UK Economic Qs Flashcards
Describe the impact on the pound of the announcement of Brexit in 2016 and the
UK’s subsequent departure from the European Union (10 marks)
The announcement that the UK was due to leave the EU led to an initial large drop in
the value of the pound
And a limited recovery since
This has led to foreign goods and services becoming more expensive for UK residents
Meaning an increase in the cost of living
And higher levels of inflation
Due to the UK’s reliance on foreign imports
However, UK exports have become cheaper to overseas businesses
Which has positive consequences for the UK’s trade deficit and
Aggregate economic growth
Post-Brexit trade frictions continue to make the future of the pound’s strength
uncertain
Describe how the Bank of England has responded to the challenges faced by the
UK during the Covid 19 pandemic (11 marks)
Covid 19 led to the population of the UK being placed into lockdown for a number of
consecutive months, multiple times
This led to a dramatic market fall and significant rapid deflation
To address this, the Bank of England reduced interest rates
To protect businesses and employees
The Bank of England also increased it’s holding of fixed interest securities
Especially Government bonds (quantitative easing)
In an attempt to stimulate the economy
As the UK has moved out of lockdown, inflation has been rising rapidly
Significantly beyond the UK Government targets
In an attempt to combat hyperinflation
The Bank of England have made significant increases to interest rates
Describe the actions taken by Bank of the England in September 2022 in
relation to long-dated Gilts (6 marks)
On the back of the Treasury’s mini-budget in September 2022
Bond markets saw rapidly falling prices and rising yields as a consequence
This was identified as a ‘market dysfunction’ by the Bank of England
Which could impact liquidity within the economy
In line with its financial stability objective, the Bank of England chose to intervene
By temporarily buying back long-dated Gilts in an attempt to calm the bond market
Hashim has a portfolio comprising some cash, some gilts and some UK equities. If the economy begins to recover how will the returns in his portfolio be impacted? (10
marks)
Hashim’s cash holding returns will stay low initially
As interest rates are kept low by the Bank Of England
To encourage growth
This means that Hashim is unlikely to receive a ‘real rate of return’
Hashim’s gilt holding will continue to return their specified fixed interest amount
But the market value is likely to increase as fixed interest securities become more
attractive
Due to interest rates being kept low by the Bank of England
His dividend returns will start to improve as company profits start to increase
And interest on borrowing is cheap
This is likely to increase the share price of his holding
Hashim has a portfolio comprising some cash, some gilts and some UK equities.
If the economy enters a boom phase, how might this situation change? (7 marks)
As interest rates are raised to control inflation
The interest rate on his cash holding should increase
The higher rate of inflation will mean the real value of his fixed interest income will
decrease
The raised interest rates will also push the market value of his gilts down
Initially, Hashim’s equity holding and returns will benefit from high inflation
As borrowing becomes more expensive due to the increase in interest rates
This growth will start to slow – as the economy moves towards contraction
Cara, an investment adviser within an authorised advisory firm, has met with a new retail client who is seeking advice about her investments. Based upon the client’s objectives, Cara believes that a UK multi-asset fund may be suitable and is assessing the Multi-A fund as a potential investment. The fund is comprised of cash, fixed interest, equities and physical commodities. The client believes that the UK economy is deteriorating and is concerned about the impact upon any potential investment in the fund of rising interest rates and higher inflation.
The client is also concerned about the impact upon the UK’s balance of payments of a worsening economic position.
a) Explain the potential impact of rising interest rates upon fixed interest and equities asset classes held within Multi-A. (4)
Fixed interest investments will look less attractive, as investors can achieve a higher rate of return on the increasing variable rate of interest.
This will lead to a reduction in demand for fixed interest investments, and the reduction in demand will lead to a reduction in the price/value of such investments and the yield will rise.
Equities
An increase in interest rates will lead to an increase in the borrowing costs for companies, which in turn will see profits reduced.
The subsequent reduction in profits could lead to a reduction in dividend payments and a loss of investor sentiment.
This could lead to a reduction in demand for shares and a reduction in the share price/value
of shares.
Cara, an investment adviser within an authorised advisory firm, has met with a new retail client who is seeking advice about her investments. Based upon the client’s objectives, Cara believes that a UK multi-asset fund may be suitable and is assessing the Multi-A fund as a potential investment. The fund is comprised of cash, fixed interest, equities and physical commodities. The client believes that the UK economy is deteriorating and is concerned about the impact upon any potential investment in the fund of rising interest rates and higher inflation.
The client is also concerned about the impact upon the UK’s balance of payments of a worsening economic position.
b) Explain two reasons why Multi-A may increase its exposure to its equities and commodities asset classes in response to rising inflation. (4)
During periods of high inflation, real returns on fixed interest investments are reduced and therefore equities are often seen as a favorable/natural alternative.
Furthermore, company profits tend to rise in line with inflation, making shares more attractive and increasing the demand and subsequently the price/value.
Due to commodities being physical assets unlike shares and fixed interest securities, they tend to react to economic change in a different way.
This is largely due to the fact that as the price of goods and services increases through increased demand, the prices of commodities used to produce those goods and services also increase, providing protection against rising inflation.
Cara, an investment adviser within an authorised advisory firm, has met with a new retail client who is seeking advice about her investments. Based upon the client’s objectives, Cara believes that a UK multi-asset fund may be suitable and is assessing the Multi-A fund as a potential investment. The fund is comprised of cash, fixed interest, equities and physical commodities. The client believes that the UK economy is deteriorating and is concerned about the impact upon any potential investment in the fund of rising interest rates and higher inflation.
The client is also concerned about the impact upon the UK’s balance of payments of a worsening economic position.
c) The fund manager of Multi-A is considering replacing part of the fund’s fixed interest allocation
with index-linked gilts. State three reasons why the price of index-linked gilts may fall even if inflation is rising and is expected to continue to rise. (3)
Interest rates may rise at a faster rate than inflation, which could therefore reduce the
attraction/demand for an index-linked investment.
Inflation expectations may be lower than expected (even though inflation continues to rise), therefore the incremental increase may not be as required for investors like Cara to achieve their portfolio income requirements.
The baseline measure could be different (RPI v CPI)
There may be increased supply if the government wishes to reduce the budget deficit by raising more funds through borrowing. The increased supply would lead to reduced prices through market forces.
Cara, an investment adviser within an authorised advisory firm, has met with a new retail client who is seeking advice about her investments. Based upon the client’s objectives, Cara believes that a UK multi-asset fund may be suitable and is assessing the Multi-A fund as a potential investment. The fund is comprised of cash, fixed interest, equities and physical commodities. The client believes that the UK economy is deteriorating and is concerned about the impact upon any potential investment in the fund of rising interest rates and higher inflation.
The client is also concerned about the impact upon the UK’s balance of payments of a worsening economic position.
d) Excluding interest rate activity, outline to the client the main causes of inflation, and list three ways in which inflation is measured in the UK. (7)
Causes of inflation
Cost push – Cost of raw materials and production rises (possibly due to reduced supply caused by war or climate change) which leads to businesses passing on the increased cost to consumers.
Demand-pull – Supply cannot keep up with demand and due to market forces this causes prices to increase.
Increased money supply – More money in circulation and therefore more money for
consumers to spend on goods and services thus driving the price up through market forces.
High wage demands
Ways in which inflation is measured in the UK
Consumer Price Index (CPI)
Consumer Price Index including housing costs (CPIH)
Retail Price Index (RPI)
Xavier is keen to understand more about how the money supply within the UK economy impacts on the investment decisions made within his fixed income investment portfolio.
a) Describe for Xavier the key differences between M0 and M4 as a measure of money supply and explain to him which of the two measures provides a better indication of overall economic growth. (6)
M0
Narrow money
Includes notes and coins in circulation.
Includes Bank of England’s operational deposits but excludes bank/building society deposits of UK residents.
Is an indicator of consumer spending/retail sales and activity.
Growth in M0 indicates consumer spending is increasing.
A contraction in M0 indicates consumer spending is falling.
M4
Broad money
Includes notes and coins in circulation.
Includes deposits of all bank accounts of UK residents and includes deposits created by
lending.
Is an indicator of economic activity.
Fast growth in M4 indicates an increase in the demand for loans.
Fast growth in M4 may also be interpreted as a prelude to periods of high inflation.
Better indication
M4
Has a broader remit/scope, reflecting borrowing/lending activity as well as the transfer of money.
Xavier is keen to understand more about how the money supply within the UK economy impacts on the investment decisions made within his fixed income investment portfolio.
b) Explain briefly to Xavier how the Bank of England could reduce the money supply and state the effects this would have on his portfolio. (4)
Tightening of monetary policy (opposite of quantitative easing).
This would involve selling gilts to the market to increase the supply of such securities.
The increased supply would lead to a reduction in the price of gilts through market forces.
The reduction in gilt prices will then lead to an increase in yields which in turn will increase the demand for gilts and take money out of circulation as a result.
The reduction in money supply will lead to increased interest rates, again through market forces.
An increase in interest rates will impact Xavier’s fixed interest investments, as they will look less attractive than investments that pay a variable rate which may be increasing above the fixed rate offered by Xavier’s investments.
Xavier should therefore expect to see the demand for his fixed interest investments fall and in accordance with market forces this will drive the price/value of his investment down.
Xavier is keen to understand more about how the money supply within the UK economy impacts on the investment decisions made within his fixed income investment portfolio.
c) Explain briefly to Xavier how the Bank of England could increase the money supply and state the effects this would have on his portfolio. (4)
Easing of monetary policy (Quantitative Easing)
This would involve the Bank of England buying gilts from the market to reduce the supply of
such securities.
The reduced supply would lead to an increase in the price of gilts through market forces.
The increase in gilt prices will then lead to a reduction in yields which in turn will reduce the demand for gilts and inject money into the economy as a result.
The increase in money supply will lead to reduced interest rates, again through market forces.
A reduction in interest rates will impact Xavier’s fixed interest investments, as they will look more attractive than investments that pay a variable rate which may be falling below the fixed rate offered by Xavier’s investments.
Xavier should therefore expect to see the demand for his fixed interest investments rise and in accordance with market forces this will drive the price/value of his investment up.
Xavier is keen to understand more about how the money supply within the UK economy impacts on the investment decisions made within his fixed income investment portfolio.
d) Explain to Xavier the differences between monetary and fiscal policy. (4)
Monetary policy is managed by the Bank of England, whereas fiscal policy is managed by the government and associated legislation.
Monetary policy involves using interest rates and money supply to control inflation and
maintain it within the government target of 2% to 3%.
Fiscal policy involves using government spending and taxation to influence the economy and achieve healthy economic growth.
Petra has recently listened to a news podcast where it was mentioned that the UK economy is currently running at a balance of payments deficit. The terms capital and current account were also used during the discussion.
a) Briefly explain to Petra what is meant by the balance of payments. (4)
A record of trade transactions a country has made with the rest of the world.
Receipts represent GBP flowing into the UK, or transactions that require the conversion of foreign currency for GBP.
Payments represent GBP flowing out of the UK, or transactions that require the conversion of GBP into foreign currency.
A healthy economy will aim to have a surplus, as this illustrates that money is accumulating within the economy and is a sign of financial strength.
Petra has recently listened to a news podcast where it was mentioned that the UK economy is currently running at a balance of payments deficit. The terms capital and current account were also used during the discussion.
b) Describe briefly what is meant by current account and capital account in the context of the balance of payments. (6)
Current Account
The import of goods and services, minus
The exports of goods and services, plus
Receipts from overseas assets which generate income.
A positive balance suggests the account is in surplus, and a negative balance suggests the account is in deficit.
Capital Account
The movement of all money into and out of the country for investment.
A positive balance suggests the account is in surplus, and a negative balance suggests the account is in deficit.
