Question 3:
Explain inflation targeting and discuss its advantages and disadvantages. [8 marks]
To begin, inflation targeting is a central bank strategy that entails setting an inflation target and
adjusting monetary policy to achieve that goal. Given that the primary goal of inflation targeting is to
ensure price stability, advocates believe it also supports economic progress and stability.
In order to ensure price stability, inflation targeting has become the most often used monetary
policy tool. In the medium term, a particular numerical target for inflation, such as 2%, is defined.
Advantages of inflation targeting
It is simple to understand for the general audience.
Reduces the time-inconsistency problem, in which policymakers say one thing (e.g., limit inflation)
but end up doing something other (reducing interest rates to promote short-term economic growth
at the price of greater inflation in the medium/long term).
Lessens political pressure on central banks to generate short-term growth because central banks
have a primary mission.
Increases central banks' responsibility - may measure their effectiveness based on their ability to
meet their targets.
Disadvantages of inflation targeting
A tight regulation limits central banks' flexibility to respond to unanticipated occurrences, such as an
increase in oil prices, which may trigger a surge in UK prices if the Bank of England has raised interest
rates to combat inflation. It didn't because raising interest rates would have triggered a recession. As
a result, central banks prefer to take a flexible approach to inflation targeting.
Inflation is difficult to manage in the longer run because there are substantial delays between policy
implementation and inflation consequences. As a result, some economists prefer to target
something with shorter delays, such as Money Supply increase.
How might a change in bank rate by the Bank of England affect domestic demand, exchange rate and
hence inflation? [12 marks]
If the bank rate is raised, the cost of borrowing rises, slowing expenditure and, as a result, domestic
demand. If demand falls compared to supply, inflation should fall. There are temporal delays
involved, for example, interest rates influence demand after around a year. After another 6
months/1 year, changes in demand effect inflation.
Higher interest rates increase the cost of borrowing money and encourage people to save. As a
result, customers are likely to spend less money overall. When customers spend less on goods and
services in general, prices tend to rise more slowly. Slower price rises indicate lower inflation.
If banks discover that their reserves have increased (due to pension funds depositing cash with
them), they may lend more, encouraging consumption and so GDP. The Bank's asset purchases,
notably of debt instruments, will drive up prices while driving down rates (inverse relationship).
Long-term yields should fall, lowering loan interest rates and benefitting businesses and families that
borrow.
Discuss Quantitative Easing as unconventional monetary policy carried out by the Bank of England
since 2009. [13 marks]
Following the 2008 global financial crisis, the Bank of England reduced interest rates to 0.25%. This
was to offer some stimulation to the economy, which was reeling from the consequences of the
crisis, which resulted in a decrease in bank lending and, as a result, a recession. Given the severity of
the crisis, the base rate cut was deemed inadequate, and the Bank of England predicted deflation. To
fulfil its inflation objective, the bank needed to find other ways to raise demand to avoid deflation.
Because interest rates could not fall any further (there is a lower constraint of zero), the Bank of
England used unorthodox tactics to increase demand, known as QE.
At the time of its inception in 2009, quantitative easing was envisioned in the United Kingdom as a
short-term solution to help the economy weather the global financial crisis. However, during the last
decade or two, the programme has grown significantly, becoming the Bank of England's primary
monetary policy instrument. Quantitative easing is a flawed policy instrument. Quantitative easing is
a flawed policy instrument. The impacts of quantitative easing are still poorly understood, and the
Bank has struggled to explain why it was the proper reaction to economic circumstances in recent
years, notably during the COVID-19 epidemic. Quantitative easing has also made policymaking at the
Bank of England and HM Treasury more interconnected, merging monetary and fiscal policy, and this
has begun to damage the idea that the Bank has operated entirely independently of political
reasons.
Question 4:
Explain financial “bubble” in asset markets and why it might be difficult to identify when a market
has a “bubble”. [7 marks]
Financial bubbles form in markets when asset values soar well above their intrinsic worth. Bubble
markets are vulnerable to correction (price drops back to intrinsic value) when unfavourable news
about the asset emerges. When investors begin to sell the asset, a correction happens asset.
It is difficult to detect a bubble since it needs understanding of the asset's basic worth. The total of
the current values of all future cash flows equals fundamental value.
i.e., P = ∑𝑛
𝑖= 1𝐶𝑖
For assets with unpredictable future cash flows, such as equities and gold, various viewpoints
regarding future cash flows and hence intrinsic value might exist.
What is Minsky’s instability hypothesis and how does it help us understand the causes of “bubbles”
in financial markets? [10 marks]
Minsky argued that the supply of credit (debt) is pro-cyclical, meaning that it encourages or
exaggerates the economic cycle. As a result, when the economy is expanding, there is more
lending/borrowing (to finance asset purchases), and when the economy is contracting, there is less.
Extra borrowing/lending during periods of expansion causes asset prices to rise faster than they
would ordinarily, resulting in the formation of a bubble. Minsky also believed that for a bubble to
form, the economy must be subjected to an external shock, such as the creation of a popular asset
class, such as internet (dot-com) stocks in the late 1990s.
Discuss the causes and consequences of the 2008 global financial crisis. [16 marks]
The causes:
Most Western economies have become more vulnerable because of a prolonged period of economic
prosperity. Low-cost exports from China/India, for example, caused Western inflation to fall in the
late 1990s and early 2000s. This resulted in very low nominal short-term interest rates (low inflation
Equals low interest rates under an inflation-targeting regime) and little volatility in economic growth.
China and oil exporting countries have current account surpluses. Deficits in the United States and
other nations (incl. UK). Surplus countries bought government bonds, primarily US Treasuries, in
response to these surpluses. Long-term interest rates fall as a result.
This favourable environment resulted in a rise in consumer and commercial loans. Banks take on
increasingly greater credit risk to earn larger returns over time, assuming that macroeconomic
stability would be maintained, and that the more sophisticated risk models employed by banks
would allow them to control/minimize losses in the case of a change in the environment. Investors
have no interest to continue purchasing any short-term debt issued by CDO trusts in the summer of
2007. However, in order to make their CDO agreements more appealing to investors, several banks
agreed to acquire that short-term debt if it couldn't be rolled over.
The correction of the US home market bubble was the catalyst. This was due in part to the fact that
many subprime borrowers began to default. In addition, interest rates in the United States were
beginning to climb. The drop in home values and the enormous number of mortgage defaults
generated issues not just for the banks who provided the mortgages, but also for the institutions
that held MBSs and CDOs connected to the failed mortgages.
The consequences:
A solvency shock followed by a liquidity shock. Solvency shock because of mortgage loan writedowns following the collapse of the housing market bubble, as well as a write-down in the value of
mortgage-backed securities and CDOs This, in turn, prompted a loss of trust in many banks, resulting
in a liquidity shock as depositors (especially foreign banks) withdrew savings from banks known to
be experiencing write-downs.
Capital support was provided through recapitalizing bankrupt or near-insolvent banks, with
governments acquiring stock holdings in the failing institutions. Support for the banking system's
liquidity - the central bank offered additional liquidity to banks by allowing them to exchange illiquid
assets for liquid assets provided by the central bank. New requirements, notably Basel 3, require
banks to keep more capital and liquidity.
Question 5:
Discuss the too big to fail problem in banking. [23 marks]
Too big to fail was a phrase used to describe banks that were deemed too large to fail because the
implications of failure would be too severe for individual depositors and the economy. The Financial
Stability Board and other authorities employ a more precise description of this problem: 'too
systemically significant to fail.' This signifies that the institution plays a significant role in the running
of the financial system, and its failure would have a significant impact on the financial system. This
might include modest institutions such as clearing houses for derivative markets or payment system
specialists.
Implicit benefits to banks that are seen as too big to fail?
A too large to fail (TBTF) bank would be perceived as obtaining preferential treatment from other
market participants and authorities that non-TBTF banks do not. These advantages may include:
- less market discipline: shareholders may be more complacent about the risks the bank takes since
they know the firm will be bailed out if things go wrong.
- Regulatory forbearance: regulators may be more flexible in their regulation, allowing the institution
to continue functioning even if it is insolvent, for example.
- Political clout: Because of their centrality in the system's operation, the institution would have
political power.
- Lower funding costs: the market may enable the institution to obtain money more cheaply because
it is unlikely to fail better credit ratings, and so on.
Problems of having banks that are ‘too big to fail’?
The two main problems are:
-Moral hazard arises when TBTF enterprises have an incentive to take more risks than they would
otherwise since they are sheltered from at least part of the negative consequences of those risks if
failure is avoided.
- Bailout costs - In the case of a financial crisis, such as 2008, the cost of bailing out multiple TBTF
banks and other organisations is extraordinarily high, causing challenges for governments that must
borrow to fund the bailouts.
The Glass-Steagall Act was enacted in the United States in 1933 to prohibit deposit-taking
commercial banks from engaging in speculative banking. It prohibited commercial banks from,
among other things, acquiring assets for their own accounts (speculating on market movements). As
a result, banks could only expand through traditional banking rather than trade. Banks were not
permitted to operate a trading subsidiary. This stifled bank expansion. The main arguments in favour
of repealing the Glass-Steagall Act were:
I) Diversification - By enabling banks to engage in additional businesses, they would benefit from
more diverse income sources, making them more robust.
(ii) Size - it was assumed that larger banks would have more capital and hence be less likely to fail.
The three solutions are:
I) Strengthen banks' resilience to failure by increasing capital and liquidity (through Basel 3)
(ii) Reduce the size of banks or make the various portions less interconnected. The Volker rule
prevents banks in the United States from trading (reducing their size). In the United Kingdom, ringfencing was employed to segregate a bank's deposit-taking operations from its riskier investment
banking operations.
(iii) Allow TBTF banks to collapse if they go bankrupt. This is accomplished through the use of
recovery and resolution programmes (living wills).
b) How does Basel 3 impact on the liquidity of banks? (10 marks)
Basel 3 proposes two new bank liquidity adequacy measures. The first is the liquidity coverage ratio,
which specifies that banks should keep enough high-quality liquid assets (mostly government bonds)
on hand to cover at least 30 days of net cash outflows.
The net stable financing ratio, the second ratio, is more of a long-term liquidity ratio. This indicates
that the quantity of steady financing should be adequate to satisfy the bank's requirements over a
year of stressful conditions. In other words, the bank should have enough stable cash, mainly stable
(long term) deposits, to maintain the bank's assets under pressured market conditions.