Chapter 6: Economic influences

Question 1

c. the influences over the commercial and economic environment from central banks.

List seven areas in which a central government may be interested.

Answer 1

(T-he P-rinting of M-oney F-or G-overnment I-n C-ountry)

1. Taxation
2. Printing of money and Minting of coins
3. performance and integrity of Financial markets
4. Government borrowing implementation
5. In banking regulation
6. Currency market intervention

Question 2

c. the influences over the commercial and economic environment from central banks.

Describe the role of the central bank in monetary policy and control.

Answer 2

Primarily concerned with monetary policy and control, including the following aspects:

• adjustment of banking sector liquidity
• control of money supply growth and short-term interest rates.

Question 3

c. the influences over the commercial and economic environment from central banks.

Outline reasons why the central bank may be concerned with the adjustment of banking sector liquidity

Answer 3

1. Smooth Functioning of Financial System: A healthy banking system relies on sufficient liquidity. This ensures banks have enough cash reserves to meet their daily obligations, like withdrawals and loan repayments.
2. Lending and Economic Growth: Adequate liquidity allows banks to lend money to businesses and individuals. This fuels economic activity and growth.
3. Financial Stability: Insufficient liquidity can lead to financial instability. Banks might become reluctant to lend, credit might dry up, and the economy could suffer.

Question 4

c. the influences over the commercial and economic environment from central banks.

Outline reasons why the central may be concerned with the control of money supply growth and short-term interest rates.

Answer 4

By controlling money supply growth and short-term interest rates, the central bank aims to achieve its primary objectives, which often include:

1. Price Stability: Maintaining low and stable inflation.
2. Economic Growth: Promoting sustainable economic growth and employment.
3. Financial Stability: Mitigating financial risks and maintaining a stable financial system.

Question 5

c. the influences over the commercial and economic environment from central banks.

Outline how the central bank may fulfil its roles in relation to the adjustment of banking sector liquidity and the control of money supply growth and interest rates.

Answer 5

It can fulfil its roles:

1. Directly through open money market operations
   - buying and selling of bills to influence level of liquidity within banking sector and ST interest rates
2. Indirectly through:
   - setting minimum liquid reserve ratios
   - setting discount rates and interest rate ceilings for bank deposits
   - issuing directives on types of lending

Question 6

c. the influences over the commercial and economic environment from central banks.

Describe how the central influences money supply growth and interest rates indirectly through:
1. setting minimum liquid reserve ratios
2. setting discount rates and interest rate ceilings for bank deposits
3. issuing directives on types of lending

Answer 6

1. set minimum reserve ratios
   - This requires banks to hold a specific portion of customer deposits as reserves, limiting the amount available for lending.
   - While lending expands the money supply, these reserve requirements restrict a bank’s ability to lend, ultimately impacting overall money growth.
2. interest rate ceilings for bank deposits
   - restricts the ability of banks to compete for investor’s money
   - therefore, restricts amount coming into the system
   - thus, restricts extent bank lending is able to expand money supply
3. directives on types of lending
   - restricts expansion of money supply by directly restricting lending, e.g., restrict extent to which consumer credit is available

Question 7

c. the influences over the commercial and economic environment from central banks.

Describe Quantitative Easing.

Answer 7

it is a tool used to stimulate economic activity.

it involves the increases in money supply and the increase from the fractional reserve system.

Usually, the Central bank will credit its account with money and use it to buy financial assets.

Usually, the assets bought are gov bonds, quasi gov debt, MBS, and corporate bonds in OMO.

Central banks using QE may provide forward guidance to market regarding the anticipated levels of QE that they intend to conduct in the short to medium term.

Question 8

c. the influences over the commercial and economic environment from central banks.

Describe Forward Guidance.

Answer 8

it is a tool used by central banks to indicate (in the absence of unforeseen events) how it believes monetary policy will change in the future - usually of over the following 18 to 24 months.

It is designed to help people see how the central bank sets interest rates and to reduce the uncertainty about the future path of monetary policy.

it allows the CB to influence:
- long-term interest rates
- inflation expectations
- and economic activity

it is not a guarantee. The CB can depart from its guidance either as a consequence of unforeseen economic event or if the economic outlook changes.

Question 9

c. the influences over the commercial and economic environment from main investor classes.

List the four main classes of investor.

Answer 9

1. Private individuals (Households)
2. corporates (Businesses)
3. managers of ST and LT savings products (Financial intermediaries)
4. Foreign investors

Question 10

c. the influences over the commercial and economic environment from main investor classes.

List the four features that vary between different categories of investor and also the investors within each category.

Answer 10

1. time horizon, e.g., whether they want investment returns over ST or LT
2. appetite for risk, i.e. extent to which averse or tolerant to risk
3. taxation position - reflects both tax rules that apply to particular type of investor and individual investor’s circumstances, e.g., how wealthy or otherwise
4. liability profile and other features and circumstances

Question 11

c. the influences over the commercial and economic environment from main investor classes.

List other features that might further differentiate categories of investors.

Answer 11

1. Investment Knowledge and Experience
   - Sophisticated vs. Retail Investors
   - Investment Focus (specific asset classes or investment styles)
2. Investment Objectives
   - Income vs. Growth
   - Liquidity Needs
3. Investment Restrictions
   - Investment Mandates
   - Regulatory Requirements
4. Demographic Factors
   - Age
   - Risk Tolerance

Question 12

c. the influences over the commercial and economic environment from main investor classes (Households).

List considerations for households when making investments.

Answer 12

LET WORDS Improve Life

1. Liabilities
2. Expertise
3. Tax
4. Wealth
5. Outgo and income uncertainty
6. Risk appetite
7. Diversification
8. Stability of Asset value
9. Investment and risk characteristics
10. Liquidity

Question 13

c. the influences over the commercial and economic environment from main investor classes (Financial intermediaries).

State four possible advantages offered by financial intermediaries compared to direct investment.

Answer 13

1. Pool resources and thereby enable small investors to gain access to investments which they could otherwise not do so by themselves
2. diversification (through lending to many borrowers)
3. Expertise (built through volumes of business they conduct)
4. lower dealing, administration and management costs (through economies of scale)

Question 14

c. the influences over the commercial and economic environment from main investor classes (Financial intermediaries).

List the examples of FI.

Answer 14

Examples include:
- banks
- insurers
- pension funds
- CIS
They sell their own liabilities to raise funds that are used to purchase the liabilities of other corporations.

Question 15

c. the influences over the commercial and economic environment from main investor classes (Financial intermediaries).

State four possible disadvantages offered by financial intermediaries compared to direct investment.

Answer 15

1. Additional layer of costs to investors
2. products offered might not meet the exact requirements of investor (e.g., LT bonds not available)
3. products offered may be inflexible (e.g., fixed term or penalty for early redemptions)
4. Investor loses element of control over investment choice

Question 16

c. the influences over the commercial and economic environment from main investor classes (businesses).

Describe:
- the aims of business when issuing securities
- the role of investment banks in the issue of securities

Answer 16

Aims of business:

Issue securities to raise money to finance investment in real assets. Aim to:
- get best possible price for securities
- market issues at lowest possible cost
- issue securities that best meet their requirements with regards to term, pattern and flexibility of funding

Roles of investment banks:
- advise issuing firms on prices they can charge
- handle marketing of security issue to the public (advertising, maintaining of applications, determining allocations, holding investor’s money and issuing securities)
- protect reputation by checking and certifying quality of information offered
- innovate security design and packaging to stimulate demand

Question 17

c. the influences over the commercial and economic environment from Government policy.

List the five main forms of government policy.

Answer 17

1. Monetary policy - control of money supply and/or level and structure of interest rates.
2. Fiscal policy - decisions on level and structure of taxation and government expenditure and hence PSBR
3. National debt management policy - manipulation of government debt in order to influence level and structure of interest rate or availability of liquid reserve assets to banking sector.
4. Exchange rate policy - directed towards achieving some target for exchange rate of the domestic currency in terms of the foreign currency, with objective of influencing country’s international trading and investment patterns.
5. Prices and incomes policy - aimed at influencing rates of wage and price inflation.

Question 18

c. the influences over the commercial and economic environment from Government policy.

List five other main forms of government policy.

Answer 18

1. Taxation policy regarding overall level and distribution of tax between personal direct, indirect, corporate and other - will affect prices and hence demand for goods and services, including labour.
2. Competition policy - affects oligopolistic industries, such as utilities.
3. Labour policy influences flexibility of labour and bargaining power of organised labour.
4. Social policy - determines costs of health services, welfare benefits and state pensions.
5. Investment policy - influences infrastructure and private sector Invesment

(All 10 could be arranged in the acronym MT FINE PLCS)

Question 19

c. the influences over the commercial and economic environment from Government policy.

State the four major economic objectives.

Answer 19

1. Low unemployment - so as not to have economic resources lying idle that could be used to produce goods and services.
2. Low and stable inflation - so as to avoid costs of inflation, both anticipated and unanticipated
3. high and stable economic growth - as growth leads to more goods and services and hence higher standard of living.
4. Sustainable balance of payments position that does not constrain achievement of other objectives. Stable exchange rate often viewed as desirable to encourage international trade.

Question 20

c. the influences over the commercial and economic environment from Government policy.

Describe the main problem associated with tax policy in an environment where trade is truly global and where there is liberation of capital flows, and outline the three main ways in which the problem manifest itself.

Answer 20

Cross-border investors and international companies will seek to maximise profits net of tax, and therefore seek to move profits to countries with low tax rates. This produces competition pressure for countries to lower their tax rates.

How the problem manifests itself:

1. subsidiaries in high-tax countries are heavily leveraged, meaning that the profits after interest are very low
2. Intra-group transfer pricing rates are set, which are inconsistent with the market rates, leaving profits in high tax countries significantly lower
3. Hybrid instruments are used, that lead to a tax deduction in one country and a tax liability in another to transfer taxable profits.

Question 21

c. the influences over the commercial and economic environment from Government policy (interest rates).

Describe the effects of higher interest rates on the:

• personal sector
• business sector

Answer 21

Personal sector:

Consumers’ expenditure reduced due to:

• Increase in mortgage interest payments, which reduce disposable income
• higher rates on credit facilities
• higher rates on interest on saving (encouraging higher levels of saving)

Business sector:
- Investment reduced due to increase cost of capital and reduce growth and profits prospects…
-… also increase opportunity cost of committing funds for investment and higher cost of borrowing…
- Current corporate profitability reduced, particularity if much floating rate corporate borrowing.
-…All of above result in reduce employment and lower sd of living
-

Question 22

c. the influences over the commercial and economic environment from Government policy (interest rates)

Describe the effect of interest rates on the:
- exchange rate and the capital account of balance of payments
- current account of balance of payments

Answer 22

Exchange rate and capital account:
- Increase in interest rates attracts ‘hot money’, leading to increase in domestic currency’s exchange rate
- if it is believed that domestic activity likely to be depressed, then may be reduced inward flows of direct capital investment

Current account:
- if exchange rates rise, then likely to result in adverse movements in the volumes of trade. For example…
-…reduce exports and higher imports, i.e., reduction in value of net export.