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Teaching guide: podcast - financial markets and monetary policy

These podcast teaching guides cover topics from our AS and A-level Economics specifications. You can download them below.

Podcast 3: Financial markets and monetary policy

This podcast teaching guide looks at how the macroeconomy works. It aims to highlight how students can apply economic concepts and tools to critically analyse real life examples and comment on the potential impact to macroeconomic variables.

Transcript

In this podcast we will be talking about Financial Markets and Monetary Policy. Paying particular attention to; the structure of financial markets and financial assets, the different financial institutions and monetary policy, and the regulation of financial systems.

On the 23rd June 2016, the United Kingdom voted, in a referendum, to leave the EU. The following morning, Mark Carney, the Governor of the Bank of England, had this to say about the massive decision that the Nation had just made:-

“The capital requirements of our largest banks are now ten times higher than before the crisis. The Bank of England has stress tested them against scenarios more severe than the country currently faces. As a result of these actions, UK banks have raised over £130billion of capital, and now have more than £600bn of high quality liquid assets. Why does this matter?

This substantial capital and huge liquidity gives banks the flexibility they need to continue to lend to UK businesses and households, even during challenging times. Moreover, as a backstop, and to support the functioning of markets, the Bank of England stands ready to provide more than £250billion of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required.”

What has this got to do with AQA AS and A-level Economics? And why did Mr Carney feel the need to provide such strong re-assurance to markets and consumers at this time?

The answer to the first question is that Financial Markets and Monetary Policy is an area in the new specification which have been given greater weight because of the impact of these matters have on the UK economy; particularly since the financial crisis of 2007-08.

As for the second question of why it was that Mr Carney felt the need to speak and reassure us all. The crisis to which he referred was the 2007 to 2008 financial crisis which severely weakened the UK economy and threatened the stability of the financial sector. In short, there is a general acceptance that the UK government needs to monitor this sector much more closely to avoid a repeat of the events of 2007-2008. In order to fully engage students with this, seemingly, dry area of the specification, it is crucial to educate them as to why this sector of the economy is so important, and, to do that, there is probably no better starting point than the recent financial crisis.

The financial crisis of 2007–08, also known as the global financial crisis, is considered by many economists to have been the worst financial crisis since The Great Depression of the 1930s. It threatened the collapse of large financial institutions, which was only prevented by the bailout of banks by national governments.

Despite this unprecedented intervention by governments in financial markets, stock markets still dropped worldwide. The crisis played a significant role in the failure of key businesses, as well as declines in consumer wealth and a downturn in economic activity leading to the recession.

Many causes for the financial crisis have been suggested, but it is widely agreed that: the over selling of high risk, complex financial products; undisclosed conflicts of interest; ‘risky lending and investment opportunities’ and the failure of regulators were all contributory factors.

In the UK, after 2008 the government took a number of measures to try and ensure that the crisis could not be repeated. Many of those measures are now included in the specification showing just how much the crash taught us about the significance of this sector of the economy.

In short, students need to understand the basics of how the financial sector functions, how it is regulated and the role of the central bank. Likewise it is important for students to understand just how vital a stable and robust financial sector is for the general economic health of an economy and all key indicators such as inflation, growth, unemployment, trade and living standards. The first topic in the specification under 4.2.4 looks at the structure of financial markets and financial assets. This topic is mostly a descriptive area and doesn’t always demand complex teaching inputs. Students simply need to learn definitions and inter-relationships. They will not be expected to be able to understand the fine detail of complex financial products and processes. There will be a lot of new terminology to take on board such as broad and narrow money, capital and money markets, debt, equity and many more. When teaching these topics it can be helpful to refer to the financial markets section of a newspaper such as the Financial Times so students can see the significance and context of these terms. It will be necessary for students to have access to clear definitions of these terms, as they will often appear in both multi-choice questions and longer assessments.

The next two sections of the specification look at financial institutions, starting with commercial and investment banks and then moving on to the role and functions of the central bank.

A good starting point for this area is to look at how banks can create credit. For many students this is a topic that can seem a bit mystical and it is common for students to ask ‘where is the real money’ when in fact it may not exist. Once students understand how credit money can be created, it is important to consider risk and pose the question “what happens if a bank creates too much credit and its depositors panic and want to withdraw their deposits?”

This would be an excellent point to introduce a mini case study of a bank such as Northern Rock who found themselves in this very situation in 2007 when, on the 14 September 2007, they sought and received a liquidity support facility from the Bank of England, as a result of its exposure in the credit markets. On the 22 February 2008, because of continued threat of collapse, the bank was taken into state ownership. The nationalisation was to prevent the bank failing. Now that it is subject to more stringent controls and regulation, it has been returned to the private sector. Not only is an example like this likely to stimulate student interest, it leads a teacher neatly and logically to acknowledge the institutions responsible for regulation. It might make sense, at this point, to deviate from the order of the specification and teach section 4.2.4.4 which looks at regulation.

Since the financial crisis, there have been three pieces of legislation aimed at making the financial sector more robust. These are ‘the Financial Services Acts of 2012 and 2016’ and the ‘Banking Reform Act of 2013’. Again, students do not need to know the detail of what these pieces of legislation contain but the specification does make reference to three key organisations that have been created as a result of this legislation. These are the Financial Conduct Authority (FCA), the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).

It is quite easy for a student to confuse the roles of these institutions because of overlapping functions. The key difference between the FCA and the PRA is hinted at in the naming of the institutions and you might chose to make this point. FCA looks at the conduct of financial institutions and champions consumer rights, whereas the PRA focuses much more on how prudent financial institutions are in terms of how they conduct their business. The PRA will, for example, look at the soundness of asset structures and liquidity ratios. The FPA’s primary objective is to identify any risks in the sector and then take action. All three institutions are departments of the Bank of England and work together to promote completion, further government policy and, most importantly, provide more robust regulation of the financial sector than was the case before 2007.

If you need to learn more about these fairly recent developments you can find useful resources on the Bank of England website.

Finally, it is important that students realise the role of the central bank and, in particular, its function of operating monetary policy. This can often be a vague area for students, with few appreciating the ways in which monetary policy has been conducted in recent years. You will need to explain the reliance on quantitative easing to students, along with recent initiatives such as the Funding for Lending Scheme which was introduced in 2012 to incentivise banks to lend more by offering cheap funds in exchange for lending growth to, small and medium sized enterprises in particular.

This scheme was, of course, introduced to encourage economic growth at a time of very sluggish macroeconomic performance. The final reference in the specification to recent Bank of England initiatives refers to Forward Guidance. Forward Guidance was first introduced in August 2013 to give yet more stability for households and firms by providing strong hints on the likely future interest rates by making statements on likely MPC decisions on bank rate changes. For example, in 2013, it was announced that interest rates were unlikely to change until unemployment fell below 7%, as long as inflationary targets were not put at risk. This process of being more open and predictable, it was felt, would improve information and, in turn, promote economic growth.

Once again the Bank of England website has many really useful resources for teachers and once students understand the role of the central bank they can be encouraged to take a more active interest in economic current affairs relating to this area of the specification. For example, you can encourage students to discuss the outcomes of the Monetary Policy Committees, or encourage them to hold regular meetings to decide on the level of bank rate or debate the effectiveness of Quantitative Easing in promoting growth.

As a final comment, I’m sure you will see why this area of the specification has been developed and grown in importance. Much of the new content relates to innovation in the regulatory sector and, as such, is quite descriptive. It is important to realise that students really only require an overview of most of this content. It is likely to be much more important for students to appreciate why the changes have been needed rather than being bogged down in descriptive detail.

Thank you for listening, we hope you have found this podcast helpful. For more AQA resources, visit the AS and A-level Economics pages of our website, aqa.org.uk/economics