Monetary Policy and the Financial Sector

What Monetary Policy and the Financial Sector covers

Monetary policy and the financial sector is examined in Unit A2 2, Managing the Economy in a Global World. It covers central banks, the banking sector and the money supply, setting the base rate and the transmission of monetary policy, the Fisher equation of exchange and the quantity theory of money, the financial sector and the real economy, moral hazard in banking, regulating the financial system, regulation and the money supply in a global economy, quantitative easing, the money supply and monetary policy in an open economy and the effectiveness of monetary policy.

The 10 subtopics

Each one has its own page.

• Central banks, the banking sector and the money supplyMain functions of a central bank, central bank normally given operational independence to set interest rates and lender of last resort function.Open →
• Setting the base rate and the transmission of monetary policyBase rate, exchange rate enter the interest rate decision and credit growth.Open →
• The Fisher equation of exchange and the quantity theory of moneyFisher equation of exchange and define each term, velocity of circulation measure and why the velocity of circulation is not constant in practice.Open →
• The financial sector and the real economyMain functions of the financial sector, maturity transformation and financial intermediary reduce risk for savers.Open →
• Moral hazard in bankingHow deposit insurance creates moral hazard, existence of a lender of last resort create moral hazard and too big to fail.Open →
• Regulating the financial systemFinancial sector regulated more heavily than most other industries, why the failure of a bank is a negative externality and systemic risk.Open →
• Regulation and the money supply in a global economyRegulatory arbitrage, shadow banking and offshore financial centres weaken domestic financial regulation.Open →
• Quantitative easingQuantitative easing, portfolio rebalancing channel of asset purchases and asset purchase programme work through expectations.Open →
• The money supply and monetary policy in an open economyIncrease in the money supply affect inflation, change in the money supply affect the exchange rate and competitive depreciation.Open →
• The effectiveness of monetary policyMain weaknesses of monetary policy, liquidity trap and rise in interest rates affect borrowers and savers differently.Open →

What you need to know

Answer each one before you reveal it.

Take Monetary Policy and the Financial Sector further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

• Microprudential regulation vs Macroprudential regulation

  Microprudential regulation: asking whether each firm is individually safe. Macroprudential regulation: asking whether the system is safe, recognising that identical prudent responses across all firms, such as selling assets to restore ratios, can be collectively destabilising.

Questions from this topic

Each one with the model answer underneath.

1. 1

   What are the main functions of a central bank?

   Model answer

   A central bank sets and operates monetary policy, usually by choosing a policy interest rate and by buying or selling assets. It issues the currency and is the ultimate source of settlement money in the economy. It acts as banker to the government, holding its account and managing the issue of its debt. It acts as banker to the commercial banks, holding their reserve balances and operating the payments system through which they settle with one another. It acts as lender of last resort to solvent but illiquid banks. It holds and manages the country's foreign exchange reserves. And it is generally responsible for the stability of the financial system as a whole, including supervision of banks and the setting of capital and liquidity requirements.

2. 2

   Why is a central bank normally given operational independence to set interest rates?

   Model answer

   A government that controls interest rates faces a temptation to keep them low, because the gain in output and employment comes quickly and the inflation arrives later, often after an election. Once the public expects that behaviour, it builds higher inflation into wage and price setting, so the government must deliver ever-looser policy simply to get the same output gain, and the economy ends up with higher inflation and no more output. Handing the instrument to an institution with a clear mandate for price stability and no electoral horizon removes the temptation. Because the commitment is credible, expected inflation falls, and the central bank can hit the target with less unemployment than a government could.

3. 3

   What does it mean to say that a central bank is banker to the commercial banks?

   Model answer

   Every commercial bank holds an account at the central bank, and the balances in those accounts are called reserves. When a customer of one bank pays a customer of another, the two banks settle by transferring reserves between their central bank accounts, so the central bank sits at the centre of the payments system. Because those reserves are the only asset with which banks can finally settle, the central bank controls the terms on which the ultimate settlement asset is supplied, and the rate it pays or charges on those balances sets the floor for interest rates across the whole banking system.

4. 4

   What is the lender of last resort function, and why does a banking system need one?

   Model answer

   Lender of last resort means that the central bank stands ready to lend to a bank that is solvent, in the sense that its assets exceed its liabilities, but illiquid, in the sense that it cannot turn those assets into cash quickly enough to meet withdrawals. Banks need such a backstop because their business is to hold long-term, illiquid loans while owing short-term, instantly withdrawable deposits, so no bank can ever repay all its depositors at once. Without a backstop, a solvent bank facing sudden withdrawals would have to sell assets at fire-sale prices and could be forced into failure by nothing more than a loss of confidence. Lending freely against good collateral at a penalty rate stops that happening while discouraging banks from relying on the facility.

5. 5

   Explain step by step how a run on a bank develops and how it can spread.

   Model answer

   First, a bank holds only a small fraction of its deposits in liquid form, because the rest is lent out long term. Second, news or rumour leads some depositors to doubt whether the bank can repay. Third, because those who withdraw first are paid in full while those who wait may not be, each depositor's best response is to withdraw immediately even if they believe the bank is basically sound. Fourth, the withdrawals exhaust the bank's liquid assets, forcing it to sell loans and securities quickly at depressed prices. Fifth, those forced sales push down the market value of the same assets held by other banks, weakening their balance sheets. Sixth, depositors at other banks observe this and begin to withdraw as well, so a problem at one institution becomes a system-wide panic. Deposit insurance and lender of last resort facilities exist to break the logic at the third step by removing the incentive to run.

6. 6

   Analyse how a change in a central bank's policy rate feeds through to the rates commercial banks charge borrowers and pay savers.

   Model answer

   The policy rate determines what banks earn on their reserves at the central bank and what they pay to borrow reserves overnight, so it fixes the marginal cost and marginal return of a bank's most liquid funds. A rise makes it more attractive to hold reserves and more expensive to fund lending, so banks raise the rate they charge on new loans and on variable-rate borrowing such as overdrafts and tracker mortgages, and they raise savings rates in order to attract deposits rather than borrow at the higher rate. The pass-through is rarely complete or immediate: banks pass rises to borrowers faster than to savers where competition for deposits is weak, and loans already fixed do not change at all until they are refinanced.

What is inside Levo

Six ways to work the same material.

Monetary Policy and the Financial Sector revision questions

What does Monetary Policy and the Financial Sector cover in CCEA A-Level Economics?

10 subtopics: central banks, the banking sector and the money supply, setting the base rate and the transmission of monetary policy, the fisher equation of exchange and the quantity theory of money, the financial sector and the real economy, moral hazard in banking, regulating the financial system, regulation and the money supply in a global economy, quantitative easing, the money supply and monetary policy in an open economy and the effectiveness of monetary policy. Each one has its own page with questions and model answers.

How is Monetary Policy and the Financial Sector organised?

By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.