The financial sector

• The financial market is where buyers & sellers can buy or trade a range of services or assets that are monetary in nature
• The role of financial markets:

  1. Facilitate savings
  2. To lend to firms and individuals
  3. Facilitate the exchange of goods & services
  4. Providing forward markets
  5. Provide a market for equities
• Forward markets = Markets dealing in commodities, currencies and securities for future (forward) delivery at prices agreed upon today
• Equities are shares in a business' assets and profits
• Quantitative easing is where the Central Bank creates new digital money to buy financial assets (e.g. Government bonds) - Unorthodox Monetary Policy -
• Quantitative easing works as such...

  1. Central Bank creates money → 2. Central Bank undertakes a series of Asset purchases (e.g. Bonds) to inject money in economy → 3. Interest Rates decline → 4. Businesses and consumers borrow more, stimulating the economy (incr in AD)
• Market failure is when the price mechanism fails to deliver efficiency and results in a misallocation of resources
• Asymmetric info = a situation where one party (either buyer or seller) has more information than the other

  • Can occur in financial markets, due to the greater complexity compared to other markets
• Moral Hazard = when one person takes more risks because someone else bears the cost of those risks (e.g. insurance market)

  • Seen in the banking sector where some large banks are seen as 'too large to fails' due to the damage they will have on the economy so therefore the government will likely bail them out
• Market Rigging = Colluding prices or exchanging information to lead to gains for themselves
• Speculation = Investment in hope of gain but with risk of loss
• A central bank is a national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.
• Main functions of a Central Bank:

  • Implementation of Monetary Policy
  • Banker to government
  • Banker to banks (Lender of last resort)
  • Role in regulation of Banking industry (varys by country )
• Why do banks fail?

  • Borrow short and lend long: They promise depositors they can have their money back on demand but they lend that money on long-term loans
  • Consumers lose confidence (run on the bank): ↓CC = take money out their account but because its a significant number of consumers doing so, the bank will struggle to convert it's assets into cash to meet their demands
• Deeper thinking:

  Why can it be argues that when there is stability there will be growing instability?

  • Stability = instability because banks take on excessive risks, with the idea that everything will work out
  • By taking excessive risks, everyone starts speculating and market bubbles are formed, causing the price of an asset to become detached from its true value (Cause of the financial crisis)
  • Furthermore, where there are calm periods, there is going to be excessive leverage, where banks take on more investments and commitments (over-leverage) which leads to stability shocks