Financial Markets & Monetary Policy (AQA A Level Economics): Exam Questions

Since 1998, the Bank of England has had responsibility for the operation of monetary policy and maintaining price stability. In response to the financial crisis of 2007–08, the Financial Services Act 2012 gave the Bank of England overall responsibility for financial stability. This was designed to reduce systemic risk and the impact on the real economy of problems that arise in financial markets.

Extract F: A new financial crisis?

Has increased regulation worked or could the UK be on the verge of another financial crisis? The Bank of England is keeping a close watch on consumer spending amid signs that households are reducing their savings and building up debts. The Governor of the Bank, Mark Carney, said that consumption has been high in recent times, helping the economy, but he repeated the warning that living costs were likely to rise on the back of a weak pound and put a strain on households’ real incomes. He also stated: “The saving ratio has fallen towards its pre-crisis lows, and consumer borrowing has accelerated noticeably.”

It can be argued that rising borrowing has been caused by Bank Rate being kept too low for too long. The Austrian economist, Friedrich Hayek, highlighted artificially low interest rates and excessive credit creation as being the main causes of cyclical instability, damaging both investment and confidence. Asset price bubbles occur, including unsustainable rises in house prices, and eventually boom turns to bust. A major cause of the financial crisis in 2007/08 was arguably the unsustainably high level of debt that had been accumulated, but total world debt is now far in excess of the 2008 level.

Some form of financial crisis appears to occur every 7 to 10 years. As inflation rises, there will come a time when the Monetary Policy Committee decides to increase Bank Rate. This will affect many people who have become accustomed to cheap credit and who are tied into mortgages where the monthly repayments vary with interest rates.

Source: News reports, 2016

Extract F: The Japanese problem

If the UK wishes to see another economy’s experience of when deflation turns bad, then it only needs to look at Japan. Over the last two decades, Japan has used a variety of policies in an attempt to overcome deflation. For almost 20 years, the Bank of Japan’s main interest rate has hovered around 0% and at times been negative. Japan has embarked on several fiscal stimulus programmes, although with a debt to GDP ratio of 245% in 2015, some see this as a worry. Furthermore, the Bank of Japan is currently carrying out quantitative easing equivalent to approximately £500bn per year. So far, the Japanese economy has not escaped from the risk of deflation.

So what can the UK learn from Japan? For much of 2015, CPI inflation in the UK was at, or very close to, 0%. Consumer spending is fairly robust at the moment but if economic agents anticipate falling prices, they may begin to factor this into their expectations. This could lead to bad deflation which can be very difficult to tackle effectively.

In recent times, the UK has arguably seen a stronger recovery than many other developed economies, although there is uncertainty over what should be done to maintain this in the future. After the financial crisis of 2007/08, UK Bank Rate was reduced to an historic low of 0.5%, and although it has since been cut to 0.25%, there is little scope to reduce it much further. The Bank of England has also used quantitative easing to try to stimulate the economy. However, the results of this are debatable. In terms of fiscal policy, the current government appears to be determined to continue with its austerity programme. What is not clear is what should be done if low inflation turns to bad deflation.

Source: News reports, 2016

In November 2022, the Bank of England warned there was a risk that the UK was heading for a recession. This announcement came shortly after the money supply fell, following its rapid growth in 2020 and 2021.

Extract B: Irish corporation tax

Ireland has dropped its low-tax policy of the past 18 years, which had helped to persuade some of the world’s biggest companies, including Google and Facebook, to site their European headquarters in Ireland. Countries who are members of the Organisation for Economic Co-operation and Development (OECD), have agreed to a minimum corporation tax rate of 15%. Initially, Ireland was one of nine countries that refused to join the scheme but they have now all agreed to do so.

The deal brings an end to the country’s 12.5% corporation tax rate that has applied since January 2003, which has been criticised in other EU countries and the UK, where higher corporation tax rates have applied. The new tax, which will be limited to firms with annual global revenues of over €750m, will come into force in 2023. According to some estimates, it will cost the Irish government between €800m and €2bn a year in lost tax revenue. Multinational corporations (MNCs) located in Ireland and elsewhere, employing up to 500 000 staff, could be affected.

Over the years, as a consequence of its low corporate tax policy, Ireland has attracted an estimated 1000 MNCs in the technology, finance and pharmaceutical sectors, including Pfizer, Intel, Yahoo, LinkedIn, TikTok, Apple, IBM and Twitter. Such is the importance of MNCs to the Irish economy, that figures released in May showed that just 100 companies accounted for almost 80% of government tax revenue. The figures exclude those sectors closed due to the lockdown, including hospitality and travel, but showed Ireland’s reliance on MNCs for employment and tax revenue. In 2020, about 32% of all jobs in Ireland were in MNCs and those employees contributed 49% of all taxes on income.

Source: News reports, 2021

Extract E: Unconventional monetary policy?

Since March 2009, an experiment has been underway in the UK. The Bank of England reduced Bank Rate to almost zero and introduced a new policy to the UK, known as quantitative easing (QE). Back then, financial markets around the world were in crisis and banks in the UK decreased lending, reducing the availability of credit for households and firms. This damaged the real economy and created high unemployment.

Faced with these problems, the Monetary Policy Committee (MPC) decided to cut Bank Rate to 0.5%, down from 5% in October 2008, but this was not enough on its own. Emergency meetings with the Chancellor at the time, Alistair Darling, led to the use of unconventional monetary policy in the form of QE. Initially, the Bank of England bought bonds worth £75bn but soon began to purchase more.

QE was originally intended to be an emergency measure but has remained in place. The total spent on buying government bonds under QE has been expanded repeatedly, reaching £895bn, with the latest round coming during the coronavirus pandemic. However, the fact that the Bank of England has continued increasing its bond purchases, and that interest rates remain close to zero, indicate that QE may not have been as successful as was hoped. Andrew Sentance, an economist who was on the MPC and who helped draw up the plan, said that financial markets in March 2009 pointed to Bank Rate returning to 3% by 2011. He also stated that he didn’t think anybody on the MPC believed that QE was anything other than an emergency measure.

In some respects, the policy worked wonders. The UK enjoyed a strong recovery from the 2008 crash and had the longest run of unbroken quarterly growth of any major economy. UK unemployment peaked at 8.5%, compared to 10% in the US and 12.1% in the eurozone. It then dropped to 3.8% before the pandemic, the lowest rate since the mid-1970s.

20 Source: News reports, 2022

Extract F: Quantitative easing – a dangerous addiction?

While helping to keep borrowing costs down, low interest rates and QE created huge inequalities. Those with assets such as property have seen their prices soar. The FTSE 100 share index reached record highs and more than doubled between 2009 and 2021. The least wealthy 10% of households saw their real wealth rise by an average of £3000 between 2008 and 2014, compared to an average rise of £350 000 for the wealthiest 10%. However, the Bank of England argues that QE has helped to keep people in work.

Low interest rates meant that the return on savings fell but families with mortgages had cheaper repayment costs. This encouraged spending, helping to fuel the economic recovery. Cheap borrowing costs have, however, allowed debts to build up. Borrowing on credit cards, personal loans and car finance have soared above pre-2008 levels. There is also the effect on the cost of living through higher inflation rates.

Rock-bottom interest rates and QE stimulated the economy. However, the Conservative-led coalition government, elected in 2010, adopted a policy of austerity, cutting government spending to reduce the budget deficit. Monetary policy fuelled growth, but austerity pulled in the opposite direction. This made it harder to raise Bank Rate as growth was low. Although interest rates began to rise in late 2017 and 2021, they are still below the rates seen before the 2007–08 financial crisis.

Some say that the use of QE is a dangerous addiction and its overuse can lead to problems in the future. Many economists believe QE has lost some of its effectiveness and warn that a fresh round could lead to higher inflation and increase wealth inequality. It is argued that, in the future, the Treasury should use fiscal policy to stimulate the economy rather than relying on QE

Source: News reports, 2022

Commercial banks provide financial services for both individuals and businesses. In 2007–08, the financial crisis led many to argue for tighter regulation of the banks to prevent problems in financial markets affecting the real economy. However, financial markets are not the only source of cyclical instability. Governments can use a variety of policies to try to create a more stable economy.