4.2.4 – Financial Markets & Monetary Policy

    71 – Financial Market Structure

    The two Functions of money are:
    o A medium of exchange or means of payment
    ▪ Money is used to pay for goods or services rather than barter
    o A store of value or store of wealth
    ▪ Money is an asset, something people own which has value (house)
    • Other two less important Functions of Money:
    o Measure of Value
    ▪ Money is the unit that goods are quoted and accounts are kept (car sale)
    o Standard of Deferred Payment
    ▪ Delayed payment for a good or service or settling a debt (credit card)
    Narrow Money – the notes and coins in circulation, plus balances held at a central bank (very liquid)
    Broad Money – the things making up narrow money + assets that are less liquid
    • The 3 Financial Markets
    o The Money Market
    ▪ Short term finance to banks, companies’ governments & individuals
    ▪ Short-term debt have a maturity of up to a year
    ▪ easily convertible to cash
    o The Capital Market
    ▪ Capital markets provide firms and governments medium to long term financing
    ▪ Firms raise finance by issuing bonds, shares or by borrowing from banks
    ▪ A capital market has a primary and secondary market
    • Primary market – new share and bond issues
    • Secondary market – existing securities traded (stock exchange) this increases
    their liquidity
    o The Foreign Exchange Market
    ▪ Where different currencies are bought and sold
    ▪ This is done to allow international trade and investment or as speculation (make
    profit from fluctuations in currency prices)
    ▪ This market splits into two:
    • Spot Market – transactions occurring now
    • Forward Market – transaction planned in the future
    • Difference between debt and equity
    o Equity finance is raised by selling shares in a company
    o The person buying the shares becomes a shareholder
    o The shareholder gains profits in the form of dividends
    o Debt finance is borrowing money that has to be paid back (with interest)
    ▪ This can involve borrowing from banks, corporate or government bonds
    • Corporate bonds – debt security issued by a company and sold to people who lend long term to the
    company. They can be resold second hand on the stock exchange
    • Government bonds – debt security issued by government and sold to people who lend long term to
    the government. They can be resold second hand on the stock exchange

    Bonds prices and Interest Rates are Inversely Proportional Bonds are a form of Borrowing
    o Interest is paid to the bondholder- the interest paid is called a coupon
    o After issued, bonds can be traded in secondary capital markets
    o The bonds yield is the annual return an investor gets from a bond
    ▪ The less paid for a bond the higher its yield – Commercial and Investment Banks

    Commercial Banks have these main roles
    o To Accept Savings
    o To Lend to individuals and firms
    o To allow payments from one person or firm to another
    o To be financial institutes – move funds from lenders to borrowers
    ▪ They can also provide insurance and financial advice
    o Commercial banking is split into two areas:
    ▪ Retail banking – providing services for individuals and smaller firms (mortgages and
    savings account)
    ▪ Wholesale banking – deal with larger firms banking needs
    o They help firm’s growth via loans, financial advice & aiding overseas trade
    • Investment Banks don’t take deposits from customers their role is to:
    o Arrange share and bond issues
    o Offer advice on raising finance, on mergers and acquisitions
    o Buy and sell securities (bonds and shares) on behalf of their clients
    Some Commercial banks operate as Investment Banks like Barclays
    ▪ By allowing banks to do this it creates systemic risk (it affects all banks due to inter-linkages)
    o As they use money from commercial side to fund investment side
    o If they lose money in bad investments then entire economy is at risk
    o To stop systemic risk, ring fencing has separated the two sectors
    • Other Financial Markets that aren’t banks
    o Pensions funds – collect pension savings and investing them in bonds/shares
    o Insurance firms – help reduce risk by paying for cover
    o Private equity firms – invest in businesses (buying equity=wealth) then maximising return by
    making the business successful then selling it for profit

    Objectives of a Commercial Banks – liquidity, profitability and security
    • Theres a Liquidity-Profitability trade off

    1. the rate of return on illiquid assets is higher than more liquid assets
    2. But Banks need a certain amount of liquid assets available
    o As depositors sometimes withdraw their savings instantly
    o They need enough to repay depositors but not too much liquidity or they become unprofitable,
    so this is a trade-off
    3. However, if people thought their savings were at risk they would withdraw their savings very quickly
    o If everyone withdraws at the same time the bank won’t have enough liquidity
    o This is why trust between depositors and banks is imperative
    o Also, its why the central bank act as an emergency lender at last resort
    • Banks create credit by giving loans to firms and households, and create new money to do this as they
    will receive that money back with interest Central Banks and Monetary Policy

    Function of a central bank
    • The Bank of England is our central bank
    • Its functions are too:
    o Maintain Macroeconomic Stability
    ▪ which is stable growth, stable employment,
    stable price level, stable current account
    balance of payments
    o Bring financial stability in the monetary system
    ▪ As they are lender of last resort to banking system
    ▪ This protects depositors and stop systemic crisis
    • They also act as the governments bank, buying and selling currencies to influence exchange rate and
    liaising with international central banks and organisations
    When setting Interest Rates the MPC look at:
    • House prices
    • Size of output gaps
    • Exchange rate of pound

    Monetary policy can either be:
    o Contractionary – fall in AD (high interest rates, strong exchange rate, restricted flow of money)
    o Expansionary – rise in AD (low interest rates, weak exchange rate, less restricted flow of money)
    Monetary Policy Objectives
    • Control of inflation (2%) is the main objective in the monetary policy
    o If it goes more than or below 1% the governor of the BoE writes letter to chancellor
    • Since 2008 recession, new methods have been created to help in recession
    • Theres new unconventional ways of bringing sustained recovery from recession
    o Quantitive Easing – money created electronically used to buy financial assets like gov bonds
    Monetary Policy Instruments
    1. The bank rate – set by MPC
    o Bank rate is the minimum interest rate charged by B of E to commercial banks
    o Two factors affecting interest rates are
    ▪ Time – The longer a loan the higher the rate of interest
    ▪ Risk – The riskier a loan the higher the rate of interest
    • A fall in interest rates due to a fall in the Bank Rate, increases AD due to these 3 factors:
    o Lower interest rates increase household consumption (C)
    ▪ Discourage saving (no incentive)
    o Lower interest rates increase business investment (I)
    ▪ Rise in confidence
    ▪ Cheaper capital goods can be bought by borrowing
    o Lower interest increases net export demand (x-m)
    ▪ Lower interest rates mean weaker pound
    ▪ Exports become cheaper and imports dearer
    ▪ Raising competitiveness internationally
    2. Quantitative easing (unconventional method)

    • Increases money supply by electronically producing money
    o The new money is injected via the buying of gilts
    o The sellers of the gilts have money to now boost economy
    Less important Unconventional Instruments
    • Funding for Lending – Borrow money cheaply from B of E, so banks lend to small/medium
    enterprises boosting the economy
    • Forward Guidance – Attempts to send signals to financial markets, businesses and individuals about
    B of E interest rates policy in the future, so these organisations
    Transmission Mechanism
    • The relationship between changes in interest rate and exchange rate
    o Rise in interest rates raises the value of the pound
    o As people buy more pounds to save in British banks raising its value
    o This is known as hot money

    Monetary Policy Needs To Look Two Years Into The Future
    • Effects of monetary policy changes aren’t felt instantly
    • For e.g., reducing interest rates won’t usually cause a sudden surge in investment or house buying
    o Firms plan investment plans carefully – months and years before they increase spending
    o House buying can take a long time – people need to find suitable homes & purchases take time
    • Time lags between Bank Rate and its effect on economy can be very long.
    o Maximum effect on firms usually felt after 1 year
    o Maximum effect on consumers felt after 2 years
    • So, Bank of England has to look two years into the future when making interest rate changes Regulation of Financial System

    Regulation – rules and laws that limit freedom of individuals
    and businesses to make decisions of their own will
    Financial Regulation in the UK by:
    1. Financial Policy Committee – part of the B of E
    • They identify, monitor and act to remove/ reduce systemic risk by strengthening the UK financial
    system. (Macroprudential Regulation)
    • They support the government’s economic policy
    • They help maintain financial stability
    2. Prudential Regulation Authority – part of the B of E
    • Supervises banks, building societies, credit unions, insurers, major investment firms
    (Microprudential Regulation)
    • This is done to ensure Financial Stability
    • The PRA require some institutes to maintain a capital and liquidity ratio
    3. Financial Conduct Authority – not part of the B of E
    • Ensure consumers receive a fair deal where their best interests are at heart
    • Protect financial markets to enhance integrity of UK financial System
    • Promote effective competition in interests of consumers



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