The International Economy

The balance of payments

Trade balance
- Measures the net value of trade between countries
- Value of exports - value of imports

Current account
- Measures the difference between money and credit going in and out of
an economy

Financial flows
- Flows of capital across national borders including debt, equity, and
foreign direct investment

Primary income
- The net flow of profits, interest, and dividends from investments in
other countries and remittances from migrant workers

Secondary income
- Net flow of overseas aid/debt relief, military grants, etc…

NET FDI
- Investment made by a firm/individual in one country into business
located in another one

Net portfolio investment

- Investments in the form of a portfolio of assets
- Includes transactions in equity, securities, and debt securities

Hot money
- Flow of capital from one country to another for short term profit on
interest rate differences or anticipated exchange rate shifts
Components of the balance of payments
- A record of all financial transactions made between consumers, firms,
and the government from one country with other countries
- It states how much is spent on imports and what the value of export is
- Exports
- Goods and services sold to foreign countries
- Positive in the balance of payments
- Inflow of money
- Imports
- Goods and services bought from foreign countries
- Negative in the balance of payments
- Outflow of money
- Balance of payments is made up of
- The current account
- Includes all economic transactions between countries
- Main transactions are the trade in goods/services, income
and current transfers
- The capital account and financial account
- Capital transfers involve transfers of the ownership of fixed
assets
- The financial account involves investment
- Direct investment
- Portfolio investment
- Balancing item
- Components of the balance of payments should balance
- The sum of the accounts should be zero
- Imbalances
- Balancing items is used to cover discrepancies

Current account deficits and surpluses

- Current account surplus
- A net inflow of money into the circular flow of income
- Current account deficit
- Capital and financial account surplus
- The UK has a surplus with services but a deficit with goods
- UK has a net current account deficit
 - The UK spends more on imports from foreign countries than they
earn from exports to foreign countries
- If the deficit is large and runs for a long time
- Financial difficulties with financing the deficit

Causes of balance of payments disequilibrium

- Appreciation of the currency
- A stronger currency means imports are cheaper and exports are
more expensive
- The current account would worsen
- Economic growth
- When consumer incomes increase, demand increases
- Increase demand for imports
- UK
- Consumers have a high propensity
- More competitive
- If a country becomes more internationally competitive with lower
inflation or economic growth in export markets
- Exports increase
- Also happens when a country becomes more productive
- Causes average unit costs to fall
- Could cause the current account deficit to improve or
increase the current account surplus
- Deindustrialisation
- UK
- The manufacturing sector has been declining since 1970’s
- The goods what the UK previously made domestically now
have to be imported
- Worsens the deficit
- Membership of the trade union
- UK
- Traditionally had negative current transfers
- Because fees are paid for membership of the EU
- Attractiveness to foreign investors
 - A capital account surplus could be caused by incoming finance
from investors buying UK bonds, securities, and financial
derivatives
- Could help fund a current account deficit
- By selling more exports to foreign countries
- UK
- Will have a greater inflow of money into the circular flow of
income
- Increase AD and improve rates of economic growth
- UK
- During periods of economic decline or recessions
- The current account deficit falls
- Consumer spending
- During periods periods of economic growth, when consumers have
higher incomes
- They can afford to consume
- There’s larger deficit on the current account
- If imported raw materials are expensive, there could be cost-push
inflation
- UK
- Since firms face higher production costs
- When the pound appreciates, imports become relatively cheaper and
exports become more expensive
- UK
- More productive, they’ll be more internationally competitive
- This causes exports to increase relative to imports

The consequences of investment flows between countries

- FDI
- Flow of capital from one country to another
- In order to gain a lasting interest in an enterprise in the foreign
country
- FDI
- Creates employment
- Encourages the innovation of technology
- Helps promote long term sustainable growth
 - Provides LEDC’s with funds to invest and develop
- Portfolio investments are passive
- Control over the company is not gained
- The investment aims to make a financial gain
- FDI
- Allows the investor to gain some control over the firm
- Includes finance such as pension funds, hedge funds, and
stock market money flows

Policies that might be used to correct a balance of

payments deficit or surplus
Currency devaluation
- Central bank makes a decision to take actionn and devalue a currency
- Reducing interest ratres
- Flooding the market with a specific currency by buying other
ones

Currency depreciation
- A fall in value of a currency caused by market forces

Fiscal policy
- If there’s a deficit on current account
- Income tax could be increased
- Reduces the amount of disposable income consumers have
- Reduces the quantity of imports
- Could impact domestic growth because consumers will
spend less on domestic goods
- Governments could reduce spending
- Reduce AD and less imports
- Forces domestic firms to increase exports
- Helps improve the disequilibrium
- Fiscal policy is effective in the short term, not in the long term
- When the policies measures end, households revert their
expenditure back on imports
- If taxes are imposed on trading partners, there could be
retaliation
 - Could reduce demand for exports
- Gov might have imperfect information about the economy, could
lead to gov failure
- Green taxes
- Carbon taxes
- Minimum prices
- Pollution permits
- Competitveness of domestic firms could be compromised
- Reduces exports from domestic firms

Monetary policy
- Expenditure reducing / Expenditure switching
- Expenditure reducing policies
- Reduces demand in the economy
- Spending on imports fall
- Expenditure switching policies
- Switch consumer spending towards domestic goods and
away from imports
- Reducing the growth of the supply of money in an economy can
be expenditure reducing or expenditure switching
- If there’s a current account deficit, banks might lower interest
rates to cause depreciation in the currency
- Causes exports to become cheaper
- Could be inflationary for the domestic economy
- Hot money might flow out the country
- Investors aren’t receiving high return on their
investment
- High interest rates could be expenditure reducing
- Demand for imports falls
- Inflation falls
- Changing the exchange rate could be a gov expenditure
switching policy
- It is hard to control money supply
- Also there’s a time lag with changing the
interest rate and seeing an effect

Supply side policies

 - Could help increase productivity with increased spending on education
and training
- Could result in the country becoming more internationally
competitive
- Could lead to a rise in exports
- This incurs time lag, making it not as effective as
immediate measure
- In the long term it is effective
- Help make the domestic economy attractive to investors
- The domestic economy could be make more competitive
through deregulation/privatisation
- Forces firms to lower their average costs
- Privatisation could result in monopolies being formed
- Won’t increase efficiency
- Could supply subsidies to some industries to encourage production
- Could be retaliation from foreign countries
- Seen this as an unfair protectionist policy

J-Curve Effect
J Curve effect
- Depreciation in the exchange rate can cause a deterioration of the
current account in the short term
- Demand is inelastic
- In the long run, demand becomes price elastic
- Current account begins to improve
- Example of how time lags affect economic policy
- Shows the link between microeconomic principles and
macroeconomic outcomes
- Elasticity and current accounts

J-Curve is related to the Marshall-Lerner condition

- PED x + PED m > 1
- Devaluation will improve the current account

Short term effect

Diagrammatical analysis
- A fall in the price of exports will only cause a smaller % rise in quantity
demanded
- A rise in the price of imports will cause a smaller % fall in demand for
imports
- Value of imports rises because we spend more on imports
- Demand is inelastic
- Follows a depreciation
- We get a worsening of the current account
Long term effect

Diagrammatical analysis
- Demand for exports/imports tend to become more price elastic
- A fall in price of exports will cause a bigger % rise in quantity demanded
- We get a bigger rise in the value of exports
- When demand is elastic
- The value of exports rise
- We get an improvement in the current account
- If demand for imports is price elastic
- There’s a bigger percentage fall in demand for imports
- The total spending on imports begin to fall

J Curve representation
The trade deficit may continue to improve if global demand picks up

Why is demand more price elastic in the long term

Diagrammatical analysis
- In the short term
- Firms and consumers may have contracts to keep buying the
good
- It takes time to find alternatives
- The higher the price of imports is an incentive for domestic firms
to increase production
- But this takes time
- In the short term
- Demand is price inelastic
- % change in Q 1/13 = 7.7%
- % change in price 42.9%
- PED = -0.17
- In the long term
- Demand is price elastic
- % change in Q 8/13 = 61.5%
 - % change in price 42.9%
- PED= -0.70

Evaluation of J-Curve effect

- Factors affect the current account apart from the exchange rate
- The current account depends on consumer spending and rate of
economic growth
- Depends consumer spending in foreign countries
- Depends on inflation
- Depreciation can cause imported inflation
- Reduces the competitiveness of exports
- Firms may engage in insurance policies to hedge against
exchange rate movements

The Marshall Lerner condition

Marshall Lerner condition
- For currency devaluation to lead to an improvement in the current
account
- Price elasticity of exports/imports must be greater than 1
- If PED x + PED m > 1
- Devaluation improves the current account
- If PED x + PED m > 1
- An appreciation will worsen the current account
- This is because the effect on the current account depends on the total
value and not just the quantity of exports

Example US depreciation and current account

From early 2002-2008
- Steady depreciation in the US Dollar
From 2002-2006
- There’s a deterioration in the current account
- Also caused by domestic consumption
- After 2006
- There’s a sharp improvement in the current account
- Suggests that the J curve may be coming into play
- The current account is responding to the depreciation in
the dollar
- However the sharp movement in the current account from 2006
- Due to the slowdown in the US economy and a decline in
consumer spending on imports

Example UK devaluation
Exchange rate systems

Factors that affect foreign exchange rates

Inflation rates
- A country with a lower inflation rate will see an appreciation in the value
of its currency
- Prices of goods/services increase at slower rates where inflation is low
- A country with lower inflation rates exhibits a rising currency value
- A country with higher inflation rates sees depreciation in its currency
- Accompanied by higher interest rates

Interest rates
- Forex rates, interest rates, and inflation are correlated
- Increases in interest rates cause a country’s currency to appreciate
- Higher interest rates provide higher rates to lenders
- Attracts more foreign capital
- Causes a rise in exchange rates

Country’s current account / Balance of payments

- A country’s current account reflects balance of trade and earnings on
foreign investment
- Consists of a total number of transactions including its exports, imports,
debts,...
- A deficit in current account due to spending more of its currency on
importing products than its earning through sale of exports causes
depreciation
- Balance of payments fluctuate exchange rate of its domestic currency

Government debt
- Public/national debt owned by the central gov
- A country with gov debt is less likely to acquire foreign capital
- Leads to inflation
- Foreign investors will sell their bonds in the open market
- If the market predicts government debt within a certain country
- Decrease in the value of its exchange rate will follow
Terms of trade
- Related to current accounts and balance of payments
- Terms of trade
- Ratio of export prices to import prices
- A country’s terms of trade improves if its exports prices rise at a greater
rate than its import prices
- Results in higher revenue
- Higher demand for the country’s currency
- Increase in the currency value
- Results in an appreciation of exchange rate

Political stability and performance

- A country with less risk for political turmoil is more attractive to foreign
investors
- Drawing investment away from other countries with more
political and economic stability
- Increase in foreign capital
- Leads to an appreciation in the value of its domestic currency
- A currency with good financial and trade policy doesn’t give room for
uncertainty in value of its currency
- A country prone to political confusions may see a depreciation in
exchange rates

Recession
- Interest rates are likely to fall

How exchange rates are determined in freely floating

exchange rate systems
Exchange rate
- Weight of one currency relative to another

Floating
 - The value of the exchange rate in a floating system is determined by the
forces of supply and demand

Floating exchange rate system

- The market equilibrium price is at P1
- When demand increases from D1 to D2
- Exchange rate appreciates to P2
- The demand for a currency is equal to exports plus capital inflows
- Supply of a currency is equal to imports plus capital outflows
- It is self correcting
- Demand for exports will increase
- And it corrects the exchange rate of the currency

How governments can intervene to influence the

exchange rate

Fixed
- A fixed exchange rate has a value determined by the government
compared to other currencies
Fixed exchange rate system
- Supply of currency can be manipulated by the central bank
- Can buy/sell the currency to change the price to where they want
- Diagram
- Supply has been increased S1 – S2
- By selling the currency so more is on the market
- Q1 – Q3
- The currency depreciates as a result
- P2 – P3
- Makes exports more competitve
- As a result of the change in price it will then result in the
exchange rate returning back to where it started

Managed
- Manage exchange rate systems
- Combine the characteristics of fixed/floating exchange rate
systems
- Currency fluctuates
- Doesn’t float on a fully free market
 - When the exchange rate floats on the market
- Central bank of the country buys and sells currencies to try
and influence their exchange rate
- Governments might try and influence their currency by maintaining a
fixed exchange rate
- China
- Kept the Yuan undervalued by buying US dollars assets to
make their exports seem cheaper

Interest rates
- Increase in interest rates
- More attractive to invest funds in the country
- Rate of return on investment is higher
- Increases demand for the currency
- Causes an appreciation
- Known as hot money

Quantitative easing
- Used by banks to help stimulate the economy when standard
monetary police isn’t effective anymore
- Has inflationary effects
- Increases the money supply
- Can reduce the value of the currency
- QE
- Used where inflation is low
- Not possible to lower interest rates further

Foreign currency transactions

- Bank of England use this to manage UK gold and foreign currency
reserves
- And managing the MPC’s pool of foreign currency reserves
- Involves buying and selling foreign currency to manipulate the
domestic currency
- China
- Kept large reserves of the US dollar by purchasing government
bonds
- Undervalues the Yuan
The advantages and disadvantages of fixed and floating
exchange rate systems

Fixed
- Advantages
- Allows for firms to plan investment
- They know they won’t be affected by harsh fluctuations in
exchange rate
- It gives the monetary policy a focused target to work towards
- They set it themselves so they can set the exchange rate to
benefit
- Disadvantages
- The government and the central bank do not necessarily know
better than the market where the currency should be
- Balance of payments does not automatically adjust to economic
shocks
- The country will continue to supply the same amount of
exports irrespective of the changes in demand
- Appreciation of the currency
- A stronger currency means imports are cheaper and
exports are more expensive
- The current account would worsen
- It can be costly and difficult for governments to hold large
reserves of foreign currencies
- If it foreign currencies exchange rate is lower in value
- When transferring the foreign currency to the
governments currency
- Money is lost in each exchange

Floating
- Advantages
- The exchange rate automatically adjusts to economic shocks
- Demand for exports will increase
- And it corrects the exchange rate of the currency
- Regulates a currencies exchange rate
- It gives the monetary policy more freedom to focus on other
macroeconomic objectives
 - Because it automatically corrects itself
- If there’s a fall in the currency
- When it depreciates they don’t have to government
intervention
- Because
- More firms will buy the currency which
then regulates the exchange rate
because there’s less of the currency in the
market
- Disadvantages
- Fluctuations in the price of exchange rate can be unpredictable
- Makes investment planning difficult
- It can affect the exports and imports of a country
- Causes a lot of unemployment if an industry is affected in
particular
- Firms are getting a lower amount of revenue compared to
before
- They need to let go of some workers in order to
survive

Monetary/Currency Unions
Members of a monetary/currency union share the same currency
- More economically integrated than a customs union and free trade area
- Example
- Eurozone

A common central monetary policy is established when a monetary union is

formed
- The Euro was implemented in 1999 to form the Eurozone

Monetary unions use the same interest rate

- Euro floats against the $/£
- The four convergence criteria countries have to meet to join the Euro
- Member nations are required to control their gov finances so
budget deficits can’t exceed 3% of GDP
- Gross national debt has to be below 6% of GDP
- Inflation has to below 1.5% of the three lowest inflation countries
 - The average govt bond yield has to be below 2% of the yield of the
countries with the lowest interest rates
- Ensures there can be exchange rate stability

The optimal currency zone

- Created when countries achieve real convergence
- Member countries have to respond similarly to external shocks/policy
changes
- Must have flexibility in product markets/labour markets to deal with
economic shocks
- Could be through the geographical/occupational mobility of
labour
- Could be through the wage and price flexibility in labour markets
- Fiscal transfers could be used to even out some regional economic
imbalances

Advantages
- The participating countries have more currency stability
- Less prone to speculative shocks
- Gives future markets more certainty so there’s more investment
and growth potential
- Fewer admin fees and less red tape when travelling abroad/exchanging
money
- Benefits firms which trade with different member states
- It’s especially beneficial to small firms
- Benefit from the time and money saving of common
currency
- German monetary credibility might result in all member states having a
lower interest rate
- Might encourage more investment and spending
- Increases more jobs

Disadvantages
- Labour mobility is limited across Europe due to language barriers
- The differences in economic performance between member
countries means a common monetary policy might not be
effective
 - Exchange rate isn’t flexible to meet each country’s need, for example if
they need a boost in exports
- Member nations lose sovereignty when there’s a common monetary
union
- Countries with a strong economy have to cooperate with
countries that have weaker economies
- They can’t adapt their policies to meet each individual
requirement

Economic growth and development

The difference between economic growth and

development
Economic growth
- The increase in a country’s output of goods/services overtime
- Usually measured by the annual percentage change in GDP
- Can lead to higher standards of living, increased employment, and
improved public services
- Economic growth doesn’t mean all members of society benefit equally

How does economic growth lead to higher standards of living, increased

employment, and improved public services
- Increased income
- Economic growth can lead to an increase in income for
individuals
- Can improve their standard of living
- As businesses grow and expand
- Create more jobs and generate more income
- Leads to more spending and consumption
- Job creation
- Economic growth can lead to increased employment
- Increased demand for goods/services
- If the economy grows, people have more disposable income
- May increase their demand for products
 - cars/houses/travel
- Leads to job creation in those industries
- Government policies
- Can play a role in job creation
- Governments may implement policies such as tax
breaks/subsidies to encourage businesses to invest/create jobs
- May also invest in infrastructure projects
- Links back to job creation

Economic development
- Broader process of improving the economic/social/political wellbeing of
a country’s citizens
- Measures to reduce poverty, increase access to education and
healthcare, promotes sustainable development, reduce inequality
- Requires more than just economic growth
- Involves structural changes in a country’s
institutions/policies/social norms

How economic development measures to reduce poverty, increase access to

education and healthcare, promotes sustainable development, reduce
inequality
- Reducing poverty
- Creates jobs

Less economically developed countries (LEDCs) tend to be characterised by

the
following features:
- Low life expectancies
- High mortality rates
- High dependency ratio
- Low GDP
- Fast population growth
- Low levels of education
- Poor standard of living
- Poor nutrition, lack of access to clean, safe drinking water and a lack of
sanitation
- Poor or absent health care provision
Indicators of development
Economic indicators
- Measure a country’s economic performance and growth
- Gross Domestic Product per capita
- Higher GDP per capita indicates people have a higher level
of income
- Can afford better goods/services
- GDP per capita alone can’t give a complete picture of a
country’s economic development
- It doesn’t take into account income distribution,
inequality, and other factors that affect people’s
wellbeing
- Gross National Income per capita
- Includes income earned by country residents living abroad
- Can provide a more accurate picture of a country’s
economic well being
- GNI per capita doesn’t consider factors such as income
inequality, poverty, and distribution
- Human Development Index
- Provides a more holistic view of a country’s level of
development
- Includes a country’s education, healthcare, and
income
- Provides a higher level of human development
- HDI
- Doesn’t account for environmental sustainability or
other social factors

Social indicators
- Life expectancy at birth
- Measures the quality of a country’s healthcare system and overall
standard of living
- High life expectancy at birth indicates better healthcare
and improved quality of life
- Doesn’t include other social factors
- Income, education, and poverty
- Adult literacy rate
 - Measures a country’s education system and level of human
capital
- High literacy rate indicates better access to education and
higher levels of human development
- Doesn’t account other social factors
- Income and poverty
- Infant mortality rate
- Measures a country’s healthcare system and standard of living
- Lower infant mortality rate indicates better access to
healthcare and improved quality of life
- Doesn’t consider other social factors
- Income, education, and poverty

Environmental indicators
- Carbon emissions per capita
- Measures a country’s contribution to global climate change and
environmental sustainability
- Lower co2 per capita indicates better environmental
sustainability and reduced impact on climate change
- Doesn’t include other environmental factors
- Deforestation and biodiversity
- Forest cover
- Measures a country’s biodiversity and environmental
sustainability
- Higher forest cover indicates better environmental
sustainability and a healthier ecosystem
- Doesn’t include other environmental factors
- Climate change and pollution
- Access to improved drinking water sources
- Measures a country’s public health and environmental
sustainability
- Improved access to drinking water sources indicates better
public health and environmental sustainability
- Doesn’t include other social factors
- Income and poverty
Factors affecting growth

Human capital
- Factors including education, training, health and nutrition, and quality
of the workforce
- Higher level of human capital
- Lead to increased productivity, innovation, and economic growth

Physical capital
- Factors including infrastructure, machinery, and equipment
- Investment in physical capital
- Increase productivity and efficiency

Natural resources
- Factors including land, water, and minerals
- Availability and quality of natural resources can impact a country’s
economic growth and development

Institutional factors
- Factors including legal systems, regulatory environments, and political
stability
- Strong institutional environment can provide a foundation for
economic growth and development

Specific factors that can affect growth and development

- Trade
- International trade can provide access to new markets,
technology, and resources
- Openness to trade can expose firms to competition, encourage
specialisation, and allows countries to take advantage of
comparative advantage
- Technology
- Technological advancements can increase productivity, efficiency,
and innovation
- Advances in communication technology, medical technology,
and transportation technology
- Demographics
 - Size, age structure and distribution of a population can have an
impact
- A growing youthful population can provide a demographic
dividend
- An ageing population can lead to increased healthcare costs and
lower productivity
- Fiscal and monetary policies
- Governments policies such taxation, public spending, and
monetary policy
- If a government increases spending on infrastructure can create
jobs and stimulate economic growth
- Global economic environment
- Interest rates and exchange rates, economic growth
- Global recession can lead to decreased demand for a country’s
exports
- Decrease in economic growth
- Environmental factors
- Climate change and resource depletion
- Climate change can cause natural disasters and have long term
impacts on agricultural productivity
- Resource depletion can limit future growth opportunities

Foreign Aid

Reasons for Foreign Aid:

Humanitarian Assistance
- One of the primary reasons for foreign aid is to provide humanitarian
assistance to countries facing a crisis, such as natural disasters, conflict,
or famine
- Foreign aid can provide crucial support for the basic needs of a
country's population, such as food, shelter, and medical care

Development Assistance
 - Another reason for foreign aid is to support long-term development
projects that can help reduce poverty and improve living standards in
developing countries
- Includes funding for education, healthcare, infrastructure, and other
development initiatives

Geopolitical and Strategic Interests

- Foreign aid can also be used to support a country's geopolitical and
strategic interests. For example, providing aid to a country can help
build diplomatic relationships and promote stability in a region
- Aid can also be used to promote economic and political reforms in
countries that are strategically important to donor countries

Reasons against Foreign Aid:

Dependency and Corruption

- One of the main criticisms of foreign aid is that it can create
dependency and promote corruption in recipient countries
- Some argue that Aid can create a culture of dependency, where
governments become reliant on aid instead of developing
self-sustaining economies
- Additionally, foreign aid can be subject to corruption, where funds are
misused or embezzled by local officials

Economic Distortions
- Critics argue that foreign aid can create economic distortions in
recipient countries, such as inflation or overvaluation of the local
currency
- This can make it difficult for local businesses to compete with imported
goods and hinder the development of local industries.

Cultural and Political Interference

- Some critics argue that foreign aid can lead to cultural and political
interference in recipient countries
- Donors may impose conditions on aid that require political or economic
reforms in recipient countries, which can be seen as infringing on
national sovereignty
 - Additionally, donors may impose their own cultural values and practices
on recipient countries, which can lead to cultural clashes and
resentment

Financial Markets and Monetary

Policy
The structure of financial markets and
financial assets

The characteristics and functions of money

A medium of exchange
- Without money, transactions were conducted through bartering
- Goods/services were traded with other goods/services
- People didn’t always get what they wanted/needed
- Goods/services exchanged weren’t always of the same value
- Exchange could only happen if there was a double coincidence of
wants
- Using money eliminates this problem

Unit of account / A measure of value

- Money provides a means to measure the relative values of different
goods/services
- Money puts a value on labour

A store of value
- Money has to hold its value to be used for payment
- It can be kept for a long time without expiring
- However
- The quantity of goods/services than be bought with money
fluctuates slightly
- Due to supply/demand
A method of deferred payment
- Money can allow for debts to be created
- People can pay for things without having money in the present
- Can pay for it later
- This relies on money storing its value

Definitions
Money supply
- The stock of currency and liquid assets in an economy
- Cash and money held in saving accounts

Narrow money
- Physical currency
- Deposits and liquid assets in the central bank

Broad money
- The entire money supply
- Cash could be in restricted accounts
- Makes it hard to calculate the money supply
- Includes liquid and less liquid assets

Money market
- Liquid assets are traded
- Used to borrow and lend money in the short term

Capital market
- Equity and debt instruments are bought and sold
- It can be to long term productive use by firms/governments

Foreign exchange market

- Currencies are traded, mainly by international banks
- Determines the relative value of different currencies will be

Less liquid money

- It can’t be quickly and easily converted into cash without a loss in value
- Saving deposits, time deposits
- Require some time and effort to convert into cash
Why should the government be concerned if broad money growth is
negative
- Could lead to a contraction in the economy
- Supply of money in an economy shrinks
- Leads to a reduction in consumer spending and business
investment
- Can lead to a slowdown in economic growth or
recession
- Makes it difficult for firms to obtain financing
- Governments monitor the growth of broad money
- Assesses the health of the economy
- Guids monetary policy decisions
- Negative growth in broad money prompts policy makers to
take action
- Stimulate economic growth
- Lowering interest rates
- Increasing government spending

Commercial banks and investment banks

Banks
Commercial bank
- Manages deposits, cheques, and savings accounts for individuals and
firms
- They can make loans using the money saved with them

Investment banks
- Facilitate the trade of stocks, bonds, and other forms of investment
- Government regulation is weaker in the investment bank industry
- This combined with their business model gives them a high risk
tolerance

Central bank
 - State institution that usually has the power to regulate commercial
banks, create monetary policy, and provide financial services

The main functions of a commercial bank

Accept deposits
- Commercial banks accept deposits from the public, usually in the form
of savings
- Those on low incomes might save for security
- Firms see saving as convenient
- Banks can meet the different needs of depositors by providing different
accounts
- Depositors could use demand deposits
- Allow deposits to be made/withdrawn immediately
- Useful for firms that need to make immediate payments
- Fixed deposits store money for a long time
- Higher rates of interest
- Since banks can use these deposits knowing they won’t be
withdrawn
- Saving deposits are done by those who withdrawn money often
- Not necessarily immediately
- And who’re generally receiving an income
- They have lower rates of interest than fixed deposits

Provide loans
- Main source of income for commercial banks is interest
- Banks earn through providing loans
- Banks create credit by using deposited funds as loans
- Some loans are secured against an asset
- A house
- Protects the bank’s funds if the loan isn’t repaid
- Loans can be in the form of cash credit
- On demand or only for the short term
- Cash credit loans are based on bonds and approved securities
- Bank enter agreements with customers so money can be withdrawn
several times a year
 - Banks deposit money periodically into the accounts of the customer
- Loans on demand are when the entire loan is paid into the account of
the borrower
- The loan is charged with interest immediately
- Short term loans tend to be personal or for working capital
- Against security

Overdraft
- When a current account has no deposits
- Consumers can still borrow money from the bank in the form of
an overdraft
- These are at high interest rates
- Borrowing amount is limited

Investment of funds
- Surplus funds could be invested into securities such as government
bonds and treasury bills
- Could earn a return for the bank

Agency functions
- Banks represent their consumers
- They collect cheques and dividends
- They pay and accept bills
- Direct debit
- They deposit interest and income tax
- They buy and sell securities and arrange the transfer of
money between places for consumers

The structure of a commercial bank’s balance sheet

Balance sheets
- Show the value of a company's assets, liabilities, and owner’s equity
during a period of time
- Usually at the end of a quarter or annum

Liabilities
- Something which must be paid
 - It’s a claim on asset

Asset
- Something that can be sold for value
- Owner’s equity
- Bank capital
- What’s left over when assets have been sold and liabilities
have been paid

Liabilities can be used to buy assets

- Income can be earned from these assets

Liabilities
- Made up of share capital, deposits, borrowing, and reserve funds
Assets
- Made up of cash, securities, bills, loans, and investments

The objectives of a commercial bank and potential

conflicts between these objectives

Liquidity
- How easy it is to turn assets into cash
- Liabilities are payable on demand
- In order to be profitable
- Banks must have cash and liquid assets
- If liquidity is priorities, profits will be low
- Banks need a balance between the two objectives
- Assets in commercial banks are liquid to different extents
- Cash is the most liquid asset
- Deposits is the second most liquid asset
- Loans and long term bonds
- Least liquid assets in a commercial bank
- If banks can borrow easily and cheaply
- They’re likely to keep fewer liquid assets
- The more expensive and difficult it is to get a loan
 - The more liquid assets are likely to be kept

Profitability
- Banks need to earn profits to pay their depositors interest, wages, and
general expenses
- Holding a lot of funds in cash
- Profitability is limited
- Liquid and safety are generally prioritised over profitability
- Supplementary for a banks survival

Security
- Banks face risk and uncertainties about how much cash they get and
whether loans will be repaid or not
- Banks have to try and maintain the safety of their assets
- A bank has to keep high proportions of their liabilities with itself and
the central bank
- Following these principles means banks only hold their safest assets
- More credit can’t be created
- Banks profits are lower and the bank might lose customers
- The bank needs a balance between the risk level and their profits
- Too much risk is harmful

The regulation of the financial system

Regulation of the financial system in the UK

Governments might regulate banks with regulation and guidelines
- Ensures the behaviour of banks is clear to institutions and individuals
that conduct business with the bank
- Some economists
- Banks have a huge influence in the economy
- If failed it would have huge consequences
- It’s important to regulate the banking industry

UK banking industry is regulated by the PRA and FCA

 - PRA
- Prudential regulation authority
- Promotes the safety and stability of banks, building
societies, investment firms, and credit unions
- Ensures policyholders are protected
- FCA
- Financial conduct authority
- Regulates financial firms to ensure they’re being honest to
consumers
- They seek to protect consumer interests
- Aims to promote competition that’s in the interests of
consumers

FPC
- Financial policy committee
- Regulates risk in banking
- Ensures the financial system is stable
- Clamps down on unregulated parts and loose credit
- The committee monitors overall risks to the financial system
- Regulates the individual groups

Why a bank might fail

Global Financial Crisis
- The Great Recession
- Decline in world GDP
- 2008-2009
- Before the crash
- Asset prices were high and rising
- Boom in economic demand
- Risky bank loans and mortgages
- Especially in the US
- Government securities were backed by subprime
mortgages
- Borrowers had poor credit histories
 - After house prices crashed in the US in
2006
- Homeowners defaulted on their
mortgages in 2007
- Banks had lost huge funds
and required assistance from
the gov in the form of
bailouts
- Risks involved with lending long term and borrowing short
term
- Might lose money on investments
- If there’s insufficient funds in a vault
- Banks can’t provide depositors with
money when demanded

Moral Hazards
- Where there’s a risk that the borrower does things that the lender
wouldn’t deem desirable
- It makes the borrower less likely to repay a loan
- Usually occurs where there’s some form of insurance for the mistake
- Example
- If a house in insured
- A borrower might be less careful because they know any
damage caused will be paid for by someone else
- Banks might take more risks if they know the Bank of England or the
Gov can help them if things go wrong
- The financial crisis has been regarded as a moral hazard
- Due to the degree of risk taking

Systematic risks
- Systematic risks in financial markets can be seen as a negative
externality
- Systematic risks
- The risk of damage of the economy or the financial market
- Example
 - Could be the risk of the collapse of a bank
- This costs firms, consumers, the economy, and the market
- It is a kin to a negative externality

Liquidity ratios and capital ratios and how they affect the
stability of financial institution

A liquidity ratio
- Used to determine how able a company is to pay off short term
obligations
- The higher the ration
- The greater the safety margin of the bank
- When creditors want payment
- They look at liquidity ratios to decide whether the bank is a
concern

Capital ration
- A comparison between the equity capital and risk weighted assets of a
bank
- A bank’s financial strength is determined using this
- Assets have different weightings
- Physical cash has zero risk and credit carries more risk

Recent financial crisis

- Showed how having insufficient

Paper 3
1. C
2. C
3. D
4. .
5. A
6. A
7. B
8. B
9. .
10. .
11. B
12.