Economics- The role of money and financial markets

What is meant by money?

Money is a system of value that facilitates the exchange of goods in an economy. It can be defined as more than the amount of banknotes and coins in circulation.

Four functions of money

1. medium of exchange

2. unit of account

3. store of value

4. standard of deferred payment

Use of money: Deferred Payment

• Money is an acceptable way to arrange terms of credit (loans) & to settle any future debts.

• This allows producers & consumers to acquire goods in the present & pay for them in the future

• For this to be useful, prices need to remain fairly stable

• Significant changes in the level of prices (eg. high inflation), mean that this use of money becomes limited

Use of Money: Store of Value

• Money holds its value over time (inflation means that is not always true)

• Enables individuals to transfer spending to future time periods, secure in the knowledge it will have a future value

• This means that money can be saved, it can be kept until required to buy goods/services

• It remains valuable in exchange over long periods of time

• Readily accepted by almost all economic agents

Use of Money: Unit of Account

• Money provides a means of ascribing value to different goods and services

• It serves as a common base of comparison that people use to present prices and record debts

• Each unit of value is seen the same (all 50ps are identical)

• Allows buyers and sellers to determine the value of goods, without this measure it is difficult for buyers & sellers to arrange an agreeable exchange

Use of Money: Medium of Exchange

• Without money, it becomes necessary for buyers & sellers to barter (exchange goods)

• Bartering is problematic as it requires two people to want each other's goods (double co-incidence of wants)

• Money enables goods and services to be exchanged, transactions to be settled and debts to be paid

• Barter is inefficient and would suppress specialisation and the division of labour

Main Agents in the Financial Sector

Financial sector is the range of institutions that provide services to retail and commercial customers within the economy.

• Allow transactions to be made

• Entails incurring and settling debt

Includes:

• The Bank of England

• Commercial banks

• Building societies

The Bank of England

Central bank for the UK and Wales

• It undertakes monetary policy

• Regulates the banking system

• Provides financial services

2 Core Functions:

• To maintain financial stability in the monetary system: banker to the banks (if commercial banks suffer a shortfall of cash, they can always borrow money from the Bank of England) (vital in maintaining liquidity and confidence in the financial system)

• To help the government maintain macroeconomic stability (to maintain price stability, monetary policy committee meet monthly to set interest rates to align with government inflation target, create right conditions for economic growth and low unemployment)

the role of the Bank of England in influencing interest rates and ensuring stability of the financial system

Monetary Policy Committee consists of 9 members, each with a dedicated team that researchers the state of the economy

• Uses changes in the Bank of England base rate to try and achieve the objectives of monetary policy incl. government's target rate of inflation.

• Base rate is the interest rate that the Bank of England charges other banks to borrow money

• If this increases, banks have to pay more in interest

• They raise their own interest rates to customers, meaning that the base rate impacts throughout the economy

A reduction in the central bank interest rate should

• Increase household consumption by discouraging saving and reducing the cost of borrowing

• This should help to boost confidence in the economy, stimulating economic growth

• Increased investment, through lower borrowing costs, helps improve confidence meaning that capital projects can add to the productive potential and total capacity of the economy in the long run

• Improve demand for exports through a weaker currency will improve the price competitiveness of UK exports and give a boost to the balance of payments on current account

An increase in the central bank interest rate should

Help to reduce inflationary pressure but comes at a potential cost of hampering economic growth and employment, and harming UK exporters via a less competitive currency.

Higher interest rates make it more expensive for people to borrow money and encourage people to save. Overall, that means people will tend to spend less. If people spend less on goods and services overall, the prices of those things tend to rise more slowly. Slower price rises mean a lower rate of inflation.

Role of high street banks in helping to fund investment and providing a service for savers and borrowers. Commercial/Retail Banks

Commercial or retail banks: Barclays, HSBC & NatWest

• Main customers are members of the general public

3 Core Functions:

1. Accepting deposits in order to provide security and to facilitate saving

2. Lending money to different economic agents who wish to borrow

3. Providing an efficient means of payment and transferring funds between different economic agents

Role of high street banks in helping to fund investment and providing a service for savers and borrowers. Building Societies

Building societies are financial institutes that provide financial services to their members.

• Type of mutual institution where the firm is owned by its customers

• Entitles customers a share of profits, normally in the form of a dividend

In particular, building societies offer mortgages...

• They receive money from members, who are paid interest and this is lent out to members, who pay interest

• Direct competitor to the high street banks

• Also provide foreign exchange and insurance services

• Have extensive branch networks, although in the modern economy many bank services are available online

• Commercial banks are in business to make profit for their shareholders through the provision of banking services to their customers

• Also help firms raise finance for investment (Providing loans to firms in order to invest)

Commercial Banks

• Increasing use of technology means that it is now easier to compare what different organisations offer

EQ: State two factors that influence the level of interest rate charged by banks when lending money to businesses. (2)

• Length/size of loan

• Security offered

• Past record of repayments

• Other interest rates - eg Bank of England's Base rate

• Risk of default

• Economic conditions - ie is business failure more likely in general

EQ: Explain one role of the Bank of England (2)

• Keeping inflation on target via MPC/interest rate changes.

• Maintaining growth as long as inflation is kept on target.

• Avoiding recessions, via appropriate monetary policy.

• Financial stability - ensuring banking system is 'behaving'.

• Maintaining integrity of banking and financial sector.

• Lender of last resort.

EQ: Explain one effect of a fall in interest rates on UK producers.

• Likely to lead to rising sales for producers (1) as households are likely to spend more of their income (1).

• Business costs will fall (1) and profits will rise (1).

• Borrowing is cheaper (1) encouraging more investment or expansion opportunities (1).

• Consumer spending will rise (1) sale of luxury goods increases (1).

• Exchange rate likely to fall (1) making it easier to export goods from UK (1).

• Exchange rate likely to fall (1) making imported goods more expensive for producers (1)