12 financial markets and monetary policy

functions of money

• medium of exchange

• unit of account - can compare values

• store of value

• standard of deferred payment - loans

characteristics of money

• durable

• divisible

• transportable

• hard to counterfit

money supply

total amount of money circulating in the economy

narrow money

notes and coins, money on demand, can be withdraw straight away

board money

• includes narrow money but also includes bank deposits which may require notice to withdraw and other liquid assets - cant be used directly on the highstreet

financial markets

• money markets - short term lending

• capital market - long term lending

• foreign exchange market (FOREX)

financial market

money and capital markets are used as sources of finance for the individuals demanding funds and a way for financial institutions to lend their funds

money market

• borrowing/lends in the short term (less than a year)

• liquid funds

• includes inter bank lending

• includes short term government borrowing

  • treasury bills

treasury bils

• issues by the treasury each week to ensure the government has enough cash for its day to day running

• treasury bills are normally issued for 3, 6 or 12 moths

• low risk as they are loaned tot he UK government - safe investment

• sold at a discount to face value (e.g. buy for £970, get £1,000 at maturity)

interbank loans

• banks in the UK provide loans to each other so that they aren’t short of cash

• interest rate paid on there is determined by the interbank lending rate

the capital market

• where financial securities like shares and bonds are issued to raise medium to long term finance (over a year)

• split into 2 sections

• primary market

  • new issues of shares and bonds

• secondary market

  • reading existing shares and bonds

bonds

• financial securities issues by governments and companies (corporate bonds) with the aim of raising capital for repayment over the medium to long term

• bonds have different values, GILT bond = $100

• if an investor wants to buy a GILT then they may purchase a 3 year GILT for $100 with a coupon rate of 4% ($4 per year)

• the coupon rate is fixed

bond yeild

• coupon rate / market price X 100

• although the coupon rate says the same as the yield, the yield can fluctuate due to changes in the bond's market price

• therefore, bond yield provides a measure of the return an investor can expect based on current market conditions

• yield and bond prices have an inverse relationship, meaning when bond prices rise, yields fall, and vice versa

  • why, coupon rate is fixed so as the price rises the coupon rate will be divided by a large number resulting in a small yield

inverse relationship between bond prices and interest rates

• government will set coupon rates as the same as market interest rates - substitutes

• if yields are higher than market interest rates, demand will increase as investors look to purchase bonds

• this drives up the market price of bonds and therefore lowers the yields

• until they reflect market interest rates

• price of bond = coupon / yields X 100

debt

• money borrowed that must be repaid, usually with interest

• form: loans, bonds, or credit

• repayment: fixed repayments over time, regardless of business performance

• ownership: lenders do not own any part of the business

• risk: lower for lender (secured), but borrower must repay even if business fails

• return: interest payments

• priority: debt is repaid before equity if a business is liquidated

equity

• ownership in a business issued shares or retained earnings

• no obligation to repay, but shareholders expect dividends

• ownership interest in a company, represented by shares

• holders are entitled to vote on company matters and receive dividends

• return is not guaranteed and depends on company performance

• equity holders face higher risk but have the potential for greater profit

• risk: higher for investors—returns depend on business performance

• return: dividends and capital gains

• priority: equity holders are paid after all debts are settled

the foreign exchange market

• a global marketplace for the trading of currencies, where foreign exchange rates are determined

• it involves participants such as banks, businesses, governments, and investors buying or selling currencies

liquidity

• the availability of liquid assets to a market or company, reflecting how easily assets can be converted into cash without affecting their price

• high liquidity indicates that an asset can be quickly sold in the market, while low liquidity might imply that selling the asset will take longer or require a discount

role of financial markets in the wider economy

• facilitate the allocation of resources, enabling capital flows among various sectors, which promotes economic growth

• provide mechanisms for price discovery, risk management, and liquidity, contributing to the overall efficiency and stability of the economy

commercial banks

• financial institutions that accept deposits from the public and make loans, crucial to the banking system and economy

• retail banks

• oligopoly, low risk

functions of commercial banks

• accept deposits

• provide current and savings accounts

• advancing loans, overdrafts, mortgages

• provide credit cards

• provide insurance

• share dealing - bonds and shares

investment bank

a financial institution that specialises in more risky financial activities

functions of investment banks

• assisting governments and businesses to raise capital

• advising businesses on mergers and takeovers

• trade in financial securities

• organise new share issues - will guarantee to buy unsold shares

• loan money for riskier business ventures

systemic risk

the collapse of the entire banking system causes by inter linkages within the financial system

why did the banking system struggle in 2007/2008

• banks lent to riskier household groups

• many traditional banks took on investment banking services

• banks started banking on inadequate capital reserves and faced significant losses from mortgage-backed securities

problems with banks failing

• if commercial banks fail many people would lose the money in their savings accounts

• businesses would lose money banked with them

• these are direct implications, it would be likely that confidence in the banking system would be 0, people and businesses would take their money out of all banks

• investment would then be less in the future and AD and AS would reduce

governments prevent colapse

• government put 850bn to ensure they dont collapse

• they took ownership of some main banks

• they allowed mergers

• lower the consequence of an investment bank failing

• the government introduced ring fencing which will ensure that a banks commercial activities are separated from their investment activities, reducing risk and protecting consumers

commercial bank balance sheet

• financial statement recording

  • assets - bank loans - advances

  • liabilities - bank owes - deposits

  • capital - bank has invested

    • retained profit, selling shares

banks main assets

most liquid

• cash

• deposits at the BOE

• short term securities - T-bills

• long term securities - bonds and shares

• loans and mortgage (advances)

• fixed assets - land

least liquid

liquidity current ratio

• requires banks to hold sufficient high quality liquid assets to exceed the net cash outflows of the next 30 days

• banks loans out 10000, bank has less money but more assets

• liquidity worsens but profitability increases

how banks create credit

• savers deposit money in banks and gain a rate of return back from banks as a result

• banks will then create loans from those savings to lend to borrowers and charge an interest rate, IR greater than rates given to savers

fractional reserve banking

• saver deposits $100

• the bank then decides how much of that saving needs to stay in the bank, knowing that its unlikely the saver will demand all that money back at once

• bank keeps 10 of 100 (10%)

• 90 is then leant out to borrowers

• spending generates income for other people meaning the 90 will end up back in the bank meaning the bank has created credit as there is now 190 in the bank

• this process then repeats

• banks artificially create money in the economy by making loans on fractional reserve banking

money multiplier

1 / reserve ratio

limits of the central bank to create credit

• the demand for credit from banks, the major influence is the price of the credit (IR on loans)

• the lower the IR, the greater the demand for credit and thus a higher credit multiplier

• confidence of businesses and consumers

• regulations prevent the bank from creating credit freely

• cash ration of the bank

objectives of commercial banks

• maintaining surficial liquidity

  • liquidity measures the ease with which tassets can be turned into cash, bank holds assets to meet LCR

• profitability

  • profits demanded by shareholders, banks need to maximise returns

• security

  • CBs must ensure they have sufficient capital

  • retained profit to cover losses

commercial bank objective conflicts

• liquidity vs profitability

  • liquid asses such as cash help at BOE tend tyo be less profitable as they are low risk compared to certain illiquid assets which are high risk, high return

  • banks need to ensure they are profitable while also ensuring they are liquid

• profitability vs security

  • banks need to hold a certain amount of capital however, there is an opportunity cost involved as this capital is not doing anything and thus costing the banks potential profit

central bank

The national institution responsible for managing a country's currency, money supply, and interest rates, often overseeing commercial banks and implementing monetary policy - BOE

functions of the central bank

• regulating the money supply

• managing inflation through interest rates

• overseeing the banking system

• providing financial stability

• serving as a lender of last resort to commercial banks

monetary policy

action that a countries central bank can take to influence how much money is in the economy and how much it costs to borrow

market interest rates - loanable funds theory

• the loanable funds model explains the determination of IRs through the relationship between supply and demand for loanable funds in an economy

• thee supply of loanable funds comes from savings (households, firms), while the demand for funds comes from consumers, firms and the government

• increase supply of loanable funds comes from

  • confidence falls - people start to save

  • people have more money - save more

    • banks loan that money out

• increase demand for loanable funds comes from

  • business expansion

  • government borrowing

  • an increase in consumer spending or investment incentives

monetary policy objectives

• control inflation (2%)

• economic growth and macroeconomic stability

  • def - absence of excessive fluctuations in the economic cycle

  • constant output

  • low and stable inflation

monetary policy instruments

• interest rates

  • affect demand for credit

• quantitative easing

  • affect amount of money in circulation

• changing cash reserve ratio

  • affect banks ability to supply credit

• exchange rate

  • affect the cost of out imports and so can affect inflation

• forward guidance

monetary policy committee ad IRs

• hawk - keeping inflation on target

• dove - someone who looks at the economy as a whole

transmission mechanism of monerary policy

• BOE increase IR

• commercial banks increase rates as it costs more to borrow from BOE

• households cut back on consumption as it costs more to borrow and they save

• firms reduce investment as it costs more

• households are encourages to save rather then spend

• government expenditure falls as the government is paying back more on debt interest payments

• AD falls

• wealth affect - decrease is wealth as high IR make other assets less attractive

• less inflation as businesses lower prices due to lack of demand

• as IR rise, ER increase causing hot money

• decrease in demand for exports

• imports become cheaper

• less cost push inflation

problems with monetary policy

• time lags - BOE estimates it can take up to 2 years for IR change takes effect

liquidity trap

• a situation in which prevailing interest rates are low and savings rates are high, rendering monetary policy ineffective

• people are reluctant to spend even with very low IRs

• people saving in a recession due to a lack of confidence (savings ration goes up)

• people weren’t borrowing because banks are unwilling to lend, leading to a stagnation in economic growth

• why

  • expectations of economic uncertainty causing job insecurity

  • expectations that IR will rise

quantitative easing

• central banks create money electronically to buy financial assets such as government bonds

• price of government bonds increases as there is more demand and so yield falls

  • IR falls as they are substitutes

• financial institutions loan money out or invest it in riskier corporate bonds or shares

• causes business to invest

• create more jobs and stimulate consumption

• AD and LRAS increase

forward guidance

• central bank announce to certain markets that it plans to keep interest rates low for an extended period, providing signals about future monetary policy to influence economic decisions

• this can boost economic activity and investment

issues with forward guidance

• a commitment to keep IRs low for a long time is an admission that the economy is deeply depressed and tis could actually knock confidence and expectations

• governor changes his mind

why might a bank fail

• borrowing short, lending long

  • can lead to a liquidity mismatch, causing insolvency if deposits are suddenly withdrawn or if the bank faces losses on long-term loans

  • systemic risk

• trading with insufficient capital and liquidity

  • capital doesn’t need to be repaid so can be used to mitigate losses

  • liquid assets are important so banks can access cash when needed

• engaging in risky banking activities

  • many banks choose to hold assets which have higher returns but are also higher risk and less liquid

  • there can often be asymmetric information

regulators of the financial system

• prudential regulation authority (PRA)

• financial conduct authority (FCA)

• financial policy committee (FPC)

PRA

• prudential Regulation Authority

• responsible for the regulation of banks and financial institutions to ensure their safety, ensures they successfully manage risk and have enough capital as security

• part of BOE

FCA

• financial conduct authority

• sperate from BOE

• responsible for ensuring that the conduct of firms in financial markets is acceptable and meets standards

FPC

• financial policy committee

• part of BOE

• exists to identify, monitor and take action to remove or reduce systemic risk

• macro advice to the government on managing financial markets

• powers include, set LCR, set cash reserve ratio

stress testing

• examines the potential impact of an imaginary adverse scenario on the entire banking system and individual firms

• designed to inform regulators about resilience to economic shocks and ensure financial stability

• scenarios

  • house prices fall by 30%

  • GDP falls

  • unemployment rises

  • chine enters recession

liquidity coverage ratio (LCR)

banks need enough high quality liquid assets to meet 30- days worth of cash outflows

core tier one capital

• baseline minimum requirement for a bank's capital; it includes common equity and is crucial for financial stability

• 4.5%

• banks assets are 100m, it must hold capital of 4.5m

moral hazard

• when one person or organisation takes greater risks because third partiers carry the burden

• banks take risk because the government bails them out

loanable funds

the money available for borrowing in the financial system, determined by the supply of funds from savers and the demand for funds from borrowers