Financial markets and monetary policy

• What are the key characteristics of money?

  • Durability: Money must last in circulation without deteriorating.
  • Portability: Money should be easy to transport.
  • Divisibility: Money should be divisible into smaller units.
  • Uniformity: All units of money should be identical.
  • Acceptability: Money must be widely accepted.
  • Stability: The value of money should remain stable over time.
• What are the primary functions of money?

  1. Medium of Exchange: Facilitates transactions between buyers and sellers.
  2. Unit of Account: Provides a standard measurement for the value of goods and services.
  3. Store of Value: Money preserves purchasing power for future use.
  4. Standard of Deferred Payment: Used to define future value in contracts (e.g., loans, wages).
• What is the money supply and what are the different types?

  Money Supply: The total amount of money in an economy.

  • Narrow Money (M1): Includes coins, paper money, and demand deposits (easily accessible forms of money).
  • Broad Money (M2/M3): Includes narrow money plus savings accounts, time deposits, and money market funds.
• What are the key types of financial markets?

  • Money Market: Deals with short-term borrowing and lending (e.g., Treasury Bills, Certificates of Deposit).
  • Capital Market: Involves long-term investment (e.g., stocks, bonds).
  • Primary Market: New securities are issued (e.g., IPOs).
  • Secondary Market: Existing securities are traded (e.g., NYSE).
  • Foreign Exchange Market: Facilitates currency exchange and determines exchange rates.
• What is the role of financial markets in the economy?

  • Resource Allocation: Channels savings to businesses and governments for investment.
  • Price Discovery: Determines the prices of financial assets.
  • Liquidity: Enables buying and selling of assets without large price changes.
  • Risk Sharing: Spreads risk among investors (e.g., through bonds, stocks).
• What is the difference between debt and equity?

  • Debt: Borrowing money with repayment obligations (e.g., bonds).
  • Bonds: Fixed-interest securities with a promise to repay principal at maturity.
  • Equity: Ownership in a company (e.g., shares).
  • Shares: Ownership units in a company, entitling holders to dividends and a portion of profits.
• Why is there an inverse relationship between bond prices and interest rates?

  • When interest rates rise, new bonds offer higher yields, making existing bonds with lower yields less attractive. This causes their price to fall.
  • Conversely, when interest rates fall, existing bonds with higher coupon rates become more attractive, so their prices rise.
• What is the difference between commercial and investment banks?

  • Commercial Banks: Provide services like accepting deposits, lending money, and offering payment services (e.g., checking accounts, mortgages).
  • Investment Banks: Specialize in large-scale capital raising, such as issuing stocks and bonds, as well as advising on mergers and acquisitions.
• What are the main functions of commercial banks?

  1. Deposits: Accepting savings and checking accounts.
  2. Lending: Providing personal, business, and home loans.
  3. Payments: Facilitating payments through credit and debit cards, and electronic transfers.

  • Liquidity: Ensuring the bank has enough funds to meet withdrawal demands.
  • Profitability: Generating profit through interest and fees.
  • Security: Safeguarding depositors’ funds.
• How do commercial banks create credit?

  Commercial banks create credit by lending out a portion of deposited funds. For example, if a bank receives a £100 deposit, it may lend out £90 of it. This new loan becomes another deposit, expanding the money supply.
• What are the main functions of a central bank?

  1. Monetary Policy: Controls money supply and sets interest rates to influence inflation and economic growth.
  2. Lender of Last Resort: Provides emergency funds to banks facing liquidity crises.
  3. Exchange Rate Management: Stabilizes the national currency’s exchange rate.
  4. Banker to the Government: Manages government’s finances, including issuing government bonds.
• What are the key tools of monetary policy?

  • Interest Rate Changes: Raising or lowering interest rates to influence borrowing and spending.
  • Quantitative Easing (QE): Central bank buys government bonds to inject money into the economy.
  • Funding for Lending: Provides banks with cheap funds to encourage lending.
  • Forward Guidance: Central bank provides future expectations on interest rates to influence economic decisions.
• What are the key regulatory bodies in the UK’s financial system?

  • Bank of England: Oversees monetary policy and financial stability.
  • Prudential Regulation Authority (PRA): Regulates banks and insurance companies to ensure financial soundness.
  • Financial Policy Committee (FPC): Monitors systemic risks and financial stability.
  • Financial Conduct Authority (FCA): Regulates market conduct, protecting consumers and ensuring transparency.
• What are some causes of bank failure?

  • Maturity Mismatch: Borrowing short-term but lending long-term can cause liquidity issues if many customers demand withdrawals simultaneously.
  • Credit Risk: If too many loans default, the bank’s capital is eroded.
  • Market Risk: Losses on investments (e.g., bonds, equities) can threaten a bank’s solvency.
• What are liquidity and capital ratios, and why are they important?

  • Liquidity Ratios: Measure a bank’s ability to meet short-term obligations. A higher ratio means the bank is more liquid.
  • Capital Ratios: Show the proportion of a bank’s assets financed by equity, indicating its ability to absorb losses without failing.
• What are moral hazard and systemic risk in the context of banks?

  • Moral Hazard: The risk that banks take excessive risks because they expect government bailouts (i.e., “too big to fail”).
  • Systemic Risk: The risk that problems in one financial institution can spread throughout the financial system, potentially leading to broader economic instability.
• What is one way financial markets contribute to the economy?

  They channel savings to businesses and governments
• How do financial markets facilitate resource allocation?

  By providing capital for investment
• What do financial markets help establish for financial assets?

  The price of financial assets
• What process do financial markets use to determine the price of assets?

  By determining supply and demand
• What is liquidity in financial markets?

  The ease of converting assets into cash
• How do financial markets enhance liquidity?

  By allowing buying and selling of assets
• What is the benefit of liquidity in financial markets?

  It prevents significant price changes
• How do financial markets allow for risk sharing?

  By purchasing a variety of assets
• What types of assets can investors purchase to spread risk?

  Stocks, bonds, and insurance
• What are the main contributions of financial markets to the economy?

  • Resource allocation: Channels savings to investments
  • Price discovery: Establishes asset prices through supply and demand
  • Liquidity: Facilitates buying/selling of assets
  • Risk sharing: Allows diversification of investments
• What is the difference between the money market and the capital market?

  • Money Market: Deals with short-term securities, typically with maturities of one year or less. Examples include Treasury bills, certificates of deposit, and repurchase agreements. Its purpose is to manage short-term liquidity.
  • Capital Market: Deals with long-term financial instruments (e.g., stocks, bonds, long-term loans). It is used by companies and governments to raise funds for long-term investment projects.
• What are the different types of bonds?

  • Government Bonds: Issued by national governments, typically considered low-risk (e.g., UK Gilts, US Treasuries).
  • Corporate Bonds: Issued by companies to raise capital, generally offering higher yields than government bonds but with higher risk.
  • Municipal Bonds: Issued by local government entities to fund projects like schools, roads, or hospitals.
  • Convertible Bonds: Bonds that can be converted into a predetermined number of shares of the issuing company.
• Why is there an inverse relationship between bond prices and interest rates?

  • When interest rates increase, the yield on new bonds rises, which makes existing bonds with lower yields less attractive. This causes the price of existing bonds to fall.
  • Conversely, when interest rates fall, existing bonds with higher yields become more attractive, pushing their prices up.
• What is the credit multiplier and how does it work?

  • The credit multiplier refers to the process by which banks can lend out a portion of the deposits they receive, thus increasing the overall money supply.
  • For example, if a bank receives a £100 deposit and keeps 10% in reserves, it can lend out £90. The borrower then spends this money, which is re-deposited in another bank. This process continues, creating more money in the economy.
• What is the primary role of a central bank in monetary policy?

  To manage the economy's monetary policy
• How does a central bank influence borrowing costs?

  By controlling the base interest rate
• What happens when a central bank raises the base interest rate?

  Borrowing costs increase in the economy
• What is the purpose of inflation targeting by central banks?

  To control inflation through interest rates
• What tools do central banks use for regulating the money supply?

  Open market operations and quantitative easing
• How do central banks stabilize the currency?

  By managing exchange rates to avoid fluctuations
• What is the relationship between interest rates and inflation control?

  Adjusting interest rates influences the money supply
• What are the main functions of a central bank in monetary policy?

  • Interest Rate Control
  • Inflation Targeting
  • Stabilizing the Currency
  • Regulating the Money Supply
• What does the Monetary Policy Committee (MPC) of the Bank of England do?

  • The MPC is responsible for setting the bank rate and implementing monetary policy to achieve the government's inflation target (usually 2%).
  • The committee meets regularly to review economic conditions, considering factors like employment, economic growth, and inflation. It uses interest rate changes as its primary tool for controlling inflation.
• What is the "Funding for Lending" program?

  • Funding for Lending: A policy where the central bank provides cheap loans to commercial banks, encouraging them to lend more to businesses and households.
  • The aim is to boost lending to stimulate economic activity, particularly during times of low economic growth or recession.