4.2.4 — Financial Markets And Monetary Policy

Question 1

What are the 4 characteristics / functions of money?

Answer 1

1. Medium of exchange:
   Replaced bartering
2. A measure of value (unit of account):
   Money provides a mean to measure the relative value of different goods / services. Money also puts a value on Labour
3. A store of value:
   Money has to hold its value to be used for payment — it can be kept for a long time without expiring. However, the quantity that can be bought with money fluctuates with the forces of supply / demand
4. Method of deferred payment:
   Money can allow for debts to be created. People can therefore pay for things without having money in present and can pay for it later

Question 2

Define money supply:

Answer 2

The stock of currency and liquid assets in an economy. It includes cash and money held in savings accounts

Question 3

Define narrow money

Answer 3

Physical currency (notes and coins), as well as deposits and liquid assets in the central bank

Question 4

Define broad money

Answer 4

It includes the entire money supply. Cash could be in restricted accounts, which makes it hard to calculate the money supply. It includes liquid and less liquid assets

Question 5

What is the difference between the money market, capital market and the FOREX?

Answer 5

In the money market, liquid assets are traded which are used to borrow and lend money in the short term.

The capital market is where equity and debt instruments are bought and sold. These can then be put to long term productive use by firms and governments

The FOREX is a market where currencies are traded, mainly by international banks. It determines what the relative value of different currencies will be

Question 6

What is the role of financial markets in the wider economy?

Answer 6

• 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 7

What is the difference between debt and equity?

Answer 7

Debt is money which has been borrowed from a lender, which is usually a bank. There is little flexibility, and the loan is later repaid with interest

Equity is a stock or security which represents interest in owning i.e a firm, a car etc. It is when there is no outstanding debt such as when a loan for a car or mortgage has been fully paid off. The owners equity is then the car or house which can be sold for cash

Question 8

Why is there an inverse relationship between market interest rates and bond prices?

Answer 8

When a bond is bought, money is lent to the issuer. The issuer agrees to pay the value of the bond back when it matures in addition to interest.

New bonds have rates close to the market interest rate. If the market interest rate falls, i.e the bond would be worth more, since it carries a higher interest rate than current market conditions — Similarly, the bond is worth less than the current market

Question 9

How can firms raise finance?

Answer 9

• by issuing shares
  > relatively cheap
  > a proportion of their profits has to be paid to shareholders
• issuing corporate bonds
  > used for larger projects I.e expansion
  > traded in a similar way to shares
• loans from a bank
  > have to pay back with interest rates
  > unaffordable for new, small firms
  > flexible
• Gov bonds
  > coupons

Question 10

Define maturity

Answer 10

Period of time for which the financial asset is outstanding. When it finishes and has been repaid it has matured

Question 11

What is a commercial bank?

Answer 11

A bank which manages deposits, cheques and savings accounts for individuals and firms. They make loans using the money saved with them

Question 12

What is an investment bank?

Answer 12

A bank which facilitates the trade of stocks, bonds and other forms of investment. Government regulation is weaker in the investment bank industry — this combined with their business model gives them a higher risk tolerance

Question 13

What are the 5 main functions of a commercial bank?

Answer 13

1. Accept deposits:
   In the form of savings (from the public), banks can meet the needs of depositors by offering different accounts i.e demand or fixed deposits
2. Provide loans:
   The main income source for banks is interest payed on loans (creation of credit) — loans can be used in the form of cash credit, on demand or only for the short term
3. Overdraft:
   When a current account has no deposits, consumers can still borrow money from the bank in the form of an overdraft. These are at a high interest rate and the amount that can borrowed is limited
4. Investment of funds:
   Surplus funds could be invested into securities i.e government bonds and treasury bills. These could earn a return for the bank
5. Agency functions:
   Banks represent their consumers i.e they collect cheques and dividends, they pay and accept bills I.e via direct debit etc

Question 14

Define loans on demand

Answer 14

When the entire loan is paid into the account of the borrower therefore the loan is charged with interest immediately

Question 15

What is a balance sheet?

Answer 15

They are what show the value of a company’s assets, liabilities and owners equity during a period of time. It is usually at the end of a quarter or an annum

Question 16

Define a liability

Answer 16

Something which must be paid. It is a claim on assets — takes money out of your pocket

Question 17

Define an asset

Answer 17

Something which can be sold for value. The owners equity is also known as bank capital and it is what is left over once an asset has been sold and liabilities have been paid — puts money into your pocket

Question 18

What are some assets and liabilities which you may find on a commercial banks balance sheet?

Answer 18

Liabilities:
- share capital
- deposits
- borrowing and reserve funds

Assets:
- cash
- securities and bills
- loans
- investments

Question 19

What are the 3 main objectives of a commercial bank?

Answer 19

1. Liquidity
2. Profitability
3. Security

Question 20

What is the liquidity of assets?

Answer 20

The liquidity of assets is how easy it is to turn assets into cash. Liabilities are payable on demand, so to be profitable banks must have cash and liquid assets.
> if liquidity is prioritised, profits will be low so banks need a balance between the 2 objectives

Question 21

What assets within a commercial bank are liquid / illiquid?

Answer 21

Liquid:
- cash
- deposits

Illiquid:
- loans
- long term bonds
- property

If banks can borrow easily / cheaply, they are likely to keep fewer liquid assets. The more expensive and difficult it is to get a loan, the more liquid assets are likely to be kept

Question 22

Why do commercial banks need to be profitable?

Answer 22

To pay their depositors interest, wages and general expenses.
Holding a lot of funds in cash mean profitability is limited, however liquidity and safety are generally prioritised over profitability

Question 23

Why do commercial banks face risks?

Answer 23

They face uncertainties about much cash they can get, and whether loans will be repaid or not. Banks therefore have to try and maintain the safety of their assets.
> banks may be less profitable or lose customers — the bank needs to balance the risk between risk level and profits

Question 24

What is monetary policy used to control (+ what tools)?

Answer 24

To control the money flow of the economy (done with interest rates and quantitative easing)

Question 25

What are the 3 functions of a central bank?

Answer 25

1. Implementation of monetary policy: MPC alters interest rates to control the money supply — IR are used to help meet the Gov target of price stability (alters cost of borrowing / saving) 2. Banker to government: The central bank provides services to the Gov. It collects and makes payments on behalf of the Gov. It also manages public debt and issues loans 3. Banker to the banks — lender of last resort: If there is no other method to increase the supply of liquidity when it is low, BofE will increase supply (bail out commercial banks) It can protect individuals who deposit funds in a bank and might otherwise lose them

Question 26

What does the base rate that central banks set do?

Answer 26

The base rate ultimately controls the interest rates across the economy

Question 27

Which factors are considered by the MPC when setting a bank rate?

Answer 27

1. Unemployment rate: > if high, C is likely to fall. This suggests the MPC will drop interest rates to encourage more spending 2. Savings rate: > if there is a lot of saving, C is likely to fall. IR are likely to fall 3. Consumer spending: > if C increases, there could be inflationary pressures on the PL. This would cause the MPC to increase IR 4. High commodity prices: > since the UK is a net importer of oil, high prices may lead to cost-push inflation. This could push the MPC to increase IR to overcome inflationary pressure 5. Exchange rate: A weak pound would cause PL to increase (SPICED WPIDEC). MPC might consider increasing the IR

Question 28

How do changes in the exchange rate affect AD and the macroeconomic policy objectives?

Answer 28

- A reduction in exchange rate causes cheaper exports that are in higher demand. This assumes that demand is price elastic. It also causes imports to become relatively expensive — UK current account deficit would improve > this is inflationary however, due to the increase in the price of imported raw materials. Production costs increase, causing cost-push inflation An increase in IR relative to other countries makes it more attractive to invest funds as the rate of return on investment is higher — this increases the demand for currency, causing appreciation

Question 29

Define hot money

Answer 29

Refers to short term, high speed capital flows that move in and out of countries in response to changing economic and financial conditions

Question 30

Name the 2 member types of the MPC and what they support

Answer 30

1. Hawks: Those who RESIST rate cuts 2. Doves: Those who are likely to INSIST rate cuts

Question 31

Name and explain 4 of the unconventional monetary policy instruments

Answer 31

1. Interest rates: MPC alters interest rates to control the money supply. They help to reach price stability since it alters the cost of borrowing and reward for saving 2. Asset purchases to increase money supply: QUANTITATIVE EASING: Used by banks when inflation is low and it is not possible to lower interest rates further. Gov purchases assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases cash flow. Encourages spending (alternatively they can sell assets to reduce spending) 3. Funding for lending: Govs can introduce a ‘funding for lending’ scheme which aims to lower high costs and provide cheap funding to banks and building societies 4. Forward guidance: This is used to detail what the future monetary policy will be. This is with the intention of reducing uncertainty in markets. I.e the MPC might state they will keep the IR at a certain level until a specified date

Question 32

What is the transmission mechanism of monetary policy?

Answer 32

The process through which monetary policy decisions affect the economy in general and the price level in particular. It is characterised by long, variable and uncertain time lags

Question 33

How many member are there in the MPC and how frequently do they meet a year to discuss interest rates?

Answer 33

9 members 8 times a year

Question 34

Why might governments regulate banks with regulations and guidelines?

Answer 34

To help ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank

Question 35

Name the UK regulates the banking industry (3 players)?

Answer 35

1. Prudential Regulation Authority (PRA) 2. Financial Conduct Authority (FCA) 3. Financial Policy Committee (FPC)

Question 36

Define financial regulation

Answer 36

Means imposing rules and laws to limit the freedom of banks and other financial institutions, & the people they employ to make decisions of their own free will

Question 37

Define microprudential regulation

Answer 37

Is concerned with the stability of individual banks and other financial institutions; identifying, monitoring and managing risks that relate to individual firms

Question 38

Define macroprudential regulation

Answer 38

Is concerned with identifying, monitoring and acting to remove risks that affect the stability of the financial system as a whole

Question 39

What is the relationship between the PRA, FCA and FPC to the Bank of England?

Answer 39

PRA; part of the BofE FCA; independent from the BofE and is funded by the firms it regulates FPC; part of the BofE

Question 40

What is the aim of the PRA?

Answer 40

It is responsible for microprudential regulation and supervision of roughly 1700 banks, building societies, credit unions, insurers and major investment firms The PRA focuses on the solvency of specific financial markets including insurance providers etc

Question 41

What is the aim of the FCA?

Answer 41

Ensures financial markets work well so consumers get a fair deal and appropriate products and services. It aims to secure an appropriate degree of protection for consumers It aims to protect / enhance the integrity of the UK financial system including people who work in the industry > promotes effective competition

Question 42

What is the aim of the FPC?

Answer 42

Identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting the resilience of the UK financial system. They publish a financial stability report identifying key threats to the stability of the UK financial system. They have the power to instruct commercial banks to alter their capital reserves buffers to help absorb any unexpired losses on their assets

Question 43

What are the (dis)advantages of regulating the financial market?

Answer 43

Advantages: - protects consumers - protects small businesses - reduces risk of loss - improves transparency of financial transactions Disadvantages: - costly for regulatory authorities - regs may vary between countries - increase in administrative work - shadow banking not regulated

Question 44

Why might a bank fail? And provide an example

Answer 44

There are risks involved with lending long term and borrowing short term. They might lose money on investments, and if there are insufficient funds in a vault, banks might not be able to give depositors their money on demand I.e 2008-09 Great Recession Before the crash, asset prices were high and rising, and there was a boom in economic demand. There were risky bank loans and mortgages (especially in the US). This means borrowers had poor credit history and several defaulted their mortgages in 2007. Banks lost huge funds, requiring assistance from the Gov (bailouts)

Question 45

What is a moral hazard?

Answer 45

When there is a risk that the borrower does things that the lender would not deem desirable, because it makes the borrower less likely to repay a loan. > It usually occurs when there is some form of insurance for the mistake I.e if a house is uninsured, a borrower might be less careful because they know any damage caused will be paid by someone else

Question 46

Under what circumstance would banks feel more comfortable taking risks?

Answer 46

If they know the BofE or Gov can help them if things go wrong > the financial crisis has been regarded as a moral hazard due to the degree of risk taking

Question 47

Define a systematic risk

Answer 47

A systematic risk in financial markets can be seen as a negative externality (cost to firms, consumers, economy etc). Systematic risks are the risk of damage of the economy or the financial market I.e it could be the risk of the collapse of a bank

Question 48

What is a liquidity ratio?

Answer 48

something that is used to determine how able a company is to pay off short-term obligations. The higher the ratio, the greater the safety margin of the bank. When creditors want payment, they look at liquidity ratios to decide whether the bank is a concern

Question 49

What is a capital ratio?

Answer 49

A comparison between the equity capital and risk-weighted assets of a bank. A banks financial strength is determined using this. Assets have different weightings, where physical cash has 0 risk and credit carries more risk

Question 50

How do liquidity and capital ratios affect the stability of a financial institution?

Answer 50

The recent financial crisis showed how having insufficient finance, in either capital or liquidity, can be dangerous. > another risk is that investors might assume other banks will fail as well, which reduces confidence

Question 51

Define bartering

Answer 51

The exchange of goods or services for other goods and services without using money

Question 52

What are the advantages and disadvantages of bartering?

Answer 52

**advantages** - everybody can get what they need - everyone just produce something to offer exchange - encourages close-knit communities **disadvantages** - unfair - easy to get scammed - limited resources

Question 53

List the 5 characteristics of money

Answer 53

- relative scarcity - uniformity - durability - portability - divisibility

Question 54

Name the 3 types of money

Answer 54

1. **Commodity** money I.e chicken 2. **Representative** money I.e good 3. **Token** money I.e notes, coins

Question 55

What is the equation for a yield?

Answer 55

Annual coupon payment ———————————— x 100 Bonds current market price

Question 56

Name the 3 types of banks

Answer 56

1. Central banks 2. Commercial / retail / high st banks 3. Investment banks

Question 57

What is the equation for market capitalisation?

Answer 57

Share price x No. Shares issued

Question 58

define systemic risk?

Answer 58

Refers to risk of a breakdown on the entire financial system, caused by inter-leakages within the system rather than simply the failure of an individual bank or financial institution within the market

Question 59

What is the formula for average tax rate?

Answer 59

Tax paid ————- Income

Question 60

What is the formula for marginal tax rate?

Answer 60

Change in tax paid ——————— Chang in Income

Question 61

Define shares

Answer 61

Undated financial assets, sold initially by a company to raise financial capital. Shares sold by PLC’s are sold on the stock exchange

Question 62

Define corporate bonds

Answer 62

Debt security issued by a company and sold as new issues to people to people who lend long term to the Gov. These can be resold second hand on a market

Question 63

Define gov bonds

Answer 63

Debt security known gilt-edged securities or gilts that are issued by the Gov and sold as new issues to people who lend long term to the Gov — can be resold second hand on a market

Question 64

Define commercial bills

Answer 64

Short-dated financial assets, sold by investment banks on behalf of client firms. These mature within a year of their issue

Question 65

Define treasury bills

Answer 65

Short dated Gov loans raced on a money market. They are sold as new issues by the BofE in behalf of the Gov with a method of financing the differences that emerge at certain times in the financial year between tax revenues and gov spending > mature within a year of issue

Question 66

Define a coupon

Answer 66

Guaranteed fixed annual interest payment often divided into two six month payments, paid by the issuer of the bond to the owner of the bond

Question 67

Define maturity date

Answer 67

The date in which the issuer of a dated security, I.e gilt-edged security or treasury bill pays the face value of the security to the security’s owner

Question 68

Define currency

Answer 68

Money in any form when in actual use or circulation as a medium of exchange

Question 69

What is the difference between bills and bonds? (Short and long term)

Answer 69

Bills: short term Bonds: long term

Question 70

What does a wealth portfolio include?

Answer 70

Contains different wealth assets that an individual owns and holds at a particular point in time Individuals can make portfolio balance decisions like whether to hold: - physical assets - financial assets