4.2.4 Financial Markets & Monetary Policy

• a medium of exchange - Money avoids the problems of barter

• A store of value

• A measure of value/unit of account

• Standard for deferred payment

• Durability: Money must be able to withstand being used repeatedly

• Portability: Money must be easily transportable so it can be easily transferred to other individuals,

• Divisibility: It is also preferable that money can be divided into smaller units of value,

• Acceptability: Money must be widely accepted for it to be usable for different types of transactions,

• Scarcity: Money must be in limited supply to ensure its value remains relatively stable,

• Security: Money must also be extremely difficult to counterfeit, as if it is easily duplicated it will cease to become a medium of exchange

• The total amount of money in the economy at a particular time

• The basic amount of notes and coins and operational deposits/reserve balances at the Bank of England.

• It is approximately equal to that out of cash in circulation – money that can be accessed ‘on demand’.

• includes all notes and coins AND deposits in savings accounts and other less liquid assets

• The ease and speed with which an asset can be turned into cash.

• Cash is a highly liquid asset, whereas property for example is more illiquid.

• security that represents the ownership of a fraction of the issuing corporation.

• Units of stock are called "shares" which entitles the owner to a proportion of the corporation's assets and profits equal to how much stock they own.

• issued by governments and corporations when they want to raise money.

• return an investor realizes on a bond.

• return on the capital invested by an investor.

• figure that shows the return you get on a bond.

• Yield formula = coupon/market price x100

If you hold on to it, it's simple. The issuer pays you £100 a year for 10 years, and then pays you back the £1,000 on the scheduled date. The yield is therefore 10% (£100/£1000).

• Money market

• Capital market

• Foreign exchange market

• The money market provides short term , typically 24 hrs to 12 months, finance to individuals, firms and governments

• This includes interbank lending, the purchase of Treasury Bills by the government amongst other short- term financial instruments

• provides medium to long- term finance to firms and governments

• This includes, for example, companies issuing shares or corporate bonds, or governments issuing bonds to finance their borrowing requirements

• The primary capital market is where newly issued securities are sold by companies or governments

• The secondary capital market is where previously issued shares or bonds are traded e.g. The London Stock Exchange is an example of a secondary capital market

• market where different currencies are bought and sold

• International trade and investment necessitates the conversion of one currency to another e.g. £s: $s

• Foreign exchange can be conducted in either the “spot” market or “forward” market

• The spot market involves the immediate exchange of foreign currency

• The forward market involves the exchange of foreign currency at some specified time in the future.

• These are typically used by exporters and importers to protect themselves against large exchange rate fluctuations and episodes of speculation

• Money market - where commercial banks provide short term loans to each other

• Capital market - businesses obtain funds to finance long-term growth

• To facilitate saving by businesses & households

• 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

• Providing depositor protection

• Rewarding savers with a rate of interest as they sacrifice their liquidity

• Mortgages for home-buyers

• Loans / credit for small and medium sized enterprises

• This relates back to the key functions of money

• allows companies & individuals to hedge against uncertainty for example by buying their currencies & commodities months in advance

• Allows businesses to fresh equity capital e.g. to fund their expansion

• Equity markets provide a market for capital control, a market discipline on listed businesses

• any exchange that facilitates the trading of financial instruments, eg stocks, bonds, commodities

• Amount owed by the borrower to the lender

• Amount of money a company’s owner has put into

• high street or retail banks e.g. Barclays, HSBC & NatWest

• Their main customers are members of the general public

• provide some other services to customers such as: foreign exchange, insurance and brokerage services

• They typically have expensive branch networks

• in business to make profit for their shareholders

1.accepting deposits

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

• help companies, the government and other financial institutions raise finance by giving advice

• arranging the new issues of shares or corporate bonds

• helping them to manage the risk in doing so

• buying & selling corporate & government bonds and other financial instruments on behalf of their clients, but also for themselves

• involved with foreign exchange & commodity trading in the secondary market

• extending loans to businesses and households

• do not need to attract deposits from savers to do this

• When a bank makes a loan, it credits their bank account with a bank deposit of the size of the loan/mortgage.

• new money is created.

• comprised of assets & liabilities

• total assets must equal total liabilities

➢an asset is any claim that the bank has against others

➢a liability is any claim that others have on the bank

• easily be a loss of confidence amongst consumers in the ability of the bank to meet its liabilities

• the bank will struggle to meet its liabilities as and when they fall

• liquid assets do not tend to be very profitable but less liquid assets carry a greater burden of risk.

1. Profitability- commercial banks have an implicit requirement to ensure investors receive a return on their investment through dividends. Banks with weak profitability will likely see their share price fall and find new investment harder to attract.

2. Liquidity- Commercial banks must ensure that they have enough liquidity to meet the legitimate demands of their depositors, who can withdraw their money at any time.

3. Security - Commercial banks seek to ensure that their assets are as secure as possible. An example of a secured loan is a mortgage, as the money advanced to the customer is secured against the property in the event of default. An unsecured loan, such as a credit card, is riskier for the bank as there’s no underlying asset acting as security, the balance between these different types of asset is important in determining the banks overall stability.

• For a commercial bank to make profits, it is vital that it makes its assets work as hard as possible

• Having first attracted some deposits from customers, a bank will advance this money to customers in the form of loans to create assets.

• the most profitable assets are the most illiquid

• If the bank simply held onto the deposits as cash, it would generate very little profitability, but it would be highly liquid

• This is dangerous because in the event of a run on a bank, such as Northern Rock in 2007, the bank may not have enough cash to meet its short term liabilities.

D

• business

• Overdraft

• Credit card

• Mortgage

• Personal loan

• Payday loan

• When a bank advances money to customers, the rate of interest is a reflection of the risk attached to that loan.

• most profitable loans charge the highest rates of interest higher rates of interest are indicative of higher risk.

• E.G A mortgage is a form of secured lending because if the customer runs into financial difficulty and cannot repay the loan, the bank will be able to repossess the property as a form of security (is not possible with unsecured loans, such as credit cards, any default on the loan means the bank is unable to recover any money = known as “bad debt”

• is a cost to the bank which reduces both its assets and its profitability.

• a national bank that provides financial & banking services for its country's government & commercial banking system, as well as implementing the government's monetary policy & issuing currency.

1. Maintain financial stability in the monetary system - achieved by the central bank acting as lender of last resort, which means that if commercial banks suffer a shortfall of cash or become illiquid in the short term, they can always borrow from the BoE. This function is vital in maintaining liquidity & confidence in the financial system and ensuring depositors are protected & systemic risk is minimised

2. Help the government maintain macroeconomic stability - Decisions to achieve this objective are taken by the Monetary Policy Committee (MPC) via setting interest rates. aims to support the govt macro objectives to help create the right conditions for economic growth & low unemployment

• Controlling the issue of notes and coins

• Acting as the bankers’ bank

• Acting as the Government’s bank

• Buying and selling currency to influence the exchange rate

• Liaising with overseas central banks and international organisations

• To promote the safety and soundness of individual financial firms

• To protect and enhance the resilience of the financial system as a whole to prevent future financial crises, or reduce their frequency and severity

• give investors a higher return on UK assets relative to their foreign-currency equivalent

• make sterling assets more attractive as investors search for higher rates of return

• should increase the demand for sterling and so increase its price causing the exchange rate to rise

• effect of reducing the price of imports and increasing the price of UK exports thus reducing the demand for UK goods and services abroad

1. The BoE agrees reserve requirements individually with each bank. Higher reserves will contract the money supply and vice versa

2. The BoE is involved in open market operations i.e. the purchase and sale of bonds and other instruments which feeds through to bond prices, yields and bank lending

3. It alters interest rates at which it lends funds to banks, which again feeds through to bank lending

• inflationary pressure is likely to accumulate quickly and lead to speculative bubbles in asset prices e.g. housing

• Conversely, contractions in the money supply or the availability of credit can decrease economic growth as economic agents find it harder to obtain finance at an affordable rate, leading to falling aggregate demand and weaker EG

• uses higher interest rates to decrease AD and shift AD curve inwards to left.

• uses lower interest rates to increase AD and to shift AD curve to right

• involves the use of taxation, public spending and the government’s budget to achieve the gov’s policy objectives

• government spending exceeds government revenue

• Represents a net injection of demand into the circular flow of income and a budget deficit is expansionary

• when G<R

• Represents a net withdrawal from the circular flow and hence a BS is contractionary

• monetary policy - includes interest rates, tax, debt

• Fiscal policy - gov spending, money supply

• Supply side - productivity

• through taxes and borrowing money if in debt

• healthcare

• Education

• National defence

• Councils

• Welfare benefits

• Social protection

• Debt interest

• Police

• Transport

• corporation tax

• National income tax

• Inheritance tax

• VAT road tax

• NICs

• Council

• expansive fiscal policy can be created through increasing GS or decreasing Income tax

• Causes AD to increase

• Increased consumption

• GDP increases

• expansionary fiscal policy increases AD

• Gov will increase spending and cut taxes

• Lower taxes will increase consumers spending because they have more disposable income

• Worsens gov budget deficit

• Changes in income tax rates and can have a significant effect on work incentives in the labour market. Consider 40% or say 15% tax???

• Higher government spending on education & training, can increase human capital / productivity to lift the long-term trend rate of growth.

• Changes in corporation tax changes profits and investment

• if Y tax / corp tax falls may help S side as efficiency rises. (incentives to work / more Bus investment)

• The government may have poor information about the state of the economy.

• Time lags. To change econ it could take several months.

• Crowding out. (fiscal only) Higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for businesses

• Raise money

• Lower Y tax helps incentives to work.

• Correct for market failure:Tax de merits ALTER D FOR SOME GOODS. • Redistribute Y / Wealth with benefits. Help poor Y end

• Manage econ to alter AD via Y tax changes

• Direct taxes – are directly on your circumstance– usually through “pay as you earn” (y tax). Also corporation tax.

• Indirect taxes – include VAT and a range of excise duties on oil, tobacco, alcohol. The burden of an indirect tax can be passed on by the supplier to the final customer

• Income Tax = Biggest rev earner, Progressive tax system

• Corporation Tax

• Capital gains tax - sell an asset for greater than purchase Price pay tax on gain

• Inheritance tax

• National insurance

1. Generate tax revenue for a government.

2. Discourage consumption of ‘harmful’ products

The burden of an indirect tax can be passed on by the supplier to the final customer

• A unit tax (specific ) is a set amount of tax per unit sold, such as a 10p tax on packets of cigarettes.

• VAT

no/low VAT:

• newspapers

• Children’s clothes

• Food and drink (chocolate covered biscuits,ice cream, crisps)

• involves a tax rate that increases as taxable income increases.

• It imposes a lower tax rate on low-Y earners and a higher tax rate on higher earners

Average tax = tax paid/ income X 100

the average rate of tax is greatest for those on lower incomes.

• VAT

• The tax on national lottery tickets (12%)

• Exercise duties on smoking and alcohol and betting and gaming duties • Higher fuel duties

• Av tax 40000/500000 times 100 = 8%

• So as Y rises vat as proportion of vat falls.....regressive

• refers to trends or predictable which consumers purchase goods or services over time

• exercises duties- taxes of cigarettes, decreases consumption

• Govt spending via subsidies- spend on merit goods such as the NHS

• Fall in income tax, changes rate of consumption

• Fall in corporation tax, increase in price changed the budget spending power

• Tax of demerit goods (e.g alcohol)

Pros:

• raises a lot of money for infrastructure, to pay welfare benefits, NHS, education, public/merit goods

• Used to change the pattern of consumption

• Reduces demand for petrol via positive ext.

  Cons:

• Indirect taxes are regressive meaning low income people are hit the hardest

• Many cause cost-push inflation causing VAT to increase the prices causing costs to increase

• Petrol/cigarette taxes have no effect on their demand

• raises a lot of money

• IDR taxes less likely to distort choices that people have between work and leisure, have less of a negative effect on work incentives

• Higher IDR taxes allows a decrease in direct tax rates, lower income tax rates so people work harder