12.0 Financial Markets and Monetary Policy (All in 1)

What are the 4 main functions of money

Medium of exchange

Measure of value

Store of value

Method of deferred payment

What is the definition of the money supply

The stock of currency and liquid assets in an economy

What does narrow money include

Physical currency (notes and coins) and liquid assets (money in current accounts)

What is broad money

It includes narrow money plus less liquid assets like savings account

What is traded in the money market

Liquid assets

What happens in the capital market

People and companies buy and sell things like shares and long-term loans.

What is the function of the foreign exchange market

Currencies are traded, determining their relative values

What is a financial market

Places where buyers and sellers come together to trade financial assets, such as stocks, bonds, currencies, and derivative

Name two examples of financial markets

The stock market and the bond market

Roles of the financial market

• Facilitate saving

• Support lending

• Facilitate exchange of goods and services

• Provide a market for equities

• Provide forward markets in currencies and commodities

What is debt in finance

Money borrowed that must be repaid with interest

What does equity represent for an individual or firm

Ownership of an asset after all debts have been repaid

What kind of relationship exists between market interest rates and bond prices

An inverse relationship - when interest rates rise, bond prices fall, and vice versa

Why does the price of an existing bond increase when market interest rates decrease

Because the bond’s fixed interest payments become more attractive compared to new bonds with lower rates

What happens to the value of a bond if market interest rates increase

The bond’s price falls since its fixed interest payments are less attractive than new bonds

What is a bond coupon

The interest payment made to bondholders periodically until the bond matures

What is the primary role of a commercial bank

To manage deposits, cheques, and savings accounts for individuals and firms, and provide loans using deposited money

How does an investment bank differ from a commercial bank

Investment banks facilitate trading of stocks, bonds, and investments and have weaker government regulation and higher risk tolerance

What types of deposits do commercial banks accept

Demand deposits, fixed deposits, and saving deposits

What is the main source of income for commercial banks

Interest earned from loans provided to individuals and firms

What is a secured loan

A loan backed by an asset (e.g. a house) to protect the bank if the loan is not repaid

What is an overdraft facility

When a current account holder can borrow money even if there are no deposits, usually at a high interest and with borrowing limits

How do commercial banks invest surplus funds

By buying securities like government bonds and treasury bills

What are agency functions of commercial banks

Collecting cheques, dividends, paying bills, buying and selling securities, and transferring money for customer

What are the main components of a commercial bank’s balance sheet

Assets and liabilities

What are common assets for a commercial bank

Cash, securities, bill, loans, and investments

What is liquidity in the context of a commercial bank

The ease with which assets can be converted into cash

Why must banks balance liquidity and profitability

High liquidity limits profits, but low liquidity risks being unable to meet withdrawals

How does profitability relate to a bank’s survival

Banks need profits to pay interest, expenses, and wages, but they usually prioritise liquidity and safety over profits

What conflicts arise between liquidity, profitability, and security for banks

Prioritizing liquidity or security reduces profitability, while chasing profits can increase risk and reduce liquidity.

What are the core roles of a central bank in an economy

Managing the currency, money supply, and interest rates; issuing secure currency; regulating bank lending to maintain financial stability

How does the central bank act as a banker to the government

It collects and makes payments for the government, manages public debt, and advises on finance and loan terms

What does it mean for a central bank to be the "lender of last resort"

It provides liquidity to banks in distress to prevent collapse and restore confidence, potentially avoiding a bank run

What are the key elements central banks influence through monetary policy

Interest rates, money/credit supply, and the exchange rate

Who conducts monetary policy in the UK and since when has it been independent

The Bank of England, independent since the 1990s

What is the primary objective of the UK monetary policy

To maintain price stability, targeting a 2% inflation rate (CPI)

What if the MPC and how often does it meet

The Monetart Policy Committee, comprising 9 members, meets 8 times a year to set interest rates

What is the base the rate and how does it affect the economy

The interest rate the BofE sets for lending to other banks, influencing commercial interest rates

How does the MPC use interest rates to meet inflation target

By raising or lowering the bank rate to influence borrowing, spending and inflation

What would high unemployment lead the MPC to do

Cut interest rates to boost consumer spending and stimulate economic growth

How does the savings rate influence MPC decisions

High savings imply low spending, prompting possible rate cuts to encourage consumption

How do high commodity prices affect interest rate decisions

They may prompt increases in interest rate to counteract cost-push inflation

How does exchange rate impact the MPC

A weak pound increase import costs and inflation, potentially leading to base rate increase and vice versa

What is the effect of a falling exchange rate on exports and import

Exports rise (cheaper), Imports fall (more expensive), improving the current account

Why can weaker exchange rate be inflationary

It raises import prices, leading to cost-push inflation

What is the “hot money” effect in relation to interest rates and exchange rates

Higher UK interest rates attract investment, increasing demand for the pound and causing appreciation

What is the monetary transmission mechanism

The process where interest rates changes affect consumer behaviour, investment, exchange rates and AD

What is quantitative easing (QE)

A method where the BoE buys large quantities of financial assets, like government bonds, from financial institutions, effectively injecting liquidity into the banking system

How does QE affect inflation and currency value

It can cause inflation and depreciate the currency due to increased money supply

What is forward guidance in monetary policy

A strategy where central banks communicate future policy plans to reduce market uncertainty

What is the purpose of financial regulation in the UK

To ensure financial firms are honest, protect institutions, consumers and the wider economy

What is the role of the Financial Conduct Authority (FCA)

To ensure financial firms are honest, protect consumer interests, and promote competition

What is the role of Prudential Regulation Authority (PRA)

To promote safety and stability of financial firms like banks and credit unions, and to protect

What is the role of the Financial Policy Committee (FPC)

To monitor and regulate systemic risk and ensure financial system stability, including clamping down on unregulated activity and loose credit

What triggered the Global Financial Crisis in 2007-2008

The collapse of US housing prices, defaults on subprime mortgages and banks’ exposure to risky assets

How do lending long-term and borrowing short-term contribute to bank failures

If investments fail and liquidity is low, banks may not meet withdrawal demands, leading to failure

Why did banks need bailouts during the financial crisis

They suffered massive losses on bad loans and lacked funds to stay solvent

What is a liquidity ratio

A measure of a firm’s ability to meet short-term obligations; higher ratios mean great financial safety

What is capital ratio

The ratio of a bank’s equity capital to its risk-weighted assets, indicating financial strength and risk exposure

Why are strong capital and liquidity ratios important for financial stability

They reduce the risk of collapse and maintain market confidence, especially during financial crises

What is moral hazard in banking

When banks take greater risks because they expect government or central bank support if things go wrong

Example of Moral Hazard in banking

During the GFC of 2007-08, banks acted recklessly, by giving risky loans, lending too much, borrowing short-term, lending long-term, believing they'd be bailed out, which encouraged risk taking behaviour

What is systemic risk in financial markets

The risk that a failure in one part of the system (like a major banks) causes widespread economic damage

Why is systemic risk considered a negative externality

Because the consequences affect not just the bank but also consumers, firms, and the whole economy

What can be the real economy impact of problems in financial markets

• Loss of confidence

• Reduced lending

• Recession

• Higher unemployment

• Decline in output