4.4. The Financial Sector

Question 1

financial markets

Answer 1

• any place / system that provides buyers and sellers the means to exchange goods / services and trade financial instruments, e.g. bonds, equities, international currencies, etc.

Question 2

role of financial markets

Answer 2

• 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 3

role of financial markets - to facilitate saving

Answer 3

• they provide somewhere for consumers and firms to store their funds
• savings are rewarded with interest payments from the bank
• it provides a pool of money they can lend

Question 4

role of financial markets - to lend to businesses and individuals

Answer 4

• provides access to credit
• borrowing money speeds up consumption by households and investment by firms
• it also allows households / firms to purchase assets and pay them off over an extended period of time, e.g. mortgages

Question 5

role of financial markets - to facilitate the exchange of goods and services

Answer 5

• each purchase of goods / services requires the movement of money between at least 2 parties
• financial markets provide multiple ways for this exchange to happen, e.g. phone apps (apple pay), debit cards, credit cards, and bank transfers

Question 6

role of financial markets - to provide forward markets in currencies and commodities

Answer 6

• future contracts are a method for investing in commodities and currency as they provide some price stability and help defend currencies against speculative attacks

Question 7

role of financial markets - to provide a market for equities

Answer 7

• equities are shares in public companies that are listed on stock exchanges around the world
• financial markets facilitate both long-term investment and speculation by providing platforms which connect buyers and sellers, e.g. E-trade

Question 8

market failure in the financial sector - asymmetric information

Answer 8

• sellers often have a significant information advantage over buyers
• e.g. during the GFC, financial institutions bundled thousands of mortgages together and sold them onto investors - the sellers had more info on the risk profile of each bundle than the buyers

Question 9

market failure in the financial sector - externalities

Answer 9

• negative externalities of production and consumption exist in financial markets
• e.g. when investors speculate on property prices, a negative consumption externality occurs as young buyers end up paying more (or are forced out of the market) to the higher prices caused by speculation (airbnb effect)
• e.g. landlords decide to convert their long-term rental properties into short-term rental properties which decreases supply of long-term rentals and puts an upward pressure on them

Question 10

market failure in the financial sector - moral hazards

Answer 10

• this is when a borrower has an incentive to increase its exposure to risk because it doesn’t bear the full costs of that risk
• i.e. they’re insured so know that their insurer will pay the associated costs
• e.g. banks may take more risks if they know the BoE or the govt. can help them if things go wrong, e.g. during the GFC

Question 11

market failure in the financial sector - speculation and market bubbles

Answer 11

• a market bubble occurs when the price of an asset is predicted to rise significantly, causing it to be traded more, and demand exceeds supply so the price rises even more
• the bubble then ‘bursts’ when the price steeply falls back to its ordinary level
• this causes panic and investors try and sell their assets
• the higher the money supply in an economy, the greater the speculation and potential for market bubbles
• e.g. after the GFC, the UK experienced a house price bubble driven by low IR, easy access to credit and strong EG, so prices in major cities like London reached unsustainable levels, then led to a correction in the market

Question 12

market failure in the financial sector - market rigging

Answer 12

• the act of firms coming together to interfere in a market with the intention to stop it working as it’s supposed to, so the firms can gain an unfair advantage
• e.g. Libor Scandal - it was found that banks were inflating or deflating their IR to make a profit from trade or to make them seem more financially reliable, thus negatively affecting consumers and the financial market

Question 13

central bank

Answer 13

• manages the currency, money supply and interest rates in an economy
• e.g. BoE, European Central Bank (ECB)

Question 14

functions of central banks - implementation of monetary policy

Answer 14

• influences the manipulation of interest rates and the supply of money
• MPC meet each month in the UK to discuss what the interest rate should be
• IR are used to help meet the govt. target of price stability as it alters the cost of borrowing and reward for saving
• the bank controls the base rate which ultimately controls IR across the economy

Question 15

functions of central banks - banker to the govt.

Answer 15

• the CB provides services to the govt, e.g. as it manages their tax revenues and payments
• the bank can also advise the govt. on finance, including the timing and terms of new loans

Question 16

functions of central banks - banker to the banks - lender of last resort

Answer 16

• commercial banks can borrow from the CB if they run into short-term liquidity issues
• without this help, they may go bankrupt, leading to instability and a potential loss of savings for many households
• banks will usually avoid this though, as it suggests they’re experiencing a financial disaster

Question 17

functions of central banks - role in regulation of the banking industry

Answer 17

• govts. may regulate banks with regulation and guidelines to reduce the high level of asymmetric information in financial markets
• CB may regulate commercial banks by requiring them to hold back a % of money deposited with them, to avoid running into difficulties if depositors want their money back (implementation of required reserve ratios)