4.4.3 Flashcards
(22 cards)
what are some examples of central banks?
- Bank of England (UK)
- European Central Bank (ECB) for member nations of the Euro Area
- United States Federal Reserve
- Bank of Japan
- Bank of Canada (CAD)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
what are the main functions of a central bank?
- Monetary policy function
o Setting of the main monetary policy interest rate
o Quantitative easing (QE)
o Exchange rate intervention (managed/fixed currency systems) - Financial stability & regulatory function
o Supervision of the wider financial system
o Prudential policies designed to maintain financial stability - Policy operation functions
o Lender of last resort to the banking system
o Managing liquidity in the commercial banking system
o Overseeing the payments systems used by banks / retailers / credit card companies - Debt management
o Handling the issue and redemption of issues of government debt (bonds)
Monetary Policy in the UK
- The Bank of England has been independent of the UK government since 1997
- The main aim of the Bank of England is to promote monetary and financial stability
- Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the
Government’s inflation target, which the Bank seeks to meet through the decisions taken by the Monetary
Policy Committee (MPC) - The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation
target is set by the UK government. Base interest rates in the UK have been below 1 percent since 2009.
what is the monetary policy committee?
- The Monetary Policy Committee does a thorough assessment of the UK economy 8 times a year
- They look at a range of demand/supply-side indicators
- The interest rate decision is taken after this
- Key issue is the strength of inflationary pressures and the inflation forecast for the UK over the next two years
- Inevitably there is a lot of uncertainty
- Monetary policy affects both the demand and the supply-side of the economy. It does not operate in isolation
what is expansionary monetary policy?
Reducing nominal and real interest rates
Steps to expand the supply of credit from the banking system e.g. via QE
Depreciation of the external value of the exchange rate
what is deflationary monetary policy?
Higher interest rates on both loans and savings
Tightening of credit supply (i.e. loans from banks become harder to get)
Appreciation of the external value of the exchange rate
what’s the argument for maintaining very low interest rates?
- Inflationary pressures in many advanced countries have remained weak giving little justification for raising
interest rates to control inflationary pressures - Some economists argue that the Phillips Curve has flattened, i.e. the trade-off between unemployment and
inflation has weakened, this implies that an economy can operate at a higher level of aggregate demand and
employment without risking an acceleration of inflation - Maintaining low interest rates help to stimulate capital investment which increases a country’s long-run
productive potential - Low interest rates as part of an expansionary monetary policy have been helpful in supporting aggregate
demand and output during an era of fiscal austerity in many developed countries. - Keeping interest rates low may have helped to reduce the risks of price deflation and also contributed to
maintaining a competitive currency which has helped export industries
arguments in favour of rising interest rates?
A rise in monetary policy interest rates would help to control demand for credit, softens the growth of the money supply and therefore helps to control demand-pull inflation especially when unemployment is very low
2. Increased mortgage rates may cause a slowdown in house price inflation and therefore help to make property more affordable over time especially for hard-pressed young families who struggle to rent as well as but
3. Higher interest rates will increase the return to saving – raising effective disposable incomes for retirees
4. Higher interest rates reduce the risk of mal-investment by business that only goes ahead because of the cheap
cost of capital
5. Interest rates need to rise moderately now so that central banks can cut them in the event of a negative
external shock. They need to give themselves some policy leeway when the economy next experiences a recession
what are the risks of maintaining raising interest rates?
- High levels of unsecured debt – there is a risk of a significant slowdown in consumption if retail credit becomes
more expensive to service e.g. expensive credit cards - Higher interest rates might choke off much needed business investment e.g. in new house-building and
renewable energy capacity - Rise in interest rates might cause the sterling exchange rate to appreciate thus making exports less
competitive, leading to an export slowdown and a worsening external deficit - Higher interest rates make government debt more expensive
- Higher interest rates might lead to a economic slowdown which could hit share prices, pension fund assets
and dividend incomes
What is quantitative easing?
- One of the main aims of quantitative easing is to increase the supply of money available for banks to lend
- It is an alternative strategy to that of cutting interest rates
- The Bank of England’s MPC’s quantitative easing (QE) programme, where the Bank creates new money to
buy financial assets totalled £445 billion of assets in July 2019 - £435 billion of which are government bonds and £10 billion of commercial debt.
How does QE operate?
- QE involves the introduction of new money into the national supply by a central bank.
- In the UK the Bank of England creates new money (electronically) to buy assets (mainly bonds) from insurance
companies, pension funds and commercial banks - Increased demand for government bonds causes an increase in the market price of bonds and therefore
causes their price to rise - A higher bond price causes a fall in the yield on a bond (this is because there is an inverse relationship between
bond prices and yields) - Those who have sold their bonds may use the extra funds/cash to buy assets with higher yields such as shares
of listed businesses and corporate bonds - Commercial banks receive cash, and this increases their liquidity. This may encourage them to lend out more
money
through which effects does QE work?
- Wealth effect - lower yields (interest rates) lead to higher share and bond prices
- Borrowing cost effect - QE lowers the interest rate on long term debt such as government bonds and
mortgages - Lending effect - QE increases the liquidity of banks and increased lending from banks lifts incomes and
spending in the economy - Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a
depreciation) which helps exports
Arguments in favour of quantitative easing
- Gives a central bank an extra tool of monetary policy besides changing interest rates
- Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE, the fall in
real GDP would have been deeper and the rise in unemployment greater - Lower long-term interest rates have kept business confidence higher and given the commercial banking
system extra deposits to use for lending - QE can lead to a depreciation of the exchange rate will helps to improve the price competitiveness of export
industries
Criticisms of quantitative easing (with specific reference to the UK economy)
- Ultra-low interest rates can distort the allocation of capital and also keep alive zombie companies (note: this
is a key criticism of Hayekian/Austrian school) - QE has contributed to a surge in share prices and property values, the latter has worsened housing
affordability for millions of people and also contributed to increase in rents which has worsened the
geographical immobility of labour. - QE has done little to cause an increase in bank lending to businesses, many commercial banks have become
more risk averse and charge higher interest rates to business customers. - QE has contributed to a decade of ultra-low interest rates which has been bad news for millions of people
who rely on interest from their savings - Low interest rates and bond yields are a worry for pension fund investors because they worsen their deficits.
If companies must pay more into their employee pension schemes, they therefore have less money to spend on investment which could harm productivity growth in the long run
Who are the main regulators of the UK financial system?
- Financial Policy Committee (FPC)
- Prudential Regulation Authority (PRA)
- Financial Conduct Authority (FCA)
- Competition and Markets Authority (CMA)
What are the main aims of financial market regulation?
- Protect against the consequences of market failure
a. Protect the interest of consumers
b. Limit the monopoly power of commercial banks by encouraging increased competition
c. Protect borrowers from excessively high interest rates on loans e.g. on unsecured credit
d. Improved access to affordable finance services – this is key for growth & development and prevention
of poverty in many countries
e. Balance the interests of uninformed consumers with sophisticated sellers of financial services (i.e.
address problems arising from information asymmetry) - Encourage confidence in the economy & government
a. Promote capital investment and sustainable long run growth
b. Support trust in the banking system so that people and businesses are willing to save - Allow the Central Bank (e.g. the Bank of England) to perform its other roles such as lender of last resort
a. Prevent/mitigate systemic risk within financial markets that might damage the economy
what is the Financial Policy Committee of the Bank of England
- The FPC’s main role is to identify, monitor, and take actions to remove or reduce risks that threaten the
resilience of the UK financial system as a whole - The FPC publishes a Financial Stability Report identifying key threats to the stability of the UK financial system
- The FPC has the power to instruct commercial banks to change their capital buffers
- When the FPC decide that the risks to the financial system are growing, they may tell the commercial banks
and other lenders to increase their capital buffers to help absorb unexpected losses on their assets (bad debts
etc.) - These capital buffers are part of “macro-prudential policy” - prudent means being careful at times of
uncertainty.
Examples of regulation in financial markets: what are liquidity ratios?
- A liquidity ratio is the ratio of liquid assets held by a bank on their balance sheet to their overall assets
- Commercial banks need to hold enough liquidity to cover expected demands from their depositors
- In the wake of the Global Financial Crisis the Basel Agreement require commercial banks to keep enough
liquid assets, such as cash and bonds, to get through a 30-day market crisis - A liquidity ratio may refer to a reserve assets ratio for a bank which sets the minimum liquid reserves that a
bank must maintain in the event of a sudden increase in withdrawals - Liquid Asset Ratio = Cash & balances with central banks + government bonds / divided by a bank’s total
assets
Examples of regulation in financial markets: what are Capital ratios?
- A commercial bank’s capital ratio measures the funds it has in reserve against the riskier assets it holds that could be vulnerable in the event of a crisis.
- Banks must maintain sufficient capital which includes money raised from selling new shares to investors and also their retained earnings (i.e. non-distributed profits)
Examples of regulation in financial markets: what are Stress tests for commercial banks
Stress tests assess commercial banks’ ability not just to withstand severe shocks, but also to maintain the supply of credit to the real economy under severe pressure. Stress tests use tail-end risk events i.e. economic outcomes that lie well outside the mainstream forecasts. A failure to adequately insure against tail-end risk was a major reason behind the severity of the global financial crisis a decade ago.
summary of financial market failures & examples of interventions in the UK
- Externalities arising from financial instability= Depositor protection for families with savings
Increased capital requirements for commercial banks
Stress tests for commercial banks and other financial businesses Limits to highly-leverage mortgage lending (LTV ratios) - Herd behaviour and speculative bubbles in financial markets= Financial Policy Committee created to oversee financial stability
Monetary Policy Committee can raise interest rates to reduce the risk of an unsustainable housing / asset price boom
Possible regulation of use of volatile crypto-currencies - Market rigging / monopoly power of the banks= Tougher competition policy for anti-competitive behaviour
Price cap on interest rates charged by pay-day lending companies More licences to challenger banks to improve contestability - Asymmetric information and complexity of financial products= Penalties / compensation for miss-selling of PPI
Improved financial literacy education in schools and colleges Auto-enrolment in workplace pensions (mandated choice)
