finanical markets

Question 1

role of financial markets

Answer 1

role of financial markets:

1. to facilitate saving
   - allows people to save to facilitate future spending
   - this allows for the harrod domar model to take place

harrod domar model
- increase in savings —> banks have more money that they can lend —> this can lead to a rise in capital expenditure —> shifts both AD and LRAS —> increase in savings

2. to lend to businesses and individuals
   - businesses —> investment —> AD shifts right
   - individuals —> consumption could increase —> AD shifts right (multiplier effect)
   - individuals —> consumers could purchase valuable assets e.g. house —> if it appreciates in value then this leads to the wealth effect —> consumption could increase
3. to facilitate the exchange of goods and services
   - allows for movement of money to purchase goods and services
   - debit cards, credit cards, apple pay, google pay, bank transfer
4. to provide forward markets in currencies and commodities (wheat, oil)
   - the price of the currency/commodity is set today
   - a contract is in place
   - payment can take place at a later date
   - main aim is to reduce the impact of currency fluctuations as it allows for business costs to be as controlled as possible
5. to provide a market for equities
   - purchasing of shares will allow individuals/businesses to sell off when the value of the share appreciates
   - particularly for businesses, they can raise finance for investment purposes

Question 2

market failure in the financial sector

Answer 2

1. asymmetric information
   - the lender (bank) and the borrower
   - credit history could be used to reduce asymmetric information
   - lenders charge interest rates to compensate for the risk
2. externalities
   - cost to the 3rd part not involved in the transaction
   - the cost to the tax payer of bailing out banks
   - UK 2007/2008 crisis - cost to the tax payer was £1.162 trillion

air bnb effect:
- banks lend to allow for individuals to purchase houses
- home owners would convert into rented rooms
- decreases supply of housing
- upward pressure on the price of houses

3. moral hazard
   - engaging in risky behaviour as commercial banks will be saved/bailed out by the central bank
   - during the financial crisis, commercial banks were giving out mortgages to those who were unable to pay as they knew they would be saved by the central bank if they were to collapse - BOE known as lender of last resort
4. speculation and market bubbles
   - people speculate that house prices are going to rise - will buy into the market - herd behaviour occurs as everyone will also buy into the market - bubble bursts e.g. change in interest rates - people speculate that house prices will fall - start selling it off to make as much profit as possible
5. market rigging
   - an example of market rigging is known as insider trading - using insider knowledge about something that will happen in the future e.g. share value of a company increases
   - may buy into that company today to benefit from selling off the share at a later date and a higher value (vice versa)
   - moreover, group of bankers may collude and share information where they both get to benefit - however: fraudulent activity e.g. many banks including JPM and HSBC faced fines

Question 3

role of central bank - key functions of central bank

Answer 3

key functions of the central bank

1. implementation of monetary policy
   - adjust interest rates and the money supply
2. banker to the government
   - the idea that the central bank manages tax receipts and payments
   - ensures that public sector workers are paid each month
3. banker to banks - lender of last resort
   - to avoid commercial banks (HBSC, JPM) from collapsing, the BOE (central bank) will act as the lender of last resort and bail them out - if they don’t support them from failing - commercial banks will have no liquidity - can’t lend to households - less consumption - less investment
   - evaluation: encourages moral hazard
4. role in regulation of the banking industry
   financial policy committee:
   - take action to remove/reduce systemic risk (avoid banks from collapsing)
   - conduct stress tests to check how well a bank can handle an economic crisis or financial shock

prudential regulation authority:
- set standards e.g. effective competition, protection for policy holders

financial conduct authority:
- fines to financial institutions that do not provide customers with appropriate service and for misconduct e.g. market rigging
- evaluation: regulatory capture