12. Financial Markets & Monetary Policy (AQA A Level Economics): Flashcards

Good money must be divisible, meaning it can be divided into smaller units for exchange.

Money acts as a medium of exchange, a measure of value, a store of value, and a method of deferred payment.

Debt is a liability representing what a firm owes; those who lend money to the firm are called creditors.

Equity represents the physical and financial assets owned by a firm, and can be raised by selling shares that give holders ownership rights.

False.

Creditors have no ownership or voting rights; those belong to shareholders, who hold equity.

Shareholders are entitled to a share of the company's profits paid as dividends.

Money raised through debt must be repaid to creditors with interest.

A coupon is the guaranteed fixed annual interest payment made to a bondholder for the duration of the bond.

The nominal value is the face value at which a bond is issued and which the investor receives back at maturity.

There is an inverse relationship: as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise.

True.

Newly issued bonds offer higher returns, so demand for lower-coupon existing bonds falls and their price falls.

Before it reaches maturity, a bond can be resold in secondary markets.

Yield equals the annual coupon payment divided by the current market price, multiplied by 100.

Maturity is the expiration date of a bond, usually more than one year away, at which the investor receives the full nominal value.

Commercial banks, also known as retail or high-street banks, make profits by selling banking services such as loans and deposits to consumers and businesses.

Investment banks are global banks that help companies, institutions, and governments raise finance by issuing shares and bonds and advising on mergers.

False.

Investment banks are not dependent on branch networks; extensive high-street branches are a feature of commercial banks.

Assets are resources owned by the bank, such as cash, investments, and advances, including money owed to the bank.

On a balance sheet, total assets must always equal total liabilities.

Liabilities are amounts owed by the bank and act as a source of finance, for example deposits from savers and bonds the bank has issued.

A bank holds liquid assets so it can always meet customer withdrawal requests, maintaining confidence and preventing a run on the bank.

True.

Higher interest rates compensate for greater risk, so a bank must balance profitability against its desired level of security.

A commercial bank must balance liquidity, security, and profitability, which can conflict with one another.

Fractional reserve banking is the process by which banks create credit by keeping only a fraction of deposits as reserves and lending out the rest.

The central bank requires commercial banks to hold a percentage of their deposits as reserves.

Maximum total deposits equal the initial deposit divided by the reserve ratio, reflecting the credit multiplier.

A central bank is the government's bank that issues currency and controls the supply of money in the economy.

As lender of last resort, the central bank lends to commercial banks facing short-term liquidity problems, preventing bankruptcy and financial instability.

Monetary policy is the use of interest rates, the money supply, credit, and the exchange rate to help achieve the government's macroeconomic objectives.

Monetary policy aims to achieve a low and stable rate of inflation and low unemployment, among other macroeconomic goals.

True.

The Monetary Policy Committee meets eight times a year and its nine members decide policy by majority vote.

The Monetary Policy Committee decides monetary policy by majority vote.

The Monetary Policy Committee consists of nine members.

Expansionary monetary policy aims to boost aggregate demand and growth, for example by cutting interest rates or increasing quantitative easing.

Contractionary monetary policy aims to slow growth or reduce inflation, for example by raising interest rates or reducing quantitative easing.

False.

Raising interest rates is contractionary monetary policy, which aims to shift aggregate demand to the left.

Expansionary monetary policy aims to shift aggregate demand to the right.

The single most important consideration for the MPC is the 2% CPI inflation target.

The bank rate is the interest rate set by the central bank to influence borrowing, spending, and investment in the economy.

The transmission mechanism is the ripple effect through the economy by which a monetary policy decision, such as a change in the bank rate, affects output and inflation.

Forward guidance is a communication tool the central bank uses to signal its likely future policy, shaping market expectations and economic behaviour.

True.

Under quantitative easing, the central bank creates new money to buy open-market assets, increasing the money supply.

To lower inflation, the MPC will increase the interest rate.

Higher rates attract hot money inflows, raising demand for the pound so the exchange rate appreciates.

True.

Higher rates offer investors a better return, causing capital inflow that raises demand for the pound and its value.

The MPC's main goal when setting the bank rate is to achieve price stability.

Lower interest rates cause the exchange rate to fall, making exports relatively cheaper.

Quantitative easing is when the central bank creates new money to buy open-market assets, increasing the money supply to stimulate the economy.

Interest rate changes work through consumption, investment, and net exports via the exchange rate.

The MPC usually adjusts the interest rate in small increments of no more than 0.25%.

Moral hazard is the tendency of banks to take excessive risks because they expect governments to bail them out, seeing themselves as 'too big to fail'.

The Financial Conduct Authority (FCA) regulates financial services firms and markets to ensure they operate fairly and in consumers' best interests.

Systemic risk is the risk that the failure of a single bank triggers the breakdown of an entire market or financial system, spreading across borders.

True.

The Prudential Regulation Authority (PRA) sets rules for banks and insurers and monitors compliance to help avoid insolvency.

The liquidity ratio compares a bank's cash and liquid assets to its deposits.

The liquidity ratio is the ratio of a bank's cash and other liquid assets to its deposits, measuring its ability to meet short-term obligations.

A bank may fail through issuing too many high-risk loans, which can lead to bad debt and a run on the bank.

The capital ratio is the amount of capital on a bank's balance sheet as a proportion of its loans, indicating the level of risk in its lending.

False.

Bailing out banks increases moral hazard, as banks take greater risks expecting the government to bear the consequences.

The capital ratio expresses a bank's capital as a proportion of its loans.

Asymmetric information occurs when sellers of complex financial products hold an information advantage over buyers, contributing to bank failures.

The three main regulators are the Prudential Regulation Authority, the Financial Policy Committee, and the Financial Conduct Authority.