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names of central banks
UK → Bank of England
USA → Federal Reserve Bank (aka the Fed)
Eurozone group of countries → European Central Bank
Japan → Bank of Japan
China → People's Bank of China
implementation of monetary policy
the central bank controls monetary policy through interest rates and controlling money supply in order to keep inflation low and stable.
explain how an increase in the base interest rate affects aggregate demand in the UK economy.
increase in base rate → cost of borrowing increases → consumer confidence falls → investment falls
c - some consumption financed by borrowing, that finance becomes more expensive, c goes down, return on savings ; uk housing market mortgage rate increases, less disposable income
i - return on savings, cost of borrowing
g - regard as somewhat independent of interest rates
x-m - relative interest rate increase - increase demand for pound as floating exchange rate, drives down x-m
quantitative easing
central bank purchases government and corporate bonds and other liquid assets (cash, cash like deposits) will lend money or in absence of risk aversion
yield = coupon/variable rate
coupon may be fixed amount (what bond owners of return which is yield)
banker to the government
most central banks act as the banker to their governments.
except the European Central Bank, where there is no national European government for it to serve in this role.
examples of being a banker to the government
Central banks may handle the accounts of government departments and make short-term advances to government.
what is the role of the central bank as a lender of last resort?
short term liquidity problem bank not at risk of failure not in fundamental trouble
yes, central bank becomes lender of last resort in sense that it lends money to banks to prevent them from collapsing
banker to other banks
it can be argued that acting as lender of last resort results in moral hazard, as banks know that they can engage in highly profitable, high-risk activities in the short term because if they ultimately make large losses, then the central bank will bail them out.
the counterargument to the above (i.e. why is the lender of last resort role crucial to the banking system) is that one bank failing would almost certainly see customers of other banks trying to get their money out: this is known as a 'run on the banks'.
the whole banking system could fail because banks only keep a small fraction of their assets in relatively liquid assets e.g. Barclays could not pay back in cash in one day every single pound deposited with it.
i.e. cost to the economy of a whole banking system failing > cost of a central bank bailing out a bank which was in difficulties.
role in regulation of banking industry
financial regulation is needed for three main purposes.
financial institutions need to be monitored because otherwise they would engage in a wide range of practices which would harm their customers.
e.g. they sell products to customers that either give the customers no benefit or actually harm their financial interests.
financial institutions have an incentive to engage in risky activities which give them short-term profits, but could lead to their collapse.
this requires regulation as the cost of bailing out a financial institution are borne by those outside the financial sector i.e. the tax payer
the whole financial system needs to be regulated to prevent it from collapse. The risk of the whole system collapsing is called systemic risk
Application: growth of shadow banking
financial institutions, parts of financial institutions and financial markets that are either much less regulated than the mainstream financial system or are completely unregulated.
relaxation of regulation and growth of unregulated financial markets ntually leads to another financial crisis
how does the term "regulatory capture" apply to financial institutions?
financial institutions tend to be highly profitable and are well connected with government.
they have the resources to influence government and their regulators
they push the boundaries of regulation because it is so profitable to do so.
method of regulation: issue rules about how financial institutions should behave and then fine them when they break those rules
examples of poor behaviour
Market rigging
Selling unsuitable products to customers
Charging extortionate rates of interest on loans
methods of regulation: make sure financial institutions have enough reserves of money to cover any losses they make.
capital ratio → like the bank's own money (its savings) compared to (i.e. divided by) the money it owes to others (borrowed money, like deposits).
role in regulation of banking industry
if the bank has only a little of its own money (a low capital ratio), it can borrow more money and lend it out → the bank can make more profits because it earns interest on those loans.
the less money the bank keeps as "safety savings" in reserve, the more it can invest or lend out.
gulators want banks to have enough of their own money (a higher capital ratio) so they can survive if things go wrong, like if borrowers can't pay back loans or the economy hits a rough patch. If a bank doesn't have enough of its own money, it could collapse, causing big problems for everyone who trusted the bank with their money.
two regulatory arms of the Bank of England
The Financial Policy Committee (FPC)
Macroprudential regulation;
'charged with a primary objective of identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.
it has been responsible for ensuring that regular 'stress
stress test → a hypothetical scenario to see what would happen to a financial institution if certain extreme events happened.
e.g., what would happen to a bank if interest rates rose to 7% and there was a 30% fall in world stock market prices?
if a financial institution collapsed under moderate stresses, it would be forced to strengthen its underlying financial position by holding much more capital.
these are reserves that would be used to make up any losses.
