Financial Markets and Monetary Policy

• The characteristics of money include durability, divisibility, transportability, non-counterfeitability, and scarcity.
• The functions of money include medium of exchange, store of value, unit of account, and standard of deferred payment.
• Narrow money (M0) includes all physical money, such as coins and notes, as well as deposits on demand and cash held by the central bank.
• Broad money (M4) includes all narrow money, as well as other financial assets which are less liquid, such as savings accounts and business and institutions bank accounts.
• Money markets are institutions that want to borrow or lend on a short-term basis.
• Primary money market instruments include new issues like treasury bills.
• Secondary money market instruments include trading in existing short-term securities.
• Banks operating in both commercial and investment banking create a systemic risk as they may use deposits from the commercial banking side of their business to fund investment banking activity.
• Pension funds collect people’s pension savings and invest them into securities.
• Insurance firms charge customers fees to provide insurance cover against all kinds of risk.
• Hedge funds are firms that invest pooled funds from different contributors in the hope of receiving high returns.
• Private equity firms invest in business and then try to make the maximum return.
• The money market allows those who require money to borrow it from those who have a surplus.
• The main functions of a central bank include providing an account for the Government, managing the National Debt by arranging the sale of bonds, redeeming debt when it has matured, paying interest for the Government on debt and actually holding debt itself.
• A central bank supports financial institutions by acting as lender of last resort, banker to retail banks, controlling the country’s currency, and overseeing the financial system.
• Monetary policy involves the government or its agents attempting to manipulate monetary variables such as the rate of interest or the money supply in order to achieve policy goals.
• Monetary policy can affect the amount of loans banks make by setting capital requirements, influence the exchange rate through buying and selling currencies and changing interest rates, and is usually responsible for controlling the issuing of banknotes and ensuring that confidence in the currency is maintained.
• A central bank manages the money supply by affecting the availability of credit or its cost, mainly done through controlling interest rates, but it can also be done through other methods, such as quantitative easing (QE).
• Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
• The current objectives of monetary policy set by the government include low inflation (UK target is CPI 2% +/ - 1) and stable economic growth.
• Key money market instruments include the treasury, which is the government’s economic and finance ministry, controlling public spending and overseeing the economic policy, and securities, which are financial assets such as shares and Treasury Bills that can be bought and sold on markets.
• Treasury bills are short-term Government securities issued by the Treasury every week to ensure sufficient holdings of cash to meet expenditure requirements.
• Monetary policy is concerned with maintaining a sustainable rate of economic growth and keeping unemployment low.
• The Monetary Policy Committee (MPC) at the Bank of England decides the rate at which Bank Rate is set each month.
• The MPC has 8 members, 4 of whom are insiders from the Bank of England and 4 are external members appointed by the chancellor of the exchequer and the Bank’s governor.
• Bank rate is the interest rate at which a nation's central bank lends money to domestic banks, often in the form of very short-term loans.
• GDP growth and spare capacity are factors considered by the MPC when setting the bank rate.
• The main task of the MPC is to set monetary policy so that Aggregate Demand (AD) grows in line with productive potential.
• Bank lending and consumer credit figures, including the levels of equity withdrawal from the housing market and also data on credit card lending which supports consumer demand, are considered by the MPC.
• Equity markets (share prices) and house prices are considered important in determining household wealth, which then feeds through to borrowing and retail spending.
• Consumer and business confidence, as indicated by confidence surveys, are factors considered by the MPC.
• Wage inflation might be a cause of cost-push inflation so the Bank of England looks carefully at what is happening to wages.
• Unemployment figures and survey evidence on the scale of shortages of skilled labour are factors considered by the MPC.
• Trends in global foreign exchange markets, including a weaker exchange rate which could be seen as a threat to inflation and a stronger exchange rate which could bring down inflation, are factors considered by the MPC.
• International data, including recent developments in the Euro Zone, emerging market countries and the United States and Japan, are factors considered by the MPC.
• A depreciation of the exchange rate increases the cost of imports so there will be an increase in cost-push inflation.
• A depreciation increases domestic demand, so there could be some demand-pull inflation.
• A depreciation makes exports more competitive, which may reduce incentives for firms to cut costs, and could lead to declining productivity and rising prices.
• A depreciation will tend to improve the current account balance of payments because exports increase relative to imports.
• The Marshall-Lerner condition states that a depreciation improves current account deficit if PED x + PED m >1.