yr 11 eco topic 5 - financial markets

financial markets act as financial intermediaries between ____ and _____

savers and borrowers

sources of savings

• household income

• businesses (when they don’t distribute all profits to owners)

• government - when surplus

• foreign pools of savings

primary financial markets

facilitate the creation of financial assets, known as securities, that can be sold into the economy

secondary financial markets

involve transactions with financial assets that have already been issued on a primary market some time in the past

share/equity market

where ownership of shares in companies are issued or exchanged

debt market

where debt securities (e.g bonds) are exchanged, or cash is lent and borrowed

derivatives market

where people buy and sell financial assets that are based on the value of other financial assets

foreign exchange market

where financial assets defined in one country are exchanged with another country

financial products: what is the purpose of short term money markets

• brings people and businesses with temporary shortages or surpluses of funds

• those w/ surplus funds issue various forms of debt securities to those in need

financial products: what are financial futures + options and what is the purpose of them?

• contracts to trade in financial securities (e.g shares) at a later date for a certain price

• allow investors to protect themselves against adverse movements in interest rates, currency fluctuations or share prices

reasons financial markets are important

• provide an efficient process by which income that is not spend immediately can still contribute to present level of AD by allowing others to borrow the surplus for immediate consumption/investment

• influences the whole economy - direct capital to where it is most needed

securities

any form of financial instrument, including shares and bonds, that provides the holder of that instrument with a claim over real assets or a future income stream

how is the market price of securities on the secondary financial market determined?

by interaction of S and D and they are traded on ASX

futures contracts

• e.g swaps, futures, options

• obligation to buy or sell a specific quantity of a commodity on a specific date in the future

  • price is determined by the futures market when entering into a contract

• allows to buyers to secure a buying price and sellers to secure a selling price for a commodity

• traded on stock exchange (ASX)

bonds

a loan made by an investor to a borrower

unlike a regular loan, once a bond is issues it can be traded in the ____ market

secondary, i.e a bond has a market price

bond yield

• the return an investor expects

• coupon payment / bond price

what do higher bond prices result in?

lower bond yields

what happens to bond yield when interest rates increase?

bond yield will increase as bond prices fall as newly issues bonds offer better returns

why do people invest in bonds

• stable and predictable income

• lower risk than shares

• portfolio diversification

superannuation

form of saving individuals cannot access until they reach retirement age

how does superannuation reduce pressure on the government?

growth of super reduces pressure on the government to provide income for retired australians

how does superannuation promote economic growth?

• money held in super funds can be loaned to banks to provide loans for households and businesses

role/function of share market

• raises equity capital for companies through floats and capital raisings

• provides a liquid secondary market so investors can buy and sell

• allocate capital toward companies investors judge most productive

effect of share market on economy

• funds business investment, supporting output, jobs + growth

• superannuation funds invested in shares - shapes retirement savings

• volatility - could result in wealth/losses

what does net borrower mean and is australia a net borrower?

borrows more funds from overseas than it lends to foreigners,

yes

who regulates share markets?

• national governments

• exist primarily in individual countries

• e.g New York stock exchange

how does the bank of international settlements help regulate the global financial system?

international organisation that helps central banks (e.g RBA) promote financial stability through market regulations

how does the IMF (international monetary fund) help regulate the global financial system?

• oversees general stability of international financial system

• monitors economies + markets and provides financial assistance to countries struggling to meet their international financial obligations (e.g Yemen, Chad)

what international organisation oversees share markets?

international organisation of securities

why is it important for australia to have access to foreign finance?

• without access to international finance, australians would face higher borrowing costs/may not be able to easily access finance

• international financial markets also allow australians to invest and earn returns from businesses overseas

what is the main disadvantage of australia’s integration into foreign markets?

regular disturbances (e.g fuel crisis) in overseas markets are more quickly transmitted to australia

who supplies banknotes?

RBA

what is the RBAs main roles?

• conduct monetary policy and oversee the stability of the financial system

• guided by dual mandate - price stability + full employment

functions of RBA: what is MP and what is the aim of MP

• MP - RBAs main action to influence cost and availability of money in economy through influencing interest rates

• aims to achieve sustained low inflation while encouraging economic growth

functions of RBA: regulations of payments system

• responsible for ensuring efficiency of payment methods (e.g credit cards, eCash)

• responsible for promoting stability in clearing + settling of large transactions in financial markets

functions of RBA: banker to the banks

• banks hold ES accounts w/ RBA

  • accounts are used to allow banks to settle debts between themselves + with RBA

functions of RBA: banker + source of financial and economic advice to governments

• provides banking + financial agency services to govt.

• govt. can lodge excess funds w/ RBA + complete transactions on behalf of govt. - e.g welfare payments to citizens

what is APRA and why was it established?

• Australian Prudential Regulation Authority

• government body established to regulate all deposit-taking institutions (including banks, credit unions, super funds, insurance companies) (ADI - authorised deposit taking institution)

what does APRA do?

• regulates institutions to ensure deposit-holders can take back their deposit money when they want it;

• that insurance companies meet their policy obligations;

• that super funds perform well + can pay people who withdraw their savings

what does APRA require of deposit taking institutions?

to maintain certain levels of funds and manage risks accordingly

what does APRA do when ADIs experience financial difficulty?

they have the role of sorting out the institution’s financial position + ensuring policy or deposit holders receive as much of their funds as possible

what is ASIC and what are they responsible for?

• Australian Securities and Investments Commission

• government body responsible for corporate regulation, consumer protection + oversight of financial service products

what does ASIC do?

• protects consumers against misleading/deceptive conduct affecting financial products/services

• ASIC investigates suspected breaches of financial services/consumer credit laws

what are some examples of lawsuits ASIC was involved in in 2014?

• the cash store

• assistive finance australia

• GE capital finance aus.

who is the national regulator for consumer credit (e.g home loans)

ASIC

who is responsible for supervising security markets (since 2010) such as ASE?

ASIC

role of Australian Treasury

• main source of economic policy advice to government

• provides advice to government on regulatory settings for financial markets, corporate practices + consumer protection

• influences how government devises budgets, collect taxes, implement policies, etc.

what did the treasury do during GFC and COVID?

• kept government up to date on developments both domestically and overseas

• advised for best approach to minimising impacts of financial disturbance on economy

• e.g Treasury designed JobKeeper in 2020

money supply

total amount of funds in the economy

characteristics of money

• medium of exchange

• measure of value

• store of value

• method of deferred payment

  • allows a system of lending + borrowing

measure of money supply: currency

all currency in circulation held by general public

measure of money supply: M1

consists of currency + deposits held in transactional back accounts (high liquidity)

measure of money supply: M3

M1 + all non-transaction deposits (e.g term deposit) at banks (less liquid than M1)

measure of money supply: broad money

M3 + deposits in non-bank financial institutions (e.g credit unions) minus their holdings of bank deposits (widest def. on money)

interest rate

the cost of borrowing money expressed as a percentage of the total amount borrowed

how does risk affect interest rates?

the interest rate on longer term securities are usually higher than short term securities as they are seen as riskier (as much more can change over time)

how to calculate real interest rates

nominal rates - inflation

how do banks act as both borrowers and lenders?

they lend money to individuals but also use these funds to make money for themselves by lending these funds to other borrowers

how to calculate interest rate differential?

lending rate - borrowing rate

difference between short term and long term interest rates (how long)

short term — interest rates on loans with maturity of less than a year

long term — interest rates on loans with maturity of more than a year

how does the level of investment affect interest rates?

Stronger investment demand will usually lead to higher demand for borrowing by firms seeking to finance their business operations and expansion, increasing interest rates

how does the level of savings affect interest rates?

Higher savings → increased supply of loanable funds → decrease in interest rates

how does the demand for liquid funds affect interest rates?

If individuals have stronger preference for liquid funds, they may be choose to hold their funds in bank deposits/currency, meaning that the supply of loanable funds is lower and would increase interest rates

how do inflationary expectations affect interest rates?

Higher expected inflation will lead to higher nominal interest rates in the economy as inflation reduces the value of money and assets, and lenders would require a higher interest rate to be paid as compensation for the loss of value of their financial assets

how does the government budget affect interest rates?

• if the government has a budget deficit, and is a borrower in financial markets,

  • this increases overall demand for credit and can result in higher interest rates.

• If government is a net lender in financial markets, this lowers interest rates

  • as there is less government borrowing (less overall demand for credit).

how do international interest rates affect interest rates?

• If domestic interest rates are lower relative to overseas rates,

• domestic lenders may seek to invest funds overseas to take advantage of higher return rates;

  • reduces supply of loanable funds domestically and increases domestic interest rates

how does MP rates affect interest rates?

RBA manages the cash rate which has a direct influence on the returns for short-term loans and an indirect influence on interest rates on longer-term loans

monetary policy

Reserve Bank actions designed to influence the cost and availability of money in the Australian economy through influencing the general level of interest rates

conventional tool of MP

cash rate target

unconventional tools of MP

• forward guidance,

• quantitative easing - asset purchases

• the provision of term funding to the banking system,

• a yield target,

• quantity targets for the purchase of government bonds

how are MP decisions made?

• The Board (of the RBA) meets 8 times a year to discuss current economic and financial conditions to help assess whether the stance of MP is consistent with its objectives

  • price stability, economic prosperity and welfare, full employment

• The MP decision is made by a majority vote

how is MP implemented?

• Minutes of the Board meeting are published 2 weeks later after the meeting for public communication

• The RBA implements MP through:

• ensuring that its transactions in domestic money markets are consistent with its targets,

• using forward guidance,

• setting yield target,

• quantity targets for the purchase of government bonds and providing low-cost long-term funding directly to banks

i.e unconventional tools

what indicators does the RBA look at when making decisions about future movement of cash rate?

underlying inflation rate, GDP growth rate, unemployment rate

how does the RBA aim to achieve price stability?

• if inflation (CPI) is above the target (2-3%), increase in cash rate

• if inflation is below the target, decrease in cash rate

how does the RBA aim to achieve full employment?

• if labour market is judged to be above full employment level (consistent with low and stable inflation), increase in cash rate

• if ‘‘ below full employment level, decrease in cash rate

How are the objectives of price stability and full employment connected?

Low and stable inflation is needed for strong and sustainable employment in the economy because it creates the right conditions for businesses to operate and create jobs without having to worry about inflation

costs of high inflation

• the real value of money is reduced

• workers may seek larger wage increases to compensate for the effects of higher inflation on their purchasing power

• spending and investment decisions may be distorted

• businesses may need to update their prices more frequently which may lead to consumers spending more time comparing prices

  • leads to economic uncertainty

• a country’s international competitiveness may be lowered

costs of low inflation/deflation

• consumers may delay purchases if they expect prices to fall

  • reduces consumer spending and contributes to lower economic growth

• businesses facing slow growth due to low inflation may find it difficult to reduce the real wages of their employees

  • may resort to laying off workers instead

cash market

market where banks lend and borrow funds from each other overnight

exchange settlement (ES) balances

digital funds that commercial banks hold in deposit accounts with the RBA

purpose of interest rate corridor

• it ensures that banks have no incentive to borrow or lend ES balances outside the corridor,

  • effectively guarantees the actual cash rate always closely follows the RBA’s cash rate target

• corridor is also responsible for implementing changes to the RBA’s cash rate target, as the ceiling and floor of the corridor are automatically set so the cash rate target is in the middle

  • ceiling (lending rate) is 0.25% higher than cash rate target

  • floor (borrowing rate) is 0.1% lower than cash rate target

domestic market operations (DMO)

DMO refers to the purchase and sale of financial securities by the RBA in exchange for ES balances. The RBA manages the supply of ES funds so it meets demand at a price equal to the cash rate target.

how does DMO impact interest rates?

• alters cash supply in banking system

• If the demand for ES funds increases, the RBA would increase the supply of ES funds to keep the cash rate at target

  • by buying financial securities held by banks, and in exchange deposit additional funds in their ES accounts

• If demand for ES funds falls, the RBA would sell financial securities to banks and withdraw funds from their ES accounts

  • thus decreasing supply to keep the cash rate at target

why does the RBA use DMO?

to ensure the cash rate stays at its target when the demand for ES funds changes

aspects of the cash market: price

interest rate on loans in the cash market

aspects of the cash market: quantity

ES balances

aspects of the cash market: demand

demand for ES funds

aspects of the cash market: supply

supply of ES balances

aspects of the cash market: policy interest rate corridor

a pricing range defined by a ceiling (lending rate) and a floor (deposit rate) around the cash rate target, which guides overnight interbank borrowing and lending

what is meant by an ample reserve system (in MP)?

• a MP framework where a central bank fully satisfies the commercial banking sector's demand for liquid reserves

• i.e as many Exchange Settlement (ES) balances as banks demand through regular open market operations

what is forward guidance (unconventional MP)?

• Public commitments made by the RBA as to how it will conduct monetary policy in the future

• This guidance is based on the state of the economy

• e.g during COVID the RBA explicitly stated it would not raise the cash rate from 0.1% until inflation sustainably reached the 2-3% target band

what is the purpose of forward guidance

• To shape market expectations

• Reduce economic uncertainty

• Influence current financial decisions

what are asset purchases (unconventional MP)?

Buying government securities with newly created ES balances (quantitative easing)

what is the purpose of asset purchases by the RBA?

• To lower the yield on bonds,

• reduce longer-term interest rates,

• lower funding costs

• boost liquidity in the economy (especially during COVID)

what was term funding facility (TFF) and when was it used (unconventional MP)?

• 2021-24

• gave financial institutions low cost, fixed term funding

• offered banks access to 3-year loans with the interest rate fixed at the cash rate target

what was the purpose of TFF?

• As this interest rate was lower than banks were usually able to access,

  • banks’ funding costs decreased and banks were able to lower interest rates on household and business loans

    • effectively making it cheaper to borrow money for households and businesses

what was the change to the interest rate corridor in 2020?

RBA set corridor floor 0.1% below the cash rate target instead of paying interest 0.25% below the cash rate target

what effect did this change to the corridor have (esp. during COVID)?

• Enabled the RBA to lower the cash rate target further without having to worry about the risks of negative interest rates during the height of the pandemic

• Ensured that the excess ES funds created by the RBA’s unconventional tools did not make the actual cash rate too much lower than the cash rate target

how does a change in the cash rate affect households?

how would an increase in the cash rate affect households?

It changes mortgage repayments, borrowing power and savings return

e.g if cash rate goes up, mortgage payments rise and borrowing power decreases, leaving households with less disposable income