Notes · EconomicsUK · A-Levels

Financial markets and monetary policy

This chapter explains the role of money and the financial system and how monetary policy works. It covers the structure and function of financial markets, commercial banks and credit creation and the 2008 financial crisis, the role of the central bank and the objectives of monetary policy, and the instruments of monetary policy - Bank Rate, quantitative easing and forward guidance - and their transmission to the wider economy.

4 sections~18 min reading time4 competenciesLevel Standard 2 · Advanced 2

T·121212 / 14

Exam profile

AO1 · Define money, financial markets, monetary policy, Bank Rate and quantitative easingAO2 · Apply the monetary transmission mechanism to changes in Bank Rate and to dataAO3 · Analyse how monetary policy influences AD, output, inflation and the exchange rateAO4 · Evaluate the effectiveness and limitations of monetary policy including QE and very low interest rates

Operators:defineexplainanalysecalculateevaluateassessdraw a diagram to show

basic level

AS-Level requires the role of money and the central bank and how interest rates affect aggregate demand.

higher level

The full A-Level adds financial-market structure, credit creation, the financial crisis, and a critical evaluation of monetary policy including QE.

Depth

Text

Contents · 4 sections

Financial markets and monetary policy

The structure and role of financial markets#

StandardAQA 7136 4.2.4DfE GCE Economics - the structure of financial markets

The structure of financial markets

Fig. 1Financial markets are classified by the maturity and type of asset traded; capital markets split into debt (bonds) and equity (shares).

Financial markets are markets in which financial assets - claims to future money, such as loans, bonds, shares and currencies - are traded. They perform vital functions for the wider economy: they channel funds from savers (lenders) to borrowers (facilitating investment and consumption); they provide a means of saving and of borrowing; they allow risk to be spread and managed (through insurance and derivatives); they provide liquidity (turning assets into cash); and they establish the prices of financial assets, including interest rates and exchange rates. A well-functioning financial system raises the economy's productive potential by allocating savings to their most productive uses.

The main types of financial market are distinguished by what and for how long they trade. Money markets deal in short-term borrowing and lending (loans of less than a year - Treasury bills, interbank loans), providing short-term liquidity. Capital markets deal in longer-term finance: the bond market (debt - governments and firms borrow by issuing bonds that pay interest) and the equity (stock) market (firms raise finance by issuing shares, which give ownership and a claim on profits). Foreign exchange (forex) markets trade currencies, setting exchange rates. Understanding the debt-equity distinction is important: debt (bonds, loans) must be repaid with interest regardless of performance, whereas equity (shares) gives part-ownership and dividends that depend on profit.

There is an inverse relationship between the price of a bond and its yield (effective interest rate) that the specification requires. A bond pays a fixed cash amount (the coupon); if the market price of the bond rises, that fixed coupon represents a smaller percentage return, so the yield falls, and vice versa. When central banks buy bonds (as in quantitative easing), they raise bond prices and so lower yields - long-term interest rates - which is one channel through which policy works. This relationship, though it looks technical, is the mechanism behind much of monetary policy.

Financial markets are enormously beneficial but also a potential source of instability, which is why they are regulated. By channelling savings to investment and spreading risk, they support growth; but they can also fail - through asymmetric information (borrowers know more than lenders), moral hazard (taking excessive risk when protected from the consequences), speculation and bubbles, and systemic risk (the failure of one institution cascading through the interconnected system). The 2008 financial crisis, examined next, is the defining example of financial-market failure and of why the sector is so heavily regulated.

Worked example

The bond price-yield relationship

A bond pays a fixed coupon of 5 pounds a year. Find its yield if it is priced at 100 pounds, and then if its market price rises to 125 pounds.

Yield at 100 pounds
Yield = coupon / price = 5 / 100 = 5%.
Yield at 125 pounds
Yield = 5 / 125 = 4%: the same fixed coupon is now a smaller percentage of the higher price.
Interpret
As the bond's price rose from 100 to 125, its yield FELL from 5% to 4% - the inverse relationship. Central-bank bond buying (QE) works this way, raising prices and cutting long-term yields.

Result: The yield falls from 5% to 4% as the bond price rises from 100 to 125 pounds - illustrating the inverse price-yield relationship behind QE.

Typical mistakes

Confusing debt (bonds - repaid with interest) with equity (shares - ownership and dividends).
Thinking a rise in bond prices raises yields - the relationship is inverse (higher price, lower yield).

Active revision

Explain the functions performed by financial markets in a modern economy, and why their failure can damage the wider economy.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Commercial banking, credit creation and the financial crisis#

AdvancedAQA 7136 4.2.4DfE GCE Economics - commercial and investment banks

Credit creation through the banking system

Fig. 2With a 10% reserve ratio, an initial deposit of 1,000 supports successive rounds of new lending (900, 810, ...) that sum to a total of 10,000 - the money multiplier of 1/0.1 = 10. Illustrative.

Commercial (retail) banks take deposits from households and firms and make loans, while investment banks help firms raise capital and trade in securities (some banks do both). A commercial bank's business is captured by its balance sheet, which balances assets (what it owns or is owed - cash and reserves, loans to customers, and investments) against liabilities (what it owes - principally customers' deposits, which the bank must repay on demand). In managing this balance sheet, a bank pursues three objectives that pull against one another: liquidity (holding enough cash and easily sold assets to meet withdrawals), profitability (making profitable but often illiquid and risky loans), and security (avoiding excessive risk). The tension between liquidity and profitability is fundamental to banking.

Banks create money through credit creation, one of the most important and least intuitive ideas in the chapter. Because only a fraction of deposits is ever withdrawn at once, a bank need keep only a fraction of deposits as reserves (the reserve or liquidity ratio) and can lend out the rest. When a bank makes a loan, it credits the borrower's account, creating a new deposit - new money. That money is spent and much of it is redeposited in the banking system, allowing further lending, and so on in diminishing rounds. Through this process the banking system as a whole can create deposits that are a multiple of the original cash, the money multiplier being 1 divided by the reserve ratio. Most money in a modern economy is bank deposits created this way, not cash.

Credit creation is powerful but risky, because it rests on confidence. If depositors lose confidence and try to withdraw their money at once (a bank run), a bank that has lent out most of its deposits cannot pay them all - it is illiquid even if fundamentally solvent. And because banks are deeply interconnected (they lend to and borrow from each other), the failure of one can spread to others - systemic risk. This is the danger the central bank, as lender of last resort, exists partly to contain.

The 2008 global financial crisis is the specification's case study in these dangers. In brief: a long boom in cheap credit fuelled a bubble in US house prices; banks made and then repackaged risky 'sub-prime' mortgages into complex securities sold worldwide, with credit ratings that understated their risk (asymmetric information); when house prices fell and borrowers defaulted, these assets collapsed in value, and because no one knew which banks were exposed, banks stopped lending to each other (a credit crunch). Highly leveraged banks faced insolvency; the failure of major institutions (such as Lehman Brothers) threatened systemic collapse, forcing governments and central banks to rescue banks and to slash interest rates. The crisis triggered a deep recession and led to much tighter regulation (higher capital and liquidity requirements) to reduce moral hazard and systemic risk - a vivid illustration of financial-market failure and government intervention.

\text{Money multiplier} = \frac{1}{\text{reserve ratio}}

The money (credit) multiplier

The banking system can create total deposits equal to the money multiplier times the initial cash. A 10% reserve ratio gives a multiplier of 10, so 1,000 of cash can support 10,000 of deposits.

Worked example

The money multiplier in action

Banks keep a reserve ratio of 10%. A new deposit of 1,000 pounds of cash enters the banking system. Calculate the money multiplier and the maximum total deposits the system can create.

Money multiplier
Money multiplier = 1 / reserve ratio = 1 / 0.10 = 10.
Maximum total deposits
Total deposits = money multiplier x initial cash = 10 x 1,000 = 10,000 pounds.
Credit created
Of the 10,000 total, 1,000 is the original cash, so 9,000 pounds of new money (credit) has been created by the banking system through successive rounds of lending.

Result: With a 10% reserve ratio the money multiplier is 10, so 1,000 pounds of cash supports 10,000 pounds of deposits - 9,000 of it newly created credit.

Typical mistakes

Thinking banks only lend out existing deposits - through credit creation the banking system creates new deposits (money) many times the original cash.
Confusing a liquidity crisis (cannot meet withdrawals now) with insolvency (liabilities exceed assets) - though one can trigger the other.

Active revision

Explain how commercial banks create credit, and analyse why this process can pose a risk to financial stability.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

The central bank and the objectives of monetary policy#

StandardAQA 7136 4.2.4DfE GCE Economics - the role of central banks

The money market and the interest rate

Fig. 3The interest rate is set where the demand for money (liquidity preference) meets the money supply. An increase in the money supply (a rightward shift) would lower the interest rate.

The central bank (in the UK, the Bank of England) sits at the heart of the financial system and performs several functions. It implements monetary policy (setting interest rates and influencing the money supply to meet the inflation target); it acts as banker to the government and to the commercial banks; it is the lender of last resort (providing emergency liquidity to solvent banks facing a run, to prevent systemic collapse); it manages the country's foreign-exchange reserves and, with the regulators, oversees the stability and regulation of the financial system. Since 1997 the Bank of England has been operationally independent, setting interest rates free from day-to-day political control, which is intended to make anti-inflation policy more credible.

Monetary policy is the use of interest rates, the money supply and credit conditions to influence aggregate demand and so to meet the government's macroeconomic objectives - principally the 2% CPI inflation target, while supporting growth and employment. In the UK, monetary policy decisions are taken by the Monetary Policy Committee (MPC), which meets regularly to set Bank Rate (the interest rate the central bank pays on reserves, which anchors other interest rates) with the aim of keeping inflation at target over the medium term.

The framework works through inflation targeting: if the MPC expects inflation to rise above target (for instance because the economy is overheating), it raises Bank Rate to dampen demand; if it expects inflation to fall below target (in a downturn), it cuts Bank Rate to stimulate demand. Because monetary policy affects the economy with long and variable time lags, the MPC must be forward-looking, setting policy on the basis of forecasts of where inflation will be in one to two years' time, not where it is now. The exact channels by which a change in Bank Rate feeds through to demand and inflation - the transmission mechanism - are the subject of the final section.

The independence and credibility of the central bank matter for how well the framework works, which is an evaluation theme. An independent central bank with a clear inflation target can anchor inflation expectations: if firms and workers believe inflation will stay near 2%, they set prices and wages accordingly, which helps keep inflation low without the cost of high unemployment. But monetary policy also faces limits - time lags, the difficulty of forecasting, and the constraint that interest rates cannot fall far below zero - which is why, since 2008, central banks have turned to unconventional tools such as quantitative easing, examined next.

Worked example

Deciding the direction of monetary policy

The MPC forecasts that in eighteen months' time inflation will be 4% (target 2%) because the economy is overheating. What should it do to Bank Rate, and why act now rather than later?

Diagnose
Forecast inflation (4%) is above the 2% target and the economy is overheating (a positive output gap), so demand needs to be restrained.
Choose the policy
The MPC should RAISE Bank Rate: higher interest rates raise the cost of borrowing and the reward for saving, dampening consumption and investment, and so reducing AD and inflationary pressure.
Explain the timing
Because monetary policy affects inflation with a lag of up to two years, the MPC must act now on the forecast - waiting until inflation is actually 4% would be too late to bring it back to target in time.

Result: The MPC should raise Bank Rate now, acting on the forecast, because policy affects inflation only after a long time lag.

Typical mistakes

Confusing monetary policy (interest rates and the money supply, set by the central bank) with fiscal policy (tax and government spending, set by the government).
Thinking the central bank sets all interest rates - it sets Bank Rate, which influences the rates banks charge and pay.

Active revision

Explain how the Monetary Policy Committee uses Bank Rate to try to keep inflation at its 2% target.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Monetary policy instruments and the transmission mechanism#

AdvancedAQA 7136 4.2.4DfE GCE Economics - monetary policy instruments

The monetary transmission mechanism

Fig. 4A cut in Bank Rate raises AD through several channels - cheaper borrowing (C and I), higher asset prices and wealth, and a lower exchange rate (higher net exports) - lifting output and inflation towards target.

The central bank's main instrument is Bank Rate, the interest rate it sets, which anchors the interest rates commercial banks charge borrowers and pay savers. When conventional policy is exhausted - notably when Bank Rate is already near zero (the zero lower bound) - central banks turn to unconventional instruments. Quantitative easing (QE) is the creation of new central-bank money to buy financial assets, mainly government bonds, from the private sector; this raises bond prices and lowers long-term yields (interest rates), increases the money supply, and aims to stimulate lending and spending. Forward guidance is the central bank communicating its likely future policy (for example, promising to keep rates low for a long time) to influence expectations and so current spending and investment.

A change in Bank Rate affects aggregate demand and inflation through the monetary transmission mechanism - a chain of effects worth learning as a sequence. A CUT in Bank Rate lowers borrowing costs and the return to saving, which: raises consumption (cheaper loans and mortgages, less incentive to save) and investment (cheaper for firms to borrow); raises asset prices and wealth (lower interest rates raise house and share prices), further boosting consumption; and tends to lower the exchange rate (lower returns make the currency less attractive to hold), which raises net exports by making exports cheaper and imports dearer. Each channel raises a component of AD, so AD shifts right, raising output and (depending on spare capacity) the price level towards the inflation target.

The reverse chain applies to a RISE in Bank Rate, which raises borrowing costs, dampens consumption and investment, lowers asset prices and wealth, and raises the exchange rate (cutting net exports) - shifting AD left to reduce inflationary pressure. The mechanism is best shown on an AD/AS diagram: an interest-rate cut shifts AD right (raising output and prices), a rise shifts it left. The exchange-rate channel links monetary policy to the international economy covered in the next chapter.

The effectiveness of monetary policy is a major evaluation theme, and it has real limits. It works with long and variable time lags (up to two years), so it can be mistimed. Its effect depends on the responsiveness of consumers and firms: if confidence is very low (as in a deep recession or a liquidity trap), even very low interest rates may not revive borrowing and spending, so monetary policy 'pushes on a string'. QE's benefits are uncertain and it can inflate asset prices (worsening wealth inequality) without much boosting real spending. Interest rates cannot fall far below zero, limiting the room to ease. And monetary policy is a blunt, economy-wide instrument that cannot target particular regions or sectors. Whether a change in policy has the intended effect therefore 'depends on' the state of confidence, the level of spare capacity, the health of the banking system, and how households and firms respond - which is why monetary and fiscal policy are often used together.

\text{Real interest rate} \approx \text{nominal interest rate} - \text{inflation rate}

The real interest rate

What matters for borrowing and saving decisions is the real (inflation-adjusted) interest rate. If nominal rates are 5% and inflation is 3%, the real interest rate is about 2%.

A cut in Bank Rate raises aggregate demand

Fig. 5By raising consumption, investment and net exports, a cut in Bank Rate shifts AD right from AD1 to AD2, raising real output and the price level along the SRAS curve.

Worked example

Tracing a Bank Rate cut and the real interest rate

The central bank cuts Bank Rate from 5% to 2% while inflation is 3%. Trace the effect on aggregate demand, and comment on the real interest rate.

Trace the transmission
Cheaper borrowing raises consumption and investment; higher asset prices raise wealth and spending; a lower exchange rate raises net exports. Each raises a component of AD, shifting AD right.
Effect on output and prices
On the AD/AS diagram, the rightward AD shift raises real output (and employment) and, with spare capacity, the price level - supporting the economy towards the inflation target.
Assess the real rate
The real interest rate falls from about 5% - 3% = 2% to about 2% - 3% = -1%. A NEGATIVE real rate strongly encourages borrowing over saving - but only if confidence is high enough for households and firms to respond.

Result: The cut shifts AD right (raising output and prices) and turns the real interest rate negative (about -1%), strongly encouraging spending - provided confidence is not too weak.

Typical mistakes

Forgetting the exchange-rate channel - a rate cut tends to lower the currency and raise net exports.
Ignoring the real interest rate - a cut in nominal rates may not lower the real rate if inflation falls too.

Active revision

Evaluate the effectiveness of cutting interest rates and using quantitative easing to stimulate an economy in a deep recession.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

Financial markets and monetary policy

4 sections~18 min reading time4 competenciesLevel Standard 2 · Advanced 2

Financial markets and monetary policy

Key points

The bond price-yield relationship

Key points

The money multiplier in action

Key points

Deciding the direction of monetary policy

Key points

Tracing a Bank Rate cut and the real interest rate

Sources

Financial markets and monetary policy

Key points

The bond price-yield relationship

Key points

The money multiplier in action

Key points

Deciding the direction of monetary policy

Key points

Tracing a Bank Rate cut and the real interest rate

Sources