financial markets and monetary policy

what are the characteristics of money?

durable, portable, divisible, stable in value, generally accepted

what are the key functions of money?

medium of exchange, store of value, unit of account, standard of deferred payments

What does unit of account mean?

value somethings on its price

M0

notes and coins plus central banks reverse

MZM

notes and coins plus all sight deposits held by non-bank private sector

M2

notes and coins plus all retail deposits held by the non-bank private sector

m4

notes and coins, deposits, certificates of deposits, securities with a maturity of less than five years held by non-bank private sector

examples of non-bank private sector?

exchange companies, insurance companies, pawn brokers, mortgage brokers

what is narrow money?

notes and coins in circulation plus other money equivalents that are easily convertible

what is broad money?

the total amount of money held by households and companies in the economy, made up of IOUs from commercial banks

what is the fundamental purpose of financial markets?

channeling funds from people who have surplus funds to those with a shortage of funds

what is the money market?

the trade in short-term loans between banks and other financial institutions

what is the capital market?

markets where securities such as shares and bonds are issued to raise medium to long term financing

what is the primary market?

new shares are issued and sold directly to the public by the company

what is the secondary market?

second hand market where shares are traded on the London stock exchange

what is the foreign exchange market?

the market where currency is traded made up of thousands of trading floors

supply for currency is determined by?

domestic demand for imports from abroad (more imports more supply)

demand for currency is determined by?

derived by a country's exports

advantages of debt finance

less capital required to be invested by the shareholders, debt can be relatively cheap sources of finance compared with dividends, easy to pay interest if profits and cash flow are string

disadvantages of debt finance

business may be vulnerable to unexpected changes in interest rates, businesses have less control of events if they are highly geared

advantages of equity finance

equity is risk capital and does not offer a fixed return so business has some control over when or if a pay a dividend to investors, gives a business more flexible

disadvantages of equity finance

dilution of ownership for the original founders, ultimately equity requires a higher return than debt because it's risk capital, growing expectations over time that dividends will be paid

what is the role of financial markets in the wider economy?

facilitates saving by businesses and households, lend to businesses and individuals, to facilitate the exchange of goods and services, to provide forward markets in currencies and commodities, to provide a market for equities

what is debt finance?

required to pay back the money plus interest rates over a set period time

what is equity finance?

carries no repayment obligation so more money can be channelled into your business

key features of bank loan

over a fixed period, rate of interest is either fixed or variable, timing and amount of loan repayments are set by the lender, usually some security required, unsecured loans pay higher interest rates because of risk

benefits of a bank loan

greater certainty of funding, provided terms of loaned complied with lower interest rate than a bank overdraft, appropriate method of financing fixed assets

drawbacks of a bank loan

requires security, interest paid on full amount outstanding, harder to arrange, starts ups and small businesses often excluded

what is a bank overdraft?

short term finance used by businesses of all sizes owes money when the bank balances goes below zero flexible source of finance only used when needed

benefits of overdrafts

relatively easy to arrange, flexible, interest only paid on the amount borrowed under the facility

drawbacks of a bank overdraft

can be withdrawn in short notice, interest rates can change, higher interest than a bank loan

what are angel investors?

people who help finance a business start up

what are consequences of debt for an economy?

debt acts as a constraint on future spending power, commercial banks who have high debt can cause a reduction in loans for businesses and households, the economy can be at risk with a high debt-to-gdp ratio

what are the consequences of the economy being at high risk of high debt-to-gdp ratio?

price deflation leads to falling consumer prices and income which leads to worse debt in real terms, nominal interest rates rise which means mortgage payers to become at risk of struggling to make repayments and slowdown and create a recession in the housing market

what are government bonds?

fixed interest securities which means bond pays a fixed annual interest known as a coupon which is fixed but the yield on a bond will vary

yield=

interest on bond (coupon) x 100 / market price of the bond

what is the yield?

effectively the interest rate on a bond

what is the coupon?

guaranteed fixed annual payment

what are commercial banks?

accept deposits, make loans, safe guard assets and work with many types of clients including general public and businesses

what are investment banks?

provide services to large corporations and institutional investors

main roles of commercial banks

to accept savings, to lend to individuals and firms, to be financial intermediaries, to allow payments from one personal or firm to another

what are the two areas of commercial banks?

retail banking and wholesale banking

what is retail banking?

often called hughstreet banks and provide services for smaller firms and individuals

what is wholesale banking?

banks that deal with larger firms banking needs

what are investment banks main roles?

arrange share and bond issues, offer advice on raising finance and on merger and acquisitions, buy and sell securities on behalf of their clients, act as a market maker to make trading in securities easier

which type of bank engages in high risk activities?

investment

how can commercial banks make a profit?

earning more interest charged on loans than the interest paid on deposits, deposit security, currency trading, business advice, cheque and credit card processing

what is liquidity?

How easy it is to turn an item into cash without losing any money

there is a conflict between profit and....

liquidity

banks tend to borrow short term and ...... long term

lend

two fundamental reasons a bank may fail:

suffers a fall in the value of its assets that is so large that its capital is wiped out, it doesn't have sufficient liquidity to meet the legitimate demands of its depositors

example of a bank that operates as both commercial and investment

HSBC

risks of liquidity

banks tend to attract short term deposits, often lend for longer periods of time, commercial banks may not be able to repay all the deposits if savers decide to withdraw their funds

how to reduce risk of liquidity?

try to attract longer term deposits

what are capital risks?

commercial banks risk lending to borrowers who can't repay their loans

how to reduce credit risk?

proper safeguards/research into credit-worthiness of borrowers and through prudential regulation

what is prudential regulation?

financial firms must control risks and have adequate capital

what is systemic risk?

is a risk to collapse of an entire financial system or entire market

what is banking credit?

an arrangement with a bank for a loan, or bank lending in general

what is bank capital?

the value of the banks assets minus its liabilities or debts

what are bank reserves?

money and liquid assets held by banks in order in order to meet withdrawals by customers

what is a banking system?

the way the banks work together to make payments and money available

what is a co-operative bank?

a bank that lends money collected from its members, at low rates of interest

what is shadow banking?

non-deposits taking financial intermediaries including investment banks

what do balance sheets show?

assets and liabilities on a particular date

assets should always equal

liabilities

What is interbank lending?

borrowing and lending between banks to manage their liquidity and other requirements for short-term funds

what do banks need to balance?

liquidity, security and profitability

what is standard of deferred payment?

expressing the value of a debt

what is a store of value?

any asset whose value can be used now or in the future

what does a barter system rely on?

there being a double coincidence of wants between the two people involved in an exchange

what is the medium of exchange?

money allows goods and services to be traded without the need for a barter system

what is the monetary policy function?

setting of the main monetary policy interest rate, quantitive easing, exchange rate intervention

what does the financial stability and regulatory function do?

supervision of the wider financial system, prudential policies designed to maintain financial Stability

what are policy operation functions?

lending of last resort to the banking system, managing liquidity in the commercial banking system

what are financial infrastructure provision function?

oversees the payment system used by banks, retailers and credit card companies

what is debt management?

handing the issue and redemption of issues of government debt

what is quantitive easing?

injecting money directly into the economy by issuing bonds, the cash injection lowers interest rates and increases value of assets to get inflation to its target

what is monetary policy?

an action by the central bank and government that influences how much money is in the economy and the cost of borrowing it influences aggregate demand

what does the monetary policy use to influence aggregate demand?

the money supply, interest rates, the availability of credit and the exchange rate

3 main monetary policy tools used by bofe?

set interest rates, quantitive easing, target of keeping inflation at 2%

what is monetary stability?

stable prices and confidence in the currency

what are stable prices defined by?

the governments inflation targets which banks seek to meet through the decisions taken by the monetary policy comittee

what are the factors considered when setting interest rates?

strength of aggregate demand, housing market, the labour market, inflation from overseas and trends in the exchange rate

what are the main aims of forward guidance?

to build confidence

how does forward guidance build confidence?

signals interest rates which stay at low levels for a period of time

what are economic impacts of a fall in policy interest rates?

fall in cost of loans, increase in consumer confidence, effective disposable income rises, business investment boosts, higher demand for houses and higher house prices, cheaper exchange rates and increased exports

what is an expansionary monetary policy designed to boost?

consumer confidence and demand during a downturn/ recession

what is nominal interest rates?

interest rates published by the Bank of England

what are real interest rates?

interest rates adjusted for inflation

why can low interest rates be ineffective?

when consumer and business confidence can be low, when savers can suffer a fall in income, when there is a large amount of debt, when there is deflation causing real interest rates to rise, when export markets are weak when currency depreciates, when fiscal policy working in the opposite direction

impacts of interest rates on aggregate demand

house market and house prices, effective disposable incomes of mortgage payers, disposable income of savers, consumer demand for credit, business capital investment, consumer and business confidence and interest rates and the exchange rates

how long does monetary policy need to look into the future?

2 years

when is the maximum effect on firms felt when interest rates have risen?

after 1 year

when is the maximum effect of individuals felt when interest rates have risen?

after 2 years

what occurs in expansionary monetary policy?

fall in nominal and real level of interest rates, measures to expand the supply of credit from the banking system, depreciation of the external value of the exchange rate

what occurs in deflationary monetary policy?

higher interest rates on both loans and savings, tightening of credit supply, appreciation of the exchange rates

Who is the lender of last resort?

Bank of England

what is microprudential regulation?

a focus on ensuring stability of individual banks and other financial institutions, it involves identifying, monitoring and managing risks that relate to individual firms

who is responsible for microprudential regulation?

prudential regulation authority (PRA) and financial conduct authority (FCA)