The Financial Sector (4.5)

Money supply

The total volume of currency held by the public sector at a particular point in time.

Interest

The return on capital. The price that borrowers pay for renting funds and paying them back over time.

Factors affecting the Demand for Credit

1. Interest Rates: The rate of interest is the payment for borrowing. Higher interest rates increase borrowing cost and lower demand for funds.

2. Future Expectations: Optimistic future outlook leads to increased investment and demand for credit. Pessimistic outlook reduces demand.

3. Government intervention: Government incentives increase demand for borrowed funds.

Factors affecting the supply of credit.

1. Interest Rates: Higher interest rates mean more earnings from lending, increasing the supply of money.

2. Future Expectations: Optimistic banks expect loan repayments and make more credit available. Pessimistic banks restrict credit.

3. Government Intervention: Policy changes by central banks, such as increasing interest rates to control inflation, can decrease the availability of credit

Positive effects of the supply of credit in an economy

1. Increase national income: By lending money, banks are injecting money into an economy. These loans lead ro consumers spending money which results in economic growth.

2. Increased employment: By banks’ lending money, jobs are created in numerous industries directly such as construction. Additionally, due to the multiplier effect, this also leads to a spin off where additional jobs are created across the Economy.

3. Increased government tax revenue: An increase in consumer spending means the governments gets increased returns on VAT. Similarly and increase in employment leads to the government getting increased revenue from income tax.

4. Industry: Some sectors are heavily reliant on the availability of credit to maintain/increase demand. The suppl,y of credit would reduce financial burdens for these sectors.

Negatives of the supply of credit in an economy.

1. Inflation: The more credit that is created, the more that is spent or invested. Demand-pull inflation can occur if the aggregate supply for goods and services does not increase to match the now large aggregate demand.

2. Balance of Payments: An increase in credit will increase our spending capacity for goods/services and therefore more people are likely to buy from abroad. More loans = More imports

3. Poor Lending: Banks trying to increase their number of loans may lead to problems similar to that of the 2008 recession.

The reserve ratio

It’s how the banks create credit/ The percentage of a bank’s total deposit that it must keep in cash form to meet customers demands for cash.

Formula for credit created from reserve ratio

1/reserve ratio x increase in cash deposits

Fractional reserve banking

A system where banks keep only a small portion of deposits as reserves and lend out the rest. This allows banks to create money and expand the money supply while still being able to meet withdrawal demands.

Run on a bank

Occurs when clients withdraw money from a bank as they believe their bank will cease to function in the future. This panic leads to insolvency.

Limitations on the Power of a Bank to Create Credit.

1. Reserve ratios: This is the percentage of cash a bank must, by law, hold to cover total deposits.

2. Lack of cash deposits: Banks need depositors in order to have borrowers and must offer sufficient interest rates to attract them.

3. Availability of suitable borrowers: When banks run out of suitable borrowers, they start to lend to unsuitable borrowers. This will lead to bad debts.

Economic advantages of non-cash-based methods of payment on the consumer

1. Increased convenience: Consumers are saved the inconvenience of carrying cash around for payments.

2. Digital record/easy to trace: With non-cash methods of payment, there is a written record of all monies received and paid from an account.

3. Reduced risk of theft: not carrying large amounts of cash around means the consumer is less vulnerable to theft. Also, since PINs are required customers’, money is much more secure.

Economic advantages of non-cash methods of payment on banks.

1. Time saved by staff dealing with cash: This may free up staff to deal with other consumer matters and improved customer satisfaction.

2. Development of new and improved banking methods: banks may have to innovate and introduce new methods for dealing with customers, i.e. greater use of technology.

3. Reduction in staff numbers: Banks may require fewer staff which may reduce the bank’s costs.

4. Reduced risk of robbery: With less cash on the business premises, the risk of storing cash, transferring cash and possible theft are reduced.

Interest rate

The interest amount expressed as a percentage of the sum borrowed.

Nominal interest rate

The interest rate unadjusted for inflation.

Real Interest Rate

Nominal interest rate minus the rate of inflation

What determines the interest rate?

The ECB’s governing council determines thee key interest rates of the eurozone. They do this, primarily, to attempt to abide by their main goal of price stability of 2% over the medium term.

Key factors affecting the interest rate

1. Inflation: To keep inflation under control, the ECB adjusts interest rates. If inflation is high, the ECB may raise interest rates to encourage people to save money instead of spending it.

2. Economic Growth: When the economy is doing well and growing quickly, the ECB might increase interest rates to prevent it from growing too fast. High interest rates can make borrowing more expensive, which can help cool down the economy.

3. Unemployment: To encourage businesses to invest and create more jobs the ECB may lower interest rates. Lower interest rates make it cheaper for businesses to borrow money, allowing them to expand and hire more workers.

4. Financial Stability: If the ECB observes risks or instability in the financial system, it may adjust interest rates accordingly. Example: during times of financial crisis, the ECB may lower interest rates to provide liquidity to banks and restore confidence in the system.

5. Exchange rates: If the euro becomes too strong, it can hurt export industries as their goods become more expensive for foreign buyers. To support export competitiveness, the ECB may lower interest rates.

Effects of an increase in interest rates on the Irish Economy

1. Increased Mortgage interest repayments: Increases in the base interest rate will lead to increases in high street bank lending rates increasing the cost of borrowing for private individuals. This will make them less inclined to borrow for personal use.

2. Slowing Economic Growth: With consumers spending less and saving more and investors less inclined to invest into the economy, there will be a dampening effect on economic growth.

3. Risk of Personal Bankruptcies due to Default on Loans: If interest rates were to increase, it may force some borrowers to default on their loans as they may be unable to repay their loans.

4. Reduced Investment: Increases in the base interest rate will lead to increases in high street bank lending rates increasing the cost of borrowing making investors less inclined to invest in capital goods.

5. Reduction in Consumption: As the reward for saving has increased people will forgo consumption to receive a higher return. Reduction in consumer spending reduces aggregate demand.

6. Rising Unemployment: With consumers spending less and saving more and investors less inclined to invest into the economy there will be less demand for goods and services and thus less demand for the employees who produce these goods and services.

If Interest rates rise I will need a MEDIC

Effects of a Decrease in Interest Rates in the Irish Economy

1. Borrowing encouraged: Borrowing is now cheaper resulting in cheaper loan repayments which will increase spending power resulting in a higher standard of living.

2. Incentive to invest: The MEC will rise resulting in increased profits and this may encourage investors. It becomes less expensive for businesses to borrow so they may invest.

3. Dirt revenue decreased: With a possible reduction in savings the government may receive less revenue through DIRT

4. Savings discouraged: With a lower rate of return people may find it less attractive to save and so they will increase their spending.

Positive Implications of FinTech

1. Speed and convenience - online

2. Greater choice - more options

3. Cheaper deals - lower overheads (no physical branches)

Risks of FinTech

1. Unclear rights - unclear who is regulated

2. Increased risk of cybercrime - hackers

3. Financial exclusion - elderly people who don’t use the internet have limited access.

Arguments FOR regulation in the Banking Sector

1. Protects Consumers: Regulation should prevent the abuse of monopoly power and so protect the interests of consumers and ensure that they are not exploited and charged at a fair price.

2. Protects Banks: Through stricter financial regulation, banks are forced to hold a certain minimum amount of equity and will therefore be better able to absorb losses.

3. Protects the Economy: Seeing as the financial system will be less vulnerable to swings, the overall risk for financial crisis situations will also be much lower if strict regulations are in place.

4. Protects the Taxpayers: Since the need for bailouts becomes less likely through the sophisticated financial regulation, there is also a lower change that taxpayers’ money must be used for those bailouts leading to lower costs for taxpayers.

Arguments AGAINST Regulation in the Banking Sector

1. More difficult for Irish businesses to access finance: It will be very challenging for businesses to expand so there is less competition and reduced economic growth. If businesses do not expand, unemployment may occur as a result.

2. No guarantee it will work: It’s success depends on the ability of regulators. The people who work in regulatory authorities may be unable to close every loophole available. This may lead to problems because bankers may be able to disguise excessive risk-taking strategies.

3. High levels of administrative work: The regulation of financial institutions also implies plenty of administrative work, both for the regulatory authorities as well as for financial institutions. All controls must be recorded, and data must be stored in a safe manner for a long period of time. However, this can lead to a significant cost to financial which may be passed onto consumers in the form of higher prices.

4. Higher barriers to entry for new financial companies: Strict financial regulations may also prevent start ups from entering the market. Investors may not be willing to provide startups in the financial sector with sufficient money since they fear those strict regulations. This leads to poor services in the long run.

Role of the Central bank of Ireland

1. Maintain Price Stability: The Irish Central Bank implements the European Central Bank’s monetary policy, aiming to achieve a 2% inflation rate in the eurozone over the medium term. The primary goal is to ensure price stability, thereby preserving the purchasing power of the euro for all eurozone countries.

2. Banker to the Government: Government revenues are deposited into the government’s account with the Central Bank, while payments made by the government are drawn from this account.

3. Regulates the Financial Sector: The central bank regulates Irish financial institutions and insurance companies, ensuring compliance with regulations. It can take necessary legal action, including suspending or revoking liscenses amend imposing significant fines for violations.

4. Ensures Financial System Stability: Financial system stability is achieved through various measures such as bank regulations, inspections, and restrictions on mortgage lending, like limiting mortgage amounts to four times the applicants gross income.