Financial markets and monetary policy

The characteristics and functions of money

A medium of exchange - product exchanged for money , A measure of value - measure relative values, A store of Value - holds its value to be used for payment, A method of deferred payment - debts - pay without having money present

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Bartering

Goods and services traded with other goods and services - did not get what they wanted or needed - not always of the same value

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Barter - Double coincidence of wants

Both parties have to want the good the other party offer

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Money supply

Stock of currency and liquid assets in an economy - cash and money in savings accounts

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Narrow money

Physical money - notes, coins, deposits and liquid assets in the central bank

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Broad money

Entire money supply - cash could be in restricted accounts - hard to calculate money supply - includes liquid and less liquid assets

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Money market

Liquid assets are traded - borrow and lend money in the short term

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Capital market

Equity and debt bought and sold - long term productive use by firms and governments

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Foreign exchange market

Currencies are traded (international banks) - relative value of different currencies will be

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The role of financial markets in the wider economy

Facilitate savings, lend to businesses and individuals, facilitate the exchange of goods and services, provide forward markets in currencies and commodities, provide a market for equities

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What is exchanged in a financial market?

Financial liquid assets - stock market and bond market

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The role of financial markets in the wider economy to facilitate savings

Provide a store for funds - rewarded with interest payments

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The role of financial markets in the wider economy to lend to businesses and individuals

Transfer of funds between agents - used for investment or consumption

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The role of financial markets in the wider economy to facilitate the exchange of goods and services

Transfer of real economic resources facilitated - makes it easier to exchange goods - providing a way that buyers and sellers can interact and transfer funds

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The role of financial markets in the wider economy to provide forward markets in currencies

Trade one currency for another - speculative attacks - affect the value of exchange rate

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The role of financial markets in the wider economy to provide forward markets in commodities

Commodity markets - investors trade primary products - future contracts are a method for investing in commodities - buying or selling an asset with an agreed price in present - but delivery and payment in the future

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Forward market

Informal financial market - contracts for future delivery are made

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The role of financial markets in the wider economy to provide a market for equities

Equity markets - trade if shares - stock market - access to capital for firms - investors to own a part of a market - returns on the investment (dividends) based on future performances

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Dividend

A share of the firm's profits

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Debt

Money borrowed from a lender (usually a bank) - little flexibility and the loan is later repaid with interest

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Equity

Stock or security - interest in owning - no outstanding debt - owner's equity can be sold for cash

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For a new bond, if the market interest rate falls, what happens to the value of the bond?

Would be worth more - carries a higher interest rate than current market conditions

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New bonds have rates close to........

the market interest rate

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Why is there an inverse relationship between market interest rates and bond prices?

Bond is bought - money is lent to the issuer who agrees to pay the value of the bond back in addition to the interest - the rate of interest is fixed when the bond is issued

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How can firms raise finance (in relation to bonds)?

Issuing shares, corporate bonds and borrowing from a bank - relatively cheap for firms - legally obliged to pay their shareholders dividends - only pay dividends when there are distributable profits and it is voted for by shareholders

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Why might borrowing be unaffordable for new smaller firms?

Paying back loans with high interest rates which could be expensive - however it is flexible - funds can be increased or decreased by borrowing more or paying back the loan

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When may corporate bonds be issued?

To raise funding for large projects - expand the firm, develop a product, move to a new premise, or take-overs

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What are bonds partially protected against?

Variable interest rates or economic changes - however the firm will have to pay the investors who buy the bonds interest

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In relation to government bonds, what is a coupon?

An interest payment to the bondholder between the date of issue and the date of maturity

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What is meant by the maturity of a coupon?

The period of time for which the financial asset is outstanding, when it finishes and has been repaid, it has matured

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What does a commercial bank manage?

Deposits, cheques and savings accounts - make loans using the money saved with them

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What do investment banks facilitate?

The trade of stocks, bonds and other forms of investment - gov regulation is weaker in the investment bank industry + business model results in higher risk tolerance

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Main functions of a commercial bank

Accept deposits, provide loans, overdraft, investment of funds, agency functions

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Commercial banks - Accept deposits

Savings, banks can meet the different needs of their depositors by providing different accounts, Demand deposits + Fixed deposits + Saving deposits

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Commercial banks - Provide loans

Interest -Main source of income for banks- earn through loans - banks create credit by using deposited funds as loans, some loans are secured against an asset - protect the bank's funds, Cash credit loans + Loans on demand + Short-term loans

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Commercial banks - Overdraft

Current account has no deposits - consumers can still borrow money from the bank in the form of an overdraft - higher interest rate - amount that can be borrowed is limited

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Commercial banks - Investment of Funds

Surplus funds - invested into securities (Gov bonds and treasury bills) - earns a return for the bank

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Commercial banks - Agency functions

Banks represent their consumers - cheques and dividends, bills, deposit interest and income tax, securities, transfer of money between places

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Demand deposits

Allow deposits to be made or withdrawn immediately

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Fixed deposits

Store money for a long time - higher interest rates - banks can use these deposits knowing they will no be withdrawn

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Saving deposits

Done by those who withdraw money often, but not necessarily immediately, and who are generally receiving an income - lower rates of interest than Fixed deposits

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Cash credit loans

Based on bonds and approved securities - money can be withdrawn several times a year - banks deposit money periodically

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Loans on demand

Entire loan is paid into the account of the borrower - charged with interest immediately

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Short-term loans

Tend to be personal or for working capital and are usually against a security

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Structure of a commercial bank's balance sheet

Show the value of a company's assets, liabilities and owner's equity - usually at the end of a quarter or an annum

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Liability

Something which must be paid - claim on assets - used to buy assets - income can be earned from these assets - made up of share capital, deposits, borrowing and reserve funds

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Asset

Something that can be sold for value - cash, securities, bills, loans and investments

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Owner's equity (Bank capital)

What is left over when assets sold and liabilities paid

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Objectives of a commercial bank

Liquidity, Profitability, Security

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The objective of liquidity in a commercial bank

How easy it is to turn assets into cash - to be profitable banks must have cash and liquid assets as liabilities are payable on demand - if liquidity is prioritised profits will be low

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Liquidity of assets in a commercial bank

Liquid to different extents - Cash and deposits most liquid - loans and long term bonds least liquid assets

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The liquidity of assets in a commercial bank if they can borrow easily and cheaply

Likely to keep fewer liquid assets - more expensive and difficult it is to get a loan the more liquid assets are likely to be kept

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The objective of profitability in a commercial bank

Need to earn profits to pay their depositors interest, wages and general expenses - a lot of funds in cash means profitability is limited - liquidity and profitability are generally prioritised over profitability - supplementary for bank's survival

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The objective of security in a commercial bank

Risks/uncertainties - how much cash they get and whether loans will be repaid - maintain the safety of their assets - high proportions of their liabilities with itself/central bank - only hold their safest assets -more credit not created-less profits

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What is monetary policy used for and how is it done?

To control the money flow in the economy by manipulating interest rates, quantitative easing, the supply of money and credit, and the exchange rate

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Which bank conducts monetary policy?

The central bank (Bank of England) - independent from the government

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Functions of a central bank

Implementation of monetary policy, Banker to the government, banker to the banks - lender of last resort

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Implementation of monetary policy

Monetary policy committee (MPC) alters interest rates to control supply of money - nine members meet each month to decide - IR used to help meet the gov target of price stability - alters cost of borrowing and reward for saving

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Base rate

Controlled by the central bank - controls the interest rates across the economy

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Banker to the government

Central bank collects payments to the gov and makes payments on behalf of the gov - maintains and operated deposit accounts of the gov - manages public debt and issues loans - advise gov on finance (Timing and term of new loans)

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Banker to the banks - lender of last resort

BoE-no other method to increase supply of liquidity - lend money-increase the supply, institution risky and no other way for it to borrow - BoE might lend to them, can protect individuals who deposit funds which are lost, prevent 'run on the bank'

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'Run on the bank'

Consumers withdraw their bank deposits in a panic, because they believe the bank will fail

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Why do banks usually avoid borrowing from the lender of last resort?

It suggests the bank is experiencing a financial disaster

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Monetary policy instruments

Interest rates, Asset purchases to increase the money supply - QE, Funding for lending, Forward guidance

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Monetary policy instruments - Interest rates

MPC alters interest rates to control the supply of money - used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving

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High interest rates

Reward for saving is high - cost of borrowing is high - encourages saving - used during period of high inflation

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Low interest rates

Reward for saving is low - cost of borrowing low - consumers and firms can access credit cheaply - encourages spending - investment in the economy - used during period of low inflation

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Monetary policy instruments - Asset purchases to increase the money supply: Quantitative Easing (QE)

Stimulate economy-standard monetary policy no longer effective-inflationary effects-increases money supply-reduce the value of the currency-usually used when inflation is low and not possible to lower IR further

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How does QE work?

Pump money directly into economy-Central Bank buys assets (gov bonds)-buy bonds from investors-increases cash flowing in financial system-encourages lending-cost of borrowing lower-encourages investment-more spending-^growth-^inflation

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After QE works to increase the rate of inflation, what may the central bank do to bring it back down to a sustainable level?

Reduce the supply of money - selling their assets - reduces the amount of spending

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Monetary policy instruments - Funding for lending

Higher funding costs - lower these costs and provide cheap funding to banks and building societies

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Monetary policy instruments - Forward guidance

Detail what the future monetary policy will be - intention of reducing uncertainty in markets - MPC keep IR at a certain level until a specified date

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Factor considered by the MPC when setting the bank rate

Unemployment rate, Savings rate, Consumer spending, High commodity prices, Exchange rate

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Factor considered by the MPC when setting the bank rate - Unemployment rate

High - consumer spending falls - MPC will drop IR to encourage spending

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Factor considered by the MPC when setting the bank rate - Savings rate

Lot of saving - Consumers not spending - IR might fall

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Factor considered by the MPC when setting the bank rate - Consumer spending

High level of spending - Inflationary pressures - MPC increase IR to encourage saving

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Factor considered by the MPC when setting the bank rate - High commodity prices

UK net importer of oil - high price - cost-push inflation - MPC increase IR to overcome this inflationary pressure

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Factor considered by the MPC when setting the bank rate - Exchange rate

Weak pound - Average price level increase - UK X relatively cheap so X increases - M relatively more expensive - increase in net exports - MPC increase IR

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How does a reduction in the exchange rate affect AD and the macroeconomic policy objectives?

Exports cheaper - increases exports - assumes demand is price elastic - imports relatively expensive - UK current account deficit improve - inflationary - increase in price of imported raw materials - production costs increase - cost-push inflation

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How does an increase in the exchange rate affect AD and the macroeconomic policy objectives?

An increase in Interest rates/Exchange rates relative to other countries - more attractive to invest in the country - rate of return on investment is higher - increases demand for the currency - appreciation - hot money

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Why might governments regulate banks with regulations and guidelines?

Ensure the behaviour of banks is clear - banks have a huge influence in the economy - if they failed it would have huge consequences

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Who regulates the UK banking industry?

Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)

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Financial Conduct Authority (FCA)

Regulates financial firms to ensure they are being honest to consumers - seek to protect consumer interests - promote competition

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Prudential Regulation Authority (PRA)

Promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policyholders are protected

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Financial Policy Committee (FPC)

Regulates risk in banking and ensure the financial system is stable - clamps down on unregulated parts and loose credit - monitors overall risks to the financial system - regulating individual groups

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Why a bank might fail

Risks involved with lending long term and borrowing short term - might lose money on investments - insufficient funds - banks might not be able to provide depositors with money when it is demanded

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Global financial crisis 2008-09

Asset prices high and rising - boom in demand - risky bank loans and mortgages - gov securities backed by subprime mortgages - borrowers poor credit history-house prices crash-defaulting-banks lost funds-required gov to bail them out

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Moral hazards

Risk that the borrower does things that the lender would not deem desirable - borrower less likely to repay loan - some form of insurance for mistake - banks might take more risks if they know BoE or Gov can help them

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Systematic risks

Risk of damage of the economy or the financial market - negative externality - risk of the collapse of a bank - since this costs firms,consumers,the economy and the market, it is akin to a negative externality

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Liquidity ratio

Used to determine how able a company is to pay off short-term obligations. Higher the ratio - greater safety margin of bank - creditors want payment - looks at liquidity ratio - whether bank is a concern

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Capital ratio

Comparison between equity capital and risk-weighted assets of a bank - bank's financial strength is determined using this - assets have different weightings - physical cash has zero risk and credit carries more risk

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What did the recent financial crisis show?

Having insufficient finance, in either capital or liquidity, can be dangerous - investors might assume other banks will fail as well, which reduces confidence

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Financial markets and monetary policy

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