2.4 Financial markets and monetary policy

Question 1

Monetary policy

Answer 1

the manipulation by government of monetary variables such as interest rates, money supply, and exchange rates to achieve its policy objectives

Question 2

policy instrument

Answer 2

a tool or set of tools used to try and achieve a policy objective

Question 3

central bank

Answer 3

a national bank that provides financial and banking services for its country’s government and banking system, as well as implementing the government’s monetary policy and issuing currency

Question 4

Bank of England

Answer 4

the central bank of the UK

Question 5

monetary policy committee (MPC)

Answer 5

nine economists, chaired by the governor of the bank of England, who meet once a month to set the Bank Rate and whether other aspects of monetary policy need changing

Question 6

inflation rate target

Answer 6

the CPI inflation target set by the government for the Bank of England to achieve. The target is currently 2%

Question 7

Bank rate (base rate of interest)

Answer 7

the rate of interest that the Bank of England pays to commercial banks on their deposits held at the Bank of England

Question 8

Lender of last resort

Answer 8

the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity when all other sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions

Question 9

Hot money

Answer 9

highly volatile money derived from investors storing money in different institutions, looking for the highest rate of return

Question 10

money supply

Answer 10

the stock of money in the economy, made up of cash and bank deposits, at a particular point in time

Question 11

Contractionary policies

Answer 11

policies aimed at reducing Aggregate Demand

Question 12

Expansionary policies

Answer 12

policies aimed at increasing aggregate demand

Question 13

monetary policy instruments

Answer 13

the tools the MPC has to achieve policy objectives. The main monetary policy instrument that the MPC has is the bank rate. There are other less conventional monetary policy instruments, such as quantative easing

Question 14

Contractionary monetary policy

Answer 14

uses higher interest rates to decrease aggregate demand and shift the AD curve to the left

Question 15

Describe contractionary monetary policy

Answer 15

• increase in bank rate
• causes an increase in exchange rate, imports are cheaper so (X-M)↓, AD↓
• causes an increase in the market rate of interest, reward for saving increases and cost of borrowing increases, so C↓ and I↓, AD↓

a) Increase in Bank Rate (Official Bank Rate/Base Rate):

The Action: The Monetary Policy Committee (MPC) of the Bank of England raises the official bank rate. This is the interest rate at which commercial banks can borrow money directly from the Bank of England.
Impact on Commercial Banks: An increase in the bank rate makes it more expensive for commercial banks to borrow funds. These increased costs are then typically passed on to consumers and businesses through higher interest rates on loans, mortgages, and credit cards.
Impact on Exchange Rate: As you correctly stated, a higher bank rate can lead to an increase in the exchange rate (appreciation of Sterling). This occurs because:
Higher interest rates in the UK can attract “hot money flows” – international investors seeking higher returns on their savings and investments.
Increased demand for Sterling to invest in UK assets pushes up its value relative to other currencies.
Impact on Net Exports (X-M): A stronger pound makes:
UK exports more expensive for foreign buyers, leading to a fall in the quantity of exports (X↓).
Imports cheaper for UK consumers and businesses, leading to a rise in the quantity of imports (M↑).
Therefore, net exports (X-M) will likely decrease (↓).
Impact on Aggregate Demand (AD): The fall in net exports (a component of AD) contributes to an overall decrease in Aggregate Demand (AD↓).
b) Increase in the Market Rate of Interest:

The Action: As commercial banks face higher borrowing costs from the Bank of England (due to the higher bank rate), they increase the market rate of interest – the interest rates they charge their customers for loans and the interest rates they offer on savings.
Impact on Consumption (C):
Increased reward for saving: Higher interest rates make saving more attractive as individuals earn a greater return on their savings. This incentivizes households to save more and spend less, leading to a decrease in consumption (C↓).
Increased cost of borrowing: Higher interest rates make borrowing more expensive for consumers. This discourages borrowing for large purchases like cars and home improvements, further contributing to a decrease in consumption (C↓).
Impact on Investment (I):
Increased cost of borrowing: Higher interest rates raise the cost of financing investment projects for firms. This makes some potential investments less profitable, leading to a decrease in investment (I↓) in capital goods.
Reduced business confidence: Higher interest rates can also signal a cooling economy, potentially dampening business confidence and further reducing the willingness to invest.
Impact on Aggregate Demand (AD): The decreases in both consumption (C) and investment (I) lead to an overall decrease in Aggregate Demand (AD↓).

Question 16

Expansionary monetary policy

Answer 16

uses lower interest rates to increase aggregate demand and to shift the AD curve to the right

Question 17

Describe expansionary monetary policy

Answer 17

• decrease in bank rate
• causes a fall in the exchange rate, imports more expensive, (X-M)↑, AD↑
• causes a fall in market rate of interest, reward for saving decreases and cost of borrowing decreases, so C↑ and I↑, AD↑

Question 18

Exchange rate

Answer 18

the external price of a currency, usually measured against another currency

Question 19

SPICED

Answer 19

Strong Pound Imports Cheaper Exports Dearer

Question 20

Describe the relationship between interest rates and the exchange rate

Answer 20

• a fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return
• this reduces demand for pounds and increases the supply of pounds on the foreign exchange market, causing the pound’s exchange rate to fall
• This reduces UK export prices and increases import prices.

The Mechanism: Capital Flows Driven by Interest Rate Differentials

Interest Rate Differentials Matter: International investors constantly seek the highest possible returns on their capital. Differences in interest rates between countries create incentives for these capital flows.
“Hot Money” Flows: Funds that move quickly between countries in response to interest rate differentials and expected exchange rate movements are often referred to as “hot money.”
Your Points Explained:

“a fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return”:

Explanation: When the Bank of England lowers interest rates, the UK becomes a less attractive place for international investors to hold their assets (e.g., bonds, bank deposits). The returns on these assets are now lower compared to similar assets in countries with higher interest rates.
Investor Response: To seek higher returns, investors will sell their Sterling-denominated assets and use the proceeds to buy assets denominated in currencies offering better interest rates. This leads to an outflow of financial capital from the UK.
“this reduces demand for pounds and increases the supply of pounds on the foreign exchange market, causing the pound’s exchange rate to fall”:

Reduced Demand for Pounds: As investors sell Sterling to buy other currencies, the demand for the pound on the foreign exchange market decreases. Fewer people want to hold Sterling.
Increased Supply of Pounds: Simultaneously, the supply of pounds on the foreign exchange market increases as investors offer their Sterling in exchange for other currencies.
Exchange Rate Depreciation: With lower demand and higher supply, the price of the pound relative to other currencies (its exchange rate) will fall. This is a depreciation of Sterling.
“This reduces UK export prices and increases import prices.”:

Impact on Export Prices: When the pound depreciates, UK goods and services become cheaper for buyers using foreign currencies. For example, if £1 used to buy $1.20 and now only buys $1.00, a UK good priced at £100 will now cost a US buyer $100 instead of $120. This makes UK exports more price-competitive.
Impact on Import Prices: Conversely, when the pound depreciates, goods and services imported into the UK become more expensive for UK consumers and businesses. To buy the same $120 good, a UK buyer would now need to pay £120 instead of £100 (using the same exchange rate example).
Further Considerations for AQA A Level Economics:

Magnitude of the Effect: The extent to which interest rate changes affect exchange rates depends on various factors, including the size of the interest rate differential, the credibility of the central bank, the overall economic climate, and market expectations.
Other Influences on Exchange Rates: Interest rates are just one factor influencing exchange rates. Others include:
Inflation rates: Higher inflation tends to weaken a currency.
Economic growth: Stronger economic growth can attract investment and strengthen a currency.
Current account balance: A large current account deficit can put downward pressure on a currency.
Government debt: High levels of government debt can make a currency less attractive.
Political stability: Political instability can lead to capital flight and a weaker currency.
Speculation: Traders buying and selling currencies based on their expectations of future movements can significantly impact exchange rates in the short run.
Central Bank Policy: Central banks often consider the impact of their interest rate decisions on the exchange rate, especially in open economies like the UK where international trade is significant. They might intervene in the foreign exchange market to manage exchange rate volatility, although this is less common with floating exchange rates.
Time Lags: The full impact of interest rate changes on the exchange rate and subsequently on trade flows may take time to materialize.
In summary for AQA A Level Economics:

Changes in interest rates create international capital flows as investors seek the highest returns. A fall in UK interest rates typically leads to an outflow of capital, reducing demand for the pound and increasing its supply on the foreign exchange market, causing the pound to depreciate. This depreciation makes UK exports cheaper and imports more expensive, impacting the UK’s trade balance and aggregate demand. However, it’s crucial to remember that exchange rates are influenced by a multitude of factors beyond just interest rates.

Question 21

Factors considered by the MPC when setting the bank rate (5)

Answer 21

• unemployment rate
• savings ratio
• consumer spending
• commodity prices
• exchange rate

Question 22

Impacts of a fall in the exchange rate on AD and policy objectives (2)

Answer 22

• A reduction in the exchange rate causes exports to become cheaper, which increases exports. This assumes that demand for exports is price elastic. It also causes imports to become relatively expensive. This means the UK current account deficit would improve.
• However, this is inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation.

Question 23

Transmission mechanism of monetary policy

Answer 23

the process by which alterations to the base rate affect determinants of aggregate demand

Question 24

Functions of money (4)

Answer 24

• medium of exchange
• measure of value
• store of value
• standard of deferred payment

Question 25

Characteristics of money (6)

Answer 25

- acceptable - portable - durable - divisible - limited in supply - difficult to forge

Question 26

How does money solve problems created by bartering?

Answer 26

- without money, transactions were conducted through bartering. - Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed. - The goods and services exchanged were not always of the same value, which also posed a problem. Exchange could only take place if there was a double coincidence of wants, i.e. both parties have to want the good the other party offer. - Using money eliminates this problem.

Question 27

Describe money as a measure of value

Answer 27

Money provides a means to measure the relative values of different goods and services.

Question 28

Describe money as a store of value

Answer 28

- Money has to hold its value to be used for payment. - It can be kept for a long time without expiring. - However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.

Question 29

Describe money as a standard of deferred payment

Answer 29

- Money can allow for debts to be created. - People can therefore pay for things without having money in the present, and can pay for it later. - This relies on money storing its value

Question 30

Narrow money

Answer 30

the part of the stock of money (or money supply) made of cash and liquid bank and building society deposits.

Question 31

Broad money

Answer 31

the part of the stock of money (or money supply) made of cash, other liquid assets such as bank and building society deposits, but also some less liquid assets. The measure of broad money used by the bank of England is called M4 ## Footnote That's a good, concise definition of broad money for AQA A Level Economics! To break it down further: Cash: This refers to physical currency – banknotes and coins – in circulation. Other liquid assets: These are funds that can be easily and quickly converted into cash without significant loss of value. This mainly includes: Bank and building society deposits: Money held in current accounts and easily accessible savings accounts. Some less liquid assets: These are assets that are not immediately usable for transactions but can still be converted into cash relatively easily, although potentially with some notice or restrictions. Examples include: Savings accounts with some withdrawal conditions. Certificates of deposit (CDs) with shorter maturities. Money market accounts. Key takeaway for AQA Economics: You're right to highlight that the Bank of England's main measure of broad money is M4. Understanding the distinction between narrow money (primarily cash and highly liquid deposits) and broad money is crucial. The inclusion of less liquid assets in broad money makes it a more comprehensive measure of the money supply and potential purchasing power in the economy

Question 32

Liquidity

Answer 32

measures the ease with which an asset can be converted into cash without loss of value. Cash is the most liquid of all assets

Question 33

Equity

Answer 33

equity is wealth: shares are known as equities. However, equity can also mean fairness or justness: it depends on the context in which the term is is used.

Question 34

Debt

Answer 34

money people owe

Question 35

Financial markets

Answer 35

markets in which financial assets or securities are traded

Question 36

Roles of financial markets (5)

Answer 36

- To facilitate saving - To lend to businesses and individuals - To facilitate the exchange of goods and services - To provide forward markets in currencies and commodities - To provide a market for equities

Question 37

Bonds

Answer 37

financial securities sold by companies (corporate bonds) or by governments (government bonds) which are a form of long term borrowing. Bonds usually have a maturity date on which they are redeemed, with the borrower usually making a fixed interest payment each year until the bond matures.

Question 38

Money markets

Answer 38

- provide a means for lenders and borrowers to satisfy their short-term financial needs. - Assets that are bought and sold on money markets are short term, with maturities ranging from a day to a year, and are normally easily convertible into cash. - The term money market is an umbrella that covers several markets, including the markets for treasury bills and commercial bills

Question 39

Capital markets

Answer 39

where securities such as shares and bonds are issued to raise medium to long term financing, and where shares and bonds are then traded on the 'second-hand' part of the market, (e.g. the London Stock Exchange)

Question 40

Foreign exchange (forex/FX/currency) markets

Answer 40

global, decentralised market where currencies are traded, mainly by international commercial banks. It determines what the relative value of different currencies will be.

Question 41

Shares

Answer 41

undated financial assets, sold initially by a company to raise financial capital. Shares sold by public companies or PLCs are marketable on a stock exchange, but shares sold by private companies are not marketable. Unlike a loan, a share signifies that the holder owns part of the enterprise.

Question 42

Corporate bonds

Answer 42

debt security issued by a company and sold as new issues to people who lend long-term to the company. They can usually be resold second-hand on a stock evchange.

Question 43

Government bonds (gilts)

Answer 43

debt security issued by a government and sold as new issues to people who lend long-term to the government. They can be resold second- hand on a stock exchange.

Question 44

Coupon payment

Answer 44

the guaranteed fixed annual interest payment paid by the issuer of a bond to the owner of the bond

Question 45

Maturity date

Answer 45

the date on which the issuer of a dated security pays the face value of the security to the security's owners

Question 46

Describe the relationship between bond prices and interest rates.

Answer 46

- inverse relationship - if the market interest rate falls, the bond would be worth more, since it carries a higher interest rate than current market conditions. - Similarly, the bond is worth less is the rate increases. This is because the bond has a lower interest rate than the current market

Question 47

Bond yield formula

Answer 47

(annual coupon payment/current market price) x 100

Question 48

Central bank

Answer 48

a national bank that provides financial and banking services for its country's government and banking system, as well as implementing the government's monetary policy and issuing currency. The Bank of England is the UK's central bank.

Question 49

Commercial bank

Answer 49

a financial institution which aims to make profits by selling banking services to its customers. Also known as a retail or high-street bank.

Question 50

Investment bank

Answer 50

- a bank which does not generally accept deposits from ordinary members of the general public - traditional investment banking refers to financial advisory work - investment banks also deal directly in financial markets for their own accounts - investment banks help companies, other financial institutions and other organisations to raise finance by selling shares or bonds to investors and to h edge against risks.

Question 51

Systemic risk

Answer 51

the risk of a breakdown of the entire financial system, caused by inter-linkages within the financial system, rather than simply the failure of an individual bank or financial institution within the system

Question 52

Credit

Answer 52

when a bank makes a loan it creates credit. The loan results in the creation of an advance, which is an asset on the bank's balance sheet, and a deposit, which is a liability of the bank

Question 53

Balance sheet

Answer 53

Balance sheets show the value of a company’s assets, liabilities and owner’s equity during a period of time

Question 54

Liability

Answer 54

- A liability is something which must be paid. It is a claim on assets - Liabilities are used to buy assets, and income can be earned from these assets. - Liabilities are made up of share capital, deposits, borrowing and reserve funds.

Question 55

Examples of liabilities (3)

Answer 55

- Deposits - Short and long term borrowing - Capital (Shareholder equity & Retained profit)

Question 56

Asset

Answer 56

- An asset is something that can be sold for value. - Assets are cash, securities and bills, loans and investments.

Question 57

Profitability

Answer 57

the state or condition of yielding a financial profit or gain

Question 58

Security

Answer 58

secured loans, such as mortgage loans secured against the value of a property, are less risky for banks than unsecured loans

Question 59

Zero lower bound

Answer 59

- when the Bank Rate is cut to a very low level, at or close to 0%, there comes a point at which a floor is reached - once the zero lower bound is reached, it becomes impossible to cut the Bank Rate any further - this renders the 'conventional' expansionary monetary policy of reducing interest rates ineffective

Question 60

Liquidity trap

Answer 60

- a situation when cutting interest rates below a certain level fails to stimulate consumer spending - it may be the case that in a deep recession however low the Bank Rate is set, consumers refuse to borrow, and banks are too nervous to lend - this causes spending in the economy to fall - a very low Bank Rate traps the economy in situation in which further cuts have little or no effect on AD

Question 61

Quantitative easing

Answer 61

when the Bank of England buys assets, usually government bonds, with money that the Bank has created electronically

Question 62

Impacts of quantitative easing (7)

Answer 62

- asset prices increase - money supply increases - total wealth increases - cost of borrowing reduces - bank lending increases - spending and income increases - inflation back at target rate ## Footnote Here's a more detailed look at each point: Asset prices increase: This is a primary transmission mechanism of QE. When central banks buy assets (usually government bonds), it increases demand, pushing their prices up. This can then spill over to other asset classes like corporate bonds and even equities as investors seek higher returns. Money supply increases: QE directly increases the reserves held by commercial banks at the central bank. This is a form of increasing the monetary base (M0). However, the impact on broader measures of the money supply (like M4) is less direct and depends on whether commercial banks choose to lend these extra reserves. Total wealth increases: As asset prices rise (e.g., houses, shares), the perceived wealth of individuals and firms holding these assets increases. This is known as the wealth effect, which can potentially lead to increased consumer spending and investment. Cost of borrowing reduces: Increased demand for bonds through QE leads to higher bond prices and therefore lower yields (interest rates). This reduction in benchmark interest rates can feed through to lower borrowing costs for businesses (corporate bonds, loans) and households (mortgages, loans). Bank lending increases: The intention of QE is that with increased reserves and lower borrowing costs, commercial banks will be incentivized to lend more to households and businesses, stimulating economic activity. However, this link is not always strong, especially if banks are risk-averse or demand for loans is low. Spending and income increases: If QE successfully lowers borrowing costs and encourages lending, this can lead to increased investment by firms and higher consumer spending (due to lower loan rates and the wealth effect). This increased aggregate demand can then lead to higher incomes in the economy through the multiplier effect. Inflation back at target rate: This is the ultimate goal of QE when used in situations of low inflation or deflation. By increasing aggregate demand, the central bank hopes to put upward pressure on prices and bring inflation back to its target level. However, the effectiveness of QE in achieving this and the potential for it to overshoot the target are subjects of ongoing debate among economists. Important Considerations for AQA Economics: Transmission Mechanism: Make sure you understand the different stages through which QE is intended to impact the economy. Effectiveness: Be aware that the effectiveness of QE can vary depending on economic conditions and the state of the financial system. For example, during a liquidity trap, banks might hoard reserves rather than lend them out. Potential Risks and Drawbacks: While your list focuses on the intended positive impacts, it's also important to consider potential negative consequences that economists discuss, such as: Asset price bubbles: Artificially low interest rates could inflate asset prices to unsustainable levels. Inflation risks: If aggregate demand increases too rapidly, QE could lead to unwanted inflation. Increased inequality: The benefits of higher asset prices might disproportionately accrue to wealthier individuals who own more assets. Moral hazard: Banks might take on more risk knowing the central bank is willing to intervene. Difficulty in reversing (Quantitative Tightening): Selling assets back into the market can have its own set of challenges.

Question 63

Evidence that quantitative easing has been successful in the UK (5)

Answer 63

- prevented 2008-09 recession from developing into a depression - QE in USA stimulated growth in UK - made it cheaper for government to borrow to finance budget deficit and pay interest on national debt - cheaper mortgage loans for house buyers - increased nominal GDP by 6%

Question 64

Evidence that quantitative easing has been unsuccessful in the UK (7)

Answer 64

- from 2010, growth rate flatlined close to zero - in 2013 more substantial recovery occurred when QE was not being implemented - responsible for high inflation rate - increased bank lending went to big corporations and speculative activity rather than households and small businesses - house and land prices went up so wealthy better off - savers and workers contributing to private pensions suffered - speculative investment into unprofitable businesses (e.g. uber)

Question 65

Forward guidance

Answer 65

attempts to send signals to financial markets, businesses, and individuals, about the Bank of England's interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden and unexpected change in policy

Question 66

Aims of forward guidance (4)

Answer 66

- increase the credibility of monetary policy through calming uncertainty in financial markets - this enables households and businesses to feel calmer about their future economic prospects - allows companies and mortgage borrowers to estimate how long low interest rates will be around - low short-term interest rates converted into lower long-term interest rates

Question 67

Limitations of forward guidance (3)

Answer 67

- relies on accurate economic forecasting - loses credibility if policy changes repeatedly in light of economic shocks - need to maintain short-term policy flexibility

Question 68

Financial regulation

Answer 68

involves limiting the freedom of banks and other financial institutions, and of the people they employ, to behave as they otherwise might wish to do

Question 69

Macroprudential regulation

Answer 69

identifying, monitoring, and acting to remove risks that affect the stability of the financial system

Question 70

Microprudential regulation

Answer 70

identifying, modifying, and acting to remove risks that affect the stability of banks and financial institutions

Question 71

Financial policy committee (FPC)

Answer 71

the part of the Bank of England charged with the primary objective of identifying, monitoring, and taking action to remove or reduce systemic risks with a view of protecting and enhancing the resilience of the UK financial system. The committee's secondary objective is to support the economic policy of the government.

Question 72

Prudential Regulation Authority (PRA)

Answer 72

the part of the Bank of England responsible for the microprudential regulation and supervision of banks, building, societies, credit unions, insurers and major investment firms. It sets standards for them to follow, and ensures certain capital and liquidity ratios

Question 73

Financial Conduct Authority (FCA)

Answer 73

aims to make sure that financial markets work well so that consumers get a fair deal, by ensuring that the financial industry is run with integrity and that consumers can trust that firms have their best interests at heart, and by providing consumers with appropriate financial products and services

Question 74

Aims of the FCA (3)

Answer 74

- protect consumers by securing an appropriate degree of protection for them - protect financial markets so as to enhance the integrity of the UK financial system - promote effective competition in the interests of consumers

Question 75

Why do banks fail? (2)

Answer 75

- loss of capital - If value of assets falls significantly, a bank can run out of capital. It is then bankrupt and must cease trading. - lack of liquidity - if its liquidity ratio falls too low, a bank may not have enough cash or liquid assets to repay deposits. At this point the bank will need to go to the Bank of England as the lender of last resort.

Question 76

Moral hazard

Answer 76

the tendency of individuals and firms, once protected against some contingency, to behave so as to make that contingency more likely

Question 77

Example of moral hazard

Answer 77

- in the 2007-08 financial crisis, banks took too many risks in pursuing the huge profits that lending allows - they did this because the believed that the Bank of England, in its role as lender of last resort, and the government through its bailouts, would not allow banks to fail

Question 78

Liquidity ratio

Answer 78

the ratio of a bank's cash and other liquid asets to its deposits

Question 79

capital ratio

Answer 79

the amount of capital on a bank's balance sheet as a proportion of its loans

Question 80

Systemic risk

Answer 80

a risk that could lead to the collapse of the financial system, due to the inter-linkages in the system, rather than simply the failure of an individual bank or financial institution within the system

Question 81

Default

Answer 81

the failure or inability to meet the legal minimum requirements of a loan