4.4 - The Financial Sector (Edexcel A-level Economics Theme 4)

What is meant by financial markets?

Financial markets are any place or system that provides buyers and sellers the ability to exchange goods/services and trade financial instruments

What can be exchanged within financial markets?

• These include bonds, equities, international currencies, and derivatives

Role of financial market (5)

• To facilitate saving

• To 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 are the different types of market failure in Financial markets? (5)

1. Asymmetric information

2. Externalities

3. Moral Hazard

4. Speculation and market bubbles

5. Market rigging

What is meant by asymmetric information?

• Financial products are often complex and hard for consumers to understand.

• Sellers have significant information advantages over buyers.

  • Example: During the financial crisis, sellers knew more about the risk of bundled mortgages than buyers.

  • Example: Mortgage sellers understand the impact of interest rate changes better than consumers.

• The Global Financial Crisis highlighted that asymmetric information can also exist between financial markets and regulators.

What is meant by externalties

Negative externalities of production and consumption exist in financial markets.

• Example: Speculation on property prices leads to higher costs for young buyers, forcing them out of the market (AirBnB effect).

• Example: Relaxed mortgage lending requirements by banks contributed to the Global Financial Crisis, which caused a global depression. This reduced or eliminated imports from many developing countries, who were third parties to the global mortgage market.

What is meant by moral hazard?

• Moral hazard has increased in the financial sector since 2008 as governments have intervened to save banks from failure (e.g. RBS).

• Banks are seen as 'too big to fail,' meaning governments bear the consequences of their risky behaviour.

What is meant by speculation and market bubbles?

• A higher money supply in an economy increases speculation and the potential for market bubbles.

• Significant quantitative easing since 2008 has raised the money supply, creating potential bubbles in markets such as property, cryptocurrency, and shares.

What is meant by market rigging?

• Allegations have been made that some banks and individual bankers have rigged key interest rates or exchange rates to maximize profits.

• This is considered fraudulent activity, but it is often difficult to identify or trace unless a whistleblower exposes the fraud.

What is the role of the Central Bank? (4)

1. Implementation of monetary policy

2. Banker to the government

3. Banker to the banks - lender of last resort

4. Regulation of the banking industry