted, as some of the funds available in the market are “soaked up” by the purchase of the government securities.
The sale of government securities will lead to a reduction in bank deposits due to the level of funds that have been soaked up.
This in turn can lead to a further reduction in the money supply, as the banks’ ability to lend is reduced. This is known as the multiplier effect.
Equally, if the central bank were to buy back securities, funds would be released into the market.
Reserve asset requirements (cash reserve ratio): the central bank can set a minimum level of liquid assets which banks must maintain. This limits their ability to lend and thereby reduces the money supply.
Special deposits: the central bank can have the power to call for special deposits. These deposits do not count as part of the bank’s reserve base against which it can lend. They have the effect, therefore, of reducing the bank’s ability to lend and thereby reducing the money supply.
Direct control: the central bank may set specific limits on the amount which banks may lend. Credit controls are difficult to impose as, with fairly free international movement of funds, they can easily be circumvented.

Question 11

How to indirectly control the money supply

Answer 11

Increase short term rates

Question 12

Problems with monetary policy

Answer 12

There is often a significant time lag between the implementation of a policy and its effects.
Credit control is ineffective in the modern global economy.
The relationship between interest rates, level of investment and consumer expenditure is not actually stable and predictable.
Increasing interest rates produces undesirable side effects, including:
Less investment, leading to reduced industrial capacity, leading to increased unemployment (as higher interest rates increase the cost of capital for a company using debt finance).
A downward pressure on share prices, making it more difficult for companies to raise fund from new share issues.
Decreases in consumer demand.
An overvalued currency, which reduces demand for exports

Question 13

Fiscal policy

Answer 13

government actions to achieve economic objectives through the use of the fiscal instruments of taxation, public spending and the budget deficit or surplus.

Question 14

How to reflate an economy using fiscal policy

Answer 14

increase government spending in order to directly increase the level of demand in the economy (e.g. if a government agrees a number of large road-building projects or establishes training schemes for sections of the population, the demand for goods and services in the economy is increased); and/or
reduce taxation in order to boost both consumption and investment.

Question 15

Efficient market

Answer 15

One where the market price of all securities traded reflect all the available information

Question 16

Perfect market

Answer 16

One which responds immediately to the information made available to it

Question 17

Problems that may occur due to reflating an economy using fiscal policy

Answer 17

government spending is an intervention into the free market and it can lead to the misallocation of resources (e.g. support for inefficient industries);
there is often a significant time lag between the authorisation of additional spending and its actual occurrence;
tax cuts are not efficient at boosting domestic demand, as in times of recession some of the extra disposable income made available will be saved, and some of the extra monies actually spent will be on imports;
a large budget deficit is likely to occur, which will lead to a large Public Sector Net Cash Requirement (PSNCR) and/or
the rate of inflation is likely to rise, as demand may increase for resources which are in limited supply and their prices rise.

Question 18

PSNCR

Answer 18

Formerly known as Public Sector Borrowing Requirement (PSBR), the PSNCR is the difference between the expenditure of the public sector and its income. A deficit is financed by borrowing − principally via the sale of government gilt-edged stocks (“gilts”).

Question 19

PSNCR

Answer 19

Formerly known as Public Sector Borrowing Requirement (PSBR), the PSNCR is the difference between the expenditure of the public sector and its income. A deficit is financed by borrowing − principally via the sale of government gilt-edged stocks (“gilts”).

Question 20

Problems with deflating an economy

Answer 20

it is not possible to cut government spending dramatically in sectors such as health care or education; and/or
increasing taxation discourages enterprise

Question 21

Which policy do keynesians favor

Answer 21

Keynesians favour adjusting the level of government spending over adjusting tax rates, as they believe it has a quicker and greater impact on the level of demand in the econom

Question 22

Supply side policies

Answer 22

policies which focus on creating the right conditions in which private enterprise can grow and therefore raise the capacity of the economy to provide the output demanded.

Question 23

Supply side policies

Answer 23

Supply-side policies include:

low corporate tax rates to encourage private enterprise;
promoting a stable, low inflation economy with minimal government intervention;
limited government spending;
a balanced fiscal budget;
deregulation of industries;
a reduction in the power of trade unions;
an increase in the training and education of the workforce;
an increase in infrastructure required by business (e.g. business parks); and
a reduction in planning legislation.

Question 24

Supply side policies and fiscal policy

Answer 24

Supporters of supply-side policies believe that, if business is to flourish, the economy must be in a stable condition and therefore fiscal policy should be in equilibrium. In other words, government spending should not exceed government receipts from taxation.

Additionally, if the private sector is to be encouraged, tax rates should be kept to a minimum and government expenditure also should be kept to a minimum.

Question 25

Problems with using supply side policies

Answer 25

there is a time delay before the policies have any impact; and/or
the private sector will not provide all the goods and services required by society

Question 26

Role of financial intermediaries

Answer 26

Aggregation: small deposits are combined and lent to large borrowers.
Maturity transformation: a continuing stream of short-term deposits can be used to lend monies in the long term.
Risk diversification: the risk of each particular borrower is effectively spread across many lenders.
Liquidity: providing a liquid market with flexibility and choice for both lenders and borrowers.
Hedging: providing instruments to business for hedging risk (e.g. forward contracts, options and swaps).

Question 27

Forms of bank lending

Answer 27

Overdraft facilities and term loans to individuals and business customers.
Investments in other financial intermediaries, such as leasing companies.
The purchase of short-term government securities.
The purchase of trade or commercial bills.
The lending of money in the very short term to discount houses, which will re-lend in the longer term, as not all of their borrowings are likely to be called in at any one time

Question 28

Roles of commercial clearing banks

Answer 28

They accept deposits from their customers which are then held in current or deposit accounts.
They issue certificates of deposit, which may then be traded. These relate to large deposits, which have a term to maturity of at least three months.
They lend money in a number of different ways, thereby ensuring that adequate returns are made. At the same time, some cash must be held in order to ensure that sufficient liquidity is maintained. Banks therefore have to find the right balance between profitability and liquidity.
They provide a money transmission service through the clearing system.

Question 29

Primary and secondary market activity

Answer 29

Primary market activity − the selling of new securities to raise new funds.
Secondary market activity − the trading of existing securities.

Question 30

Exchange rate policy

Answer 30

the way a government manages its currency in relation to foreign currencies. It is closely related to monetary policy and both generally depend on many of the same factors.

Question 31

Reasons for controlling exchange rates

Answer 31

To rectify a balance of trade deficit. If inflation in one country is higher than in others, its export prices will become uncompetitive in overseas markets and so its trade deficit will grow. The government may therefore try to bring about a fall in the exchange rates to make exports less expensive.
To prevent a balance of trade surplus. A government may try to bring about a limited rise in exchange rates to make imports less expensive.
To stabilise the exchange rate. Importers and exporters will therefore face less exchange rate risk, confidence in the currency will improve and international trade is facilitated.

Question 32

Main sources of demand

Answer 32

exports of goods;
exports of services;
inflows of foreign investment;
speculative demand.

Question 33

Main sources of supply

Answer 33

imports of goods;
imports of services;
outflows of foreign investment;
speculative selling.

Question 34

Managed float

Answer 34

A “managed float” means that the exchange rate is allowed to float but the central bank intervenes to prevent major fluctuations.

Question 35

Fixed exchange rate

Answer 35

A fixed exchange rate (“fixed peg”) regime is one in which the rate is kept fixed against that of another currency, or basket of currencies. No fluctuations are permitted; the central bank intervenes to maintain the exchange rate.

Question 36

Crawling peg

Answer 36

In a crawling peg system, a currency is allowed to fluctuate but only within a relatively narrow range around a target rate. The target rate may have to be reset due to factors such as inflation.

Question 37

Financial institutions that act as financial intermediaries

Answer 37

Commercial banks
Merchant/investment banks,
Building societies, which take deposits from the domestic sector and lend to those buying their own house.
Insurance companies,
Investment trusts and unit trusts/mutual funds, which attract investors and then reinvest the funds raised in other companies.
Pension funds,
Finance companies, which provide business and domestic credit, leasing finance and factoring/invoice discounting services. These companies are often a subsidiary of another financial institution.
Discount houses, which trade in investments such as bills of exchange.

Question 38

Capital markets

Answer 38

These markets provide long-term capital in the form of equity capital, ordinary and preference shares, or debt capital such as loan notes. Companies requiring funds for five years or more will use the capital markets.

Question 39

Money market

Answer 39

the trading between banks and other financial institutions.

Question 40

Role of money market

Answer 40

transfer money from parties with surplus funds to parties with a deficit;
allow governments and businesses to raise short-term funds;
help governments implement monetary policy;
determine short-term interest rates; and
allow businesses to manage their exposures to risk.

Question 41

How do money markets fulfill these roles

Answer 41

nterest-bearing instruments: debt issued at nominal value, paying “coupon” interest on this nominal value (see s.4.3.2);
Discount instruments: debt issued at a discount to nominal value paying no interest (i.e. zero coupon) but redeemed at nominal value (see 4.3.3);
Derivative instruments: financial institutions provide their clients with customised “over-the-counter” (OTC) instruments for hedging currency risk or interest rate risk (see 4.3.4).

Question 42

Eurocurrency markets are the international money markets, whereas Eurobond markets are the international capital markets.

Answer 42

true

Question 43

Corporate bond

Answer 43

Corporate bonds (also called “loan notes”) are often used to raise funding for large-scale projects (e.g. business expansion, takeovers, new premises or product development).

Question 44

main features of a corporate bond

Answer 44

the nominal value − the price at which the bonds are initially issued;
the “coupon” interest rate paid to the bond owner − this is usually a fixed percentage of the nominal value; and
the redemption date − when the nominal value of the bond must be repaid to the bond holder.

Question 45

Method of corporate bond issues

Answer 45

corporate bonds can be issued through the stock exchange in a similar process to issuing shares to the public. Private placement − a bond issue to a relatively small number of selected investors such as banks, insurance companies and pension funds. Private placements avoid the compliance costs of a public issue and can be used to accommodate smaller transactions.

Question 46

Murabaha

Answer 46

(trade credit): trade credit for asset acquisition that is structured so that it avoids the payment of interest. A bank buys the asset and then sells it to the customer on a deferred basis at a price that includes an agreed mark-up. The mark-up cannot be increased, even if the client does not take the asset within the time agreed in the contract.

Question 47

Ijara

Answer 47

lease finance whereby the bank buys an item for a customer and then leases it back over a specific period at an agreed amount. I

Question 48

Mudaraba

Answer 48

a bank provides all the capital, and its customer provides expertise and knowledge and invests the capital. Profits generated are distributed according in a predetermined ratio. Any losses are borne by the provider of capital, thereby exposing the bank to considerable investment risk.

Question 49

Sukuk

Answer 49

his involves Islamic bonds where the sukuk holders’ return for providing finance is a share of the income generated by the project’s assets. Typically, an issuer of the sukuk would acquire property to be leased to tenants to generate income. The issuer collects the income and distributes it to the sukuk holders. This entitlement to a share of the income generated by the assets (rather than a return based on interest on money loaned) can make the arrangement Sharia-compliant. However, the rental income is often linked to market interest rates (e.g. the Secured Overnight Financing Rate (“SOFR” on USD-denominated loans) as opposed to the returns from the underlying asset, and hence such bonds may contravene the prohibition on riba. Indeed, it does appear that Sukuk bonds are often structured to make money from money rather than making returns from a physical asset.

Question 50

Hibah

Answer 50

this is where Islamic banks voluntarily pay their customers a “gift” on savings account balances. This gift represents a portion of the profit made by using those balances in other activities

Question 51

Musharaka

Answer 51

his entails a joint venture or partnership between two parties who both provide capital towards the financing of new or established projects. Profits are shared on a pre-agreed ratio with losses shared on the basis of the relative amounts of equity invested.

Question 53

Why do governments intervene in a free market

Answer 53

monopolies, mergers or restrictive practices operate against the public interest;
an industry is of key national strategic importance;
the free market creates social injustice;
companies fail to take into account how their actions affect others outside of the company (such effects are known as externalities, and a common example is pollution caused by a company);
the free market fails to provide sufficient public goods, such as health care or education; and/or
the free market is unable to provide the amount of capital required (e.g. when a large infrastructure project, such as the construction of a new tunnel or bridge, is being undertaken).

Question 54

Competition policy

Answer 54

Monopolies and mergers legislation prevents the development of monopolies, which would have the power to act against the public interest.
Restrictive practices legislation has eliminated practices such as the setting of retail prices by manufacturers;
Deregulation in certain industries has removed regulations that restrict competition in the industry. An example is the deregulation of the UK stock market in 1986, which caused dealing costs to reduce and therefore the volume of trading to increase greatly.
The creation of internal markets within certain areas of the public sector (e.g. hospitals or schools). The providers of public sector services must compete for the resources they require based on the services they provide to their users.
The Competition and Markets Authority (CMA), a government department, was established to investigate situations which may be against the public interest (e.g. excessive market power). The CMA uses 25% market share as an indicator of potential unfair influence.

Question 55

Privatization

Answer 55

In the UK, a large number of state-owned organisations have been sold to the private sector either by sale to the general public, direct sale to another company or management buyout. Examples include British Telecom, British Gas and the electricity distribution companies.

Arguments in favour of privatisation include:

an increase in competition where a state monopoly is split into a number of operating companies prior to sale or where the monopoly position is removed;
a short-term boost to government revenues and therefore a favourable impact on the PSNCR;
a widening of share ownership, thereby increasing individuals’ stake in the economy as a whole; and
reduction in the PSNCR in the future, as borrowings by the newly privatised industries are no longer public borrowings.
Arguments against privatisation include:

many privatisations have replaced state monopolies with private sector monopolies, which have then required regulation to ensure that their monopoly position is not abused;
the breaking-up of large businesses into smaller companies results in the loss of economies of scale; and
the quality of service may deteriorate.