4.2.4 Financial Markets and Monetary Policy

• Assets = anything of value owned by a firm (e.g. machinery)
• Liabilities = anything of value owed by a firm (loans)
• Debt = Money that has to be paid back with interest and includes all funds that firms borrow directly from banks.
• Equity = Total valuation of a share in the market, value to shareholder
• A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend money.
• Coupon - the guaranteed amount of interest paid to the bond-holder expressed as a percentage of the face value of the bond. The amound paid does not change over the life of the bond.
• Maturity = this refers to the date which the borrower will repay the lender. Government bonds typically have a fixed maturity date.
• Yield = this is the income return on an investment and is the amount of interest paid on the bond expressed as a percentage of the current market price of the bond. In effect, it is the long term rate of interest earned.
• As bond prices rise, the long term rate of interest falls (yield):

  • In other words, there is an inverse relationship between bond prices and interest rates
  • This relationship is crucial for governments because this affects the cost of government borrowing.
• Lower yield (interest rates) means governments can borrow easier as it is cheaper.
• Coupon = Yield x Bond Market Price

  Yield = Coupon / Bond Market Price

  Bond Market Price = Coupon / Yield
• Commercial Banks = a financial institution which aims to make profits by selling banking services to its customers.
• Investment Banks = Do not directly serve households. Key function is to help companies, governments and other financial institutions:

  • Raise finance by giving advice
  • Arranging the new issue of shares or corporate bonds
  • Provide advice and support for firms seeking a merger in terms of price, timing and strategy.
• Some banks carry out both commercial and investment banking activities - started happening when the financial markets were de-regulated in the 1980's.
• Systemic Risk = investment banks were criticised for excessive risk-taking and their contribution to global financial instability.
• The main functions of commercial banks are?

  • accepting deposits
  • advancing loans i.e. lending money so different economic agents who wish to borrow
  • Transferring bank deposits
• Subsidiary functions?

  • foreign exchange
  • insurance
  • brokerage services (mortgages)
• Assets - Money owed to the bank?

  • Cash (notes and coins)
  • Balances at Bank of England
  • Money at call and short notice
  • Bills (commercial and treasury)
  • Investments e.g. gov. and corp. bonds
  • Advances e.g. loans and mortgages
  • Fixed Assets e.g. premises/bank building
• Liabilities - Other people’s money held within the bank?

  • Deposits (sight and time deposits)
  • Share Capital
  • Reserves (retained profit)
  • Long term borrowing e.g. bonds issued by the bank
  • Short term borrowing from money markets
• Commercial Bank’s objectives?

  • Profitability
  • Liquidity
  • Security
• Profitability = implicit requirement to ensure investors receive a return on their investment through dividends.
• Liquidity = Commercial banks must ensure that they have enough liquidity to meet the legitimate demands of their depositors.
• Security = Banks ensure that their assets are as secure (safe) as possible. 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 loans, such as a credit card, is riskier for the bank as there is no underlying asset acting as security.
• Credit is any form of deferred payment.

  • With credit, its possible to pay over time while accessing essential products and services when you need them.
  • When consumers can borrow money, economic transactions increase within the economy.
• Limits of credit creation?

  • Types of Assets held by banks
  • Demand for credit
  • Central bank policy
• Types of Assets Held by Banks = Banks won’t advance all money out to customers because the balance it seeks in meeting its objectives. If it holds more liquid assets or invests elsewhere, credit creation will be limited.
• Demand for Credit - The demand for credit may fall because of higher interest rates, or faltering confidence, so if consumers do not demand credit in the first instance, credit creation will be stifled.
• Central Bank Policy - The Bank of England can change capital ratios or cash reserve requirements to influence the amount of liquid assets the bank must hold. The larger this requirement, the more limits there are on credit creation.
• Main functions of a central bank?

  • Help government maintain macroeconomic stability
  • Maintain financial stability in the monetary system
  • Smaller other important functions that help support main 2 functions
• Help Government maintain macroeconomic stability?

  • Primary remit (function) of the BoE is to deliver price stability, inflation at 2% + or - 1%.
  • Also aims to support the governments wider macroeconomic objectives to help create the right conditions for economic growth and low unemployment.
• Maintain financial stability in the monetary system?

  • Achieved by the central bank acting as lender of last resort, illiquid banks can borrow from BoE
  • Whilst expensive, this function is vital in maintaining liquidity and confidence in the financial system and ensuring depositors are protected and systemic risk is minimised
• Smaller other important functions that help support main 2 functions?

  • Controlling the issue of notes and coins
  • Acting as the banker's bank
  • Acting as the governments banks
  • Buying and selling currency to influence the exchange rate
  • Liaising with overseas central banks and international organisations
• As a result of the 2008 financial crisis, the BoE has been given extra responsibilities?

  • To promote the safety and soundness of individual financial firms
  • To protect and enhance the resilience of the financial system
• In order to fulfil all these functions, the Bank of England has the Monetary Policy Committee (MPC)
• MPC = Part of the BoE that implements monetary policy (sets interest rates and controls the money supply).
• The Bank, via the MPC, meet every month to decide the level of interest rates and any other changes to policy strategy.
• Roles of MPC?

  • Setting interest rates is the responsibility of the MPC
  • MPC: 9 members (4 independent, 5 from within bank)
  • Chaired by the Governor of the Bank of England Andrew Bailey
  • It is independent from government, which should give it more credibility (free from political influence)
• Factors affecting MPC when setting bank rate:

  • Current role of inflation
  • Consumer & Business Confidence
  • Economy’s Growth Rate
  • Levels of Employment
• How would an increase in interest rates affect exchange rates?

  • Increased interest rates means better returns for savings and attracts international investors
  • Investors purchase pounds in order to benefit from higher savings (’hot money’/ portfolio investment capital flows)
  • Pound appreciates (SPICED) causing falling prices of imports and higher priced exports
  • Reduced AD and worsens balance of payments on current account
  • Could help reduce inflation as secondary impact
• Monetary Policy Transmission Mechanism: Household demand is affected because changes in interest rates affect savings, which indirectly affect spending.