Flashcards in environment Deck (63):
The influence of central banks varies according to
1. division of power between related government ministries,
central banks and
other regulatory bodies.
2. will also determine the bank’s importance.
In the US, the central bank (the Federal Reserve) is
fully independent of the government.
In the UK, the central bank (the Bank of England) is
1. not fully independent
2. does however have power to set
--short-term interest rates,
--does in order to meet
--UK Government’s published inflation target
--of 2% pa
--based on the Consumer Price Index (CPI).
A central bank may be interested in:
1. monetary, interest rate and inflation policy
2 banking regulation
3 implementation of government borrowing
4 performance and integrity of financial markets
5 intervention in currency markets
6 printing and minting of notes and coins, and
8. which of these are set by central bank
--in a particular country
(and which truly determined by an independent central bank rather than implementing decisions made by political entities)
--will vary from country to country.
In many states, central banks are now primarily concerned with:
monetary policy and control:
1 adjustment of banking sector liquidity
2 control of money supply growth
--and short-term interest rates.
In UK, three new regulatory bodies were established:
1 the Financial Policy Committee (FPC)
2 the Prudential Regulation Authority (PRA)
3 the Financial Conduct Authority (FCA).
The PRA and the FCA regulate the UK banking sector
--in a system referred to as “dual regulation”.
---The FPC focuses on
--higher-level systemic risks to the financial system.
Adjustment of banking sector liquidity is achieved through:
Money Market intervention
Money market intervention is achieved through
1. buying and selling bills
--to influence the level of liquidity within the banking sector and
--short-term interest rates.
2 will include activity
--to stabilise rates
(when cash flows between the government and private sectors would otherwise impinge on bank liquidity).
3. buying and selling of bills is known as open market operations or OMOs.
If the central bank buys bills back from the banks in the money markets:
1. this increases the amount of money in the banking sector
2 allowing the banks to expand the money supply
Similarly, the central bank selling bills
will reduce the money supply.
As well as market intervention to control banking sector liquidity and hence money supply,central bank may also use non-market (direct) controls such as:
1 setting minimum liquid reserve ratios
2 setting interest rate ceilings for bank deposits
3 issuing directives regarding
--the types of lending to be undertaken.
What is the main economic variable that the money supply is used to control?
Describe how each of these controls influences the money supply.
Quantitative easing usually means
Quantitative Easing (QE) is
1. a monetary policy
2. used by some central banks
3. to increase the supply of money.
4. usually involves both
--a direct increase in the money supply
(ie electronically “printing” money) and
--a knock-on effect
-----from the fractional reserve system,
---increasing the money supply further,
5. although it can involve just making changes to the fractional reserve system.
The fractional reserve system refers to
1. funds received by banks
--- and loaned on to other customers.
2. means that bank reserves are
--only a fraction of the quantity of deposits in the banks.
3. the reserve ratio: is this fraction
QE is usually implemented by:
1. a central bank first crediting its own account
--with money it creates out of nothing
2. then purchases financial assets,
---mortgage-backed securities and
--- corporate bonds,
from banks and other financial institutions
3. this process referred to as “open market operations”.
4. can also involve changing the reserve requirements for banks
--which, through the fractional reserve system,
--would increase the money supply.
How has The use of QE has evolved in recent years?
1. Now CBs typically give a degree of forward guidance
--to the market
--regarding the anticipated levels of QE that ---they intend to conduct
-- in the short to medium term.
2. part of a general evolution in the use of monetary policy,
--whereby communication by central bankers --is increasingly used
--as a monetary policy tool
--to influence the yield curve
--and consequently economic activity.
Forward Guidance is a
1. tool used by some central banks.
2. enables CB to indicate,
--in the absence of any unforeseen events,
--how the central bank believes monetary policy will change
--in the future –
----usually over following 18 to 24 months.
3. is designed to help people see
--- how the central bank sets interest rates
--and thus should reduce uncertainty
--about the future path of monetary policy.
The central bank controls short-term interest rates (here “short-term” means up to a month or so) through:
1. setting the base rate.
2. base rate in the UK is the overnight rate
--set by the central bank
--at which it will provide liquidity.
3. Forward Guidance allows central bank to
--influence long-term interest rates
--(here longer-term means up to, or slightly beyond, the period of the guidance – so up to perhaps 3 years)
--by indicating how it expects monetary policy to develop in the future.
4. also allows the central bank to influence inflation expectations
--which is also useful.
Forward Guidance is not a
guarantee and the central bank can depart from its guidance either as a consequence of some unforeseen economic event or if the economic outlook changes.
Investors may be classified into:
1 private individuals (“households”)
2 managers of short-term and long-term mass savings products (“financial
3 corporates (“businesses”)
4 foreign investors.
The different categories, and investors within each category, will vary in their
1 time horizons – eg whether they want investment returns over the short term or
the long term
2 appetite for risk – ie the extent to which they are averse to or tolerant of risk
3 taxation position – reflecting both
---1 the tax rules that apply to the particular type of investor and
---2 the individual investor’s own particular set of circumstances,
eg how wealthy or otherwise.
investments which are risky for one investor may be less or more so for another investor depending on the different
1. liability profiles and
2 other features of the investors.
Example of differing appetites and perspectives
1. Consider fixed-interest government bonds in a developed country.
2. are risk-free for an investor with fixed monetary liabilities in that currency
3. but involve risk for an investor with liabilities linked to
--retail prices in another country.
What are the risks faced by the second investor in the above example?
Households are potentially interested in
1. a wide range of assets.
2 Diversification is often a key consideration,
particularly given that the typical householder will:
1 have only a relatively small amount of wealth to invest
2 much of that wealth may be tied up in the house in which he or she lives.
Other considerations for households when making investment decisions include:
1. liabilities (generally real in nature)
3 uncertainty over future income and outgo
5 level of investment expertise
6 stability of asset values
7 investment and risk characteristics of available assets
8 attitude to risk.
The importance of diversification leads to the need for
--who form a link between households and
-- the businesses that need to
--finance investments in real assets.
The alternative to investing in the products and services of a financial intermediary is to
invest directly in the underlying assets
(eg shares, bonds, properties) themselves.
A financial intermediary
1. channels resources between lenders
(ie investors) and borrowers.
2. is a wide range of financial intermediaries eg
collective investment vehicles.
Financial intermediaries sell
1. their own liabilities
--to raise funds that are
--used to purchase
--the liabilities of other corporations.
Advantages of financial intermediaries compared to direct investment
1. pool resources of many small investors,
-- therefore able to lend considerable sums to large borrowers.
---herefore enable small investors
--to gain access to investments
--which they could otherwise not do so by themselves,
--eg large property developments.
2 by lending to many borrowers, intermediaries achieve significant diversification,
-- can accept loans that individuals might regard as too risky
3 build expertise through volumes of business they do.
-- investment manager of a life insurance company
--is able to spend more time
--thinking about and making investment decisions
--than the average individual is able to do so.
--through economies of scale.
What are possible disadvantages of financial intermediaries?
Businesses typically need to raise money to
1. finance their investment in real assets.
2. “Real assets”:
--(such as buildings and machinery)
--that are used by business
--to generate profits
--rather than investments
-----that offer a real return
-----(such as index-linked bonds).
In issuing securities to the public, they have several objectives. These typically include:
1● to get the best possible price for their securities
2● to market the issues at the lowest possible cost.
3 to issue securities that best meet their requirements
--with regards to the
----flexibility of funding.
Business often seek the aid of an investment bank to help them achieve their fund raising objectives.
In order to achieve these objectives, investment banking firms specialise in such activities. They:
1. advise the issuing firms on the prices they can charge.
--An investment banking firm will have
--good knowledge of the market and
suggest appropriate issue prices and
2 handle the marketing of the security issue to the public.
--involves advertising the issue to potential investors,
--maintaining records of applications and
--handling investors’ money and
--actually issuing the securities.
3 seek to protect their reputation for honesty
--by checking and certifying the quality of the information offered.
The ability of an investment bank to successfully issue securities
--relies on the reputation it has established. --investment bank will suffer
--if it is associated with an unsuccessful issue or
--one where investors are disappointed.
Therefore bank has strong incentive to
-ensure the quality of information offered.
4 innovate security design and
--to stimulate demand.
A business that issues securities directly would prefer to
1. issue simple securities that
1. are less expensive to arrange.
3. This may be at odds with the needs of investors,
--who may prefer a greater variety of securities.
4. There is a role for investment banks here
--as they may use their expertise and knowledge of investors
--to develop securities
--with features that will prove attractive.
5. They may also be able to package “plain vanilla” securities
--in a way that makes them more attractive to investors.
--An example here is
--the design of several different tranches of debt in a securitisation issue.
1. foreign investors are increasingly important in most investment markets.
2. The importance of their role will in part reflect
1. the general attractiveness of the particular market to foreign investors.
3. For example, foreign investors will typically not be attracted to
--markets in which they are
1. subject to
different (and more restrictive) rules
than local investors,
2. nor to markets in which they perceive
that there may be political risk
Foreign investors preferences may also differ from those of local investors due to:
1 the impact of currency movements
2 the different rules and regulations to which they are subject in the countries in
which they are based.
What two main types of security do national governments issue?
In addition to borrowing, what other sources of finance are available to governments?
main forms of government policy are:
1 Monetary policy –
2 Fiscal policy –
3 National debt management policy
4 Exchange rate policy
5 Prices and incomes policy
– the control of some measures of the money supply
--and/or the level and structure of interest rates.
--Recall from Subject A102 that monetary policy is a particularly effective tool in controlling the rate of inflation.
Fiscal policy –
1. decisions on the level and structure of taxation
2. and government expenditure and
3. hence, by implication, the public sector borrowing requirement (or debt repayment).
4. The level and structure of taxation c
--can have a major influence on the
--attractiveness both of starting up and running a business and
--also of investing in different asset types.
5. public sector borrowing requirement (PSBR) or fiscal deficit is
--the excess of government expenditure
--over government income from taxation.
6. If this quantity is negative it is known as
--the public sector debt repayment (PSDR) of fiscal surplus.
National debt management policy –
the manipulation of the outstanding stock of government debt instruments held by the domestic private sector, in order to influence the level and structure of interest rates or the availability of liquid reserve assets to the banking sector. Note that national debt management policy is closely inter-linked with monetary and fiscal policy.
Exchange rate policy –
1. directed towards achieving some target for the exchange rate of the domestic currency --
--in terms of foreign currencies,
2. perhaps with the objective of influencing the country’s international trading and investment patterns.
3. will influence the competitiveness of a location for internationally traded goods.
4. It is the relationship between currency exchange rates and the price
--in local currency
--of inputs, including labour, that determines competitiveness.
The lower the value of the domestic currency and the local currency cost
--of factor inputs (land, labour and capital),
--the more competitively priced
--will be the goods and services produced.
Prices and incomes policy
1. aimed at influencing the rates of wage and price inflation.
2. control these variables (and hence inflation) directly
--by imposing maximum increases.
practical problems when trying to implement such policies including
--distortions between public sector and private sector wages.
--The government does not consider and make decisions regarding each of these forms of policy in isolation –
--particularly as different policies may have contradictory influences on the economic environment.
--Rather, it will implement a package of policies to best target
-- its sometimes conflicting policy objectives.
Other forms of government policy include:
its overall level and
other (eg stamp duty) will affect :
1. demand for goods and services,
because of the impact on the prices.
2. will therefore affect the profitability of businesses and
--the (net) returns provided by investments
direct taxes are levied on
1. income paid to factors of production.
2. Corporate taxes are an example of these
--as they are levied on company profits
3/ whereas indirect taxes are levied on expenditure.
Competition policy will be a crucial element of the operating environment, especially for the increasing number of naturally oligopolistic industries.
Important examples of oligopolistic industries include those in which financial intermediaries operate, eg banking, insurance.
In the UK, the body responsible for most competition issues is
the Competition Commission (whose predecessor was the Monopolies and Mergers Commission).
An example of competition policy having a major impact on an oligopolistic industry was the granting of third generation mobile phone licences to a limited number of companies.
The role of competition and fair trading controls and monopolies regulators are discussed further in Chapter 8.
Labour policies will set the background for the
1. flexibility of labour and
2. the bargaining power of organised labour.
3. related domain of social policies will determine
--the cost of health services,
--welfare benefits and
-- typically are funded largely through taxation.
4. To the extent these are provided by government and
--paid for out of charges which are separate from taxation,
--they will have to be separately added to the cost of labour.
5. Such “on costs” to employment (typically labelled “national insurance” or “health insurance”)
--can be a crucial element of total labour costs.
6. Examples of labour policies include policies determining the powers of trade unions and minimum wage legislation.
--These are likely to influence the cost of labour and
--hence the relative competitiveness of businesses operating in different jurisdictions.
--They may also influence the choice of multinational companies as to where they choose to set up operations.
Effectiveness of government economic policy in practice history
In reality, there is considerable overlap between policies
Early post-war period
Throughout the post-war period and until the 1970s, monetary policy played a subsidiary supportive role to fiscal policy in most states including the UK. Governments tended to emphasise the use of demand management techniques in an attempt to “fine tune” the economy. A basically Keynesian approach was therefore adopted.
Demand management is the use of fiscal policy in particular, and also monetary policy, to offset external shocks (eg an oil price shock) to stabilise the level of economic activity and maintain close to full employment.
If such demand management techniques were being used, in a recession a government would generally increase its expenditure and expand the money supply in order to boost economic activity and reduce unemployment.
The money supply was often allowed to accommodate money demand, with little attention paid to the possible inflationary implications. Inflation was in any case only moderate up to the end of the 1960s.
From the 1970s onwards,
a much more positive role was adopted for monetary policy in many states, with explicit recognition being given to the control of the money supply as an important element in the fight against inflation. This was because controlling inflation became an important policy objective in its own right, rather than governments concentrating exclusively on full employment. This was largely in response to the very high levels of inflation witnessed in the 1970s. For example, the inflation rate in the UK peaked at over 20% pa.
Monetary policy was brought to the forefront of the economic policy package, and the other policies were seen as being merely supportive to this – in other words, a more monetarist approach was emphasised.
In the UK, this was partly a result of the monetarist views of the Conservative government. The monetarist view is that demand management policies are likely to distort the economy and move it away from its equilibrium. Therefore, Monetarists focus on achieving low inflation to allow the market to efficiently reach equilibrium and hence its full employment level, without incurring the costs associated with inflation – recall that these were discussed in Subject A102.
Governments have adopted Medium Term Financial Strategies aimed at reducing inflation (via a policy of strict monetary control) while reducing the proportion of national resources taken for public sector use and the burden of taxation on the working population.
In the UK, the Medium Term Financial Strategy (MTFS) involved the government setting out targets for and projections of key variables (eg the money supply and PSBR) over the next four years. The intention was that this would give the private sector more certainty regarding the government’s plans for managing the economy and so be reflected in private sector decision-making.
“supply side” measures are aimed at
1. boosting incentives and,
2. hopefully, encouraging long-term economic growth.
3. important element in the globalisation of business has been liberalisation of trade and capital markets,
--in both developed and emerging economies.
--With more companies operating on a truly global basis there has been
--much greater mobility of capital,
--due to the increased competition and pressure to produce where profit can be maximised.
4. trends have had significant implications for tax policy,
--as cross-border investors will generally be looking to maximise their returns net of tax.
5. Where countries are competing for foreign investment
--there will be pressure to reduce taxes,
--particularly the corporate income tax rate.
--Capital would therefore flow to the countries with lower tax rates.
cross-border tax schemes
1. moving earnings to a country with a lower tax rate
(eg internal group leverage
such as financing subsidiaries
in high tax countries
primarily with debt)
2 profit shifting through transfer mis-pricing, ie by setting prices
-for intra-group transactions
which are inconsistent with market rates
levying high charges
for the use of intellectual property
such as trademarks
3 taking advantage of differences between tax regimes,
eg through the use of ‘hybrid’ instruments
(which may lead to
a tax deduction in one country
without incurring taxation in another).
The success of a government’s economic policy can best be assessed in terms of the major economic objectives:
balance of payments
the effects of changes in interest rates on the major elements of the domestic economy:
1. increase in mortgage loan interest payments,
will reduce disposable income and hence
personal sector expenditure.
2. Consumers’ expenditure may also be discouraged by higher rates on credit facilities and
3. higher rates of interest may also encourage higher levels of saving.
4 The impact on the business sector is likely to be detrimental
since capital investment and economic growth prospects
will be reduced.
- is due to
-- increased opportunity cost of committing funds for investment and
--the higher cost of borrowing.
5. Also, the reduction in anticipated levels of economic activity, and higher domestic currency exchange rates,
--will reduce the viability of capital investment projects.
--With higher interest rates, fewer projects being considered will
--demonstrate a positive net present value, investment is therefore likely to be lower.
6. Higher levels of interest payments on outstanding debt
--will reduce corporate profitability,
--as existing borrowing costs are
--a large element of ongoing costs for many companies.
7. Lower levels of consumption and investment are likely to lead in turn to
--lower rates of economic growth.
8. All of these features are likely to result in
--reduced employment prospects and
-- a slower rate of improvement in living standards.
As regards the balance of payments, an increase in domestic interest rates is likely to
1. attract an inflow of foreign investment funds and
2. may also encourage the repatriation of domestic funds held overseas.
3. Thus, likely to be upward pressure
--on the domestic currency’s exchange rate.
4. overall effect likely to be
--a decrease in economic activity.
the balance of payments account contains two major elements:
1. the current account,
-which records all trade transactions with the rest of the world,
--plus other current income flows and current transfers
2.the financial account
(formerly known as the capital account).
--records investment transactions
--with the rest of the world
investment in physical assets,
financial securities and
bank loans and
The effects on the other elements of the capital account (now known as the financial account) will depend on
1.Investors’ expectations of domestic growth prospects.
2. If it is believed that domestic activity is likely to be depressed,
--then there may be
--reduced inward flows of direct capital investment
--in physical capital assets.
The effect on the current account will depend on the extent to which
1. exchange rates alter.
2If exchange rates rise, then
--this is likely to lead to
--an adverse movement in the volumes of trade, but
--the ultimate effects on the current account
--will depend on
--the elasticities of demand
--for traded goods and services.