Here are some questions and answers on the financial sector topic within the A-level Economics syllabus.
a) Explain one role of a central bank.
One role of a central bank is to be the lender of last resort to the country’s commercial banks. The role of lender of last resort means to provide liquidity (in the form of short term loans) to the other banks who are facing liquidity problems.
b) Explain one reason why the UK central bank lowered interest rates from 5 per cent in October 2008 to 0.5 per cent in March 2009, despite inflation being above its target of 2 per cent in 2008.
One reason why the UK central bank lowered interest rates from 5% to 0.5% between October 2008 and March 2009, is due to the financial crisis happening at that time. The UK central bank’s job is to hit an inflation target of 2% CPI; however, in abnormal times, this objective can be made flexible to accommodate for the economy’s other objectives.
During the 2008 crisis, the UK economy (and most of the world) experienced negative economic growth and significantly increased unemployment rates. Therefore, the interest rate cut made sense to provide more stimulation to aggregate demand and, hence, improve the other economic performance indicators.
c) Which one of the following is not a cause of market failure in the financial sector?
A Lenders of subprime mortgages in the US underestimating the ability of their borrowers to pay back their loans.
B Banks being prepared to invest in high-risk securities, to make a high return, because they know that they will be ‘bailed out’ if it all goes wrong.
C Banks charging low interest on lower risk loans.
D Activities in the banking sector causing external costs on the economy as a whole.
The answer is C. When banks charge lower interest rates on lower risk loans, this is because the chance of default is lower. Less risky investments attract lower rates of return.
A less risky loan is more attractive to lenders (they are more likely to get their money back), therefore, more lenders are attracted to the market for loans and this increases the supply of funding within that market. The interest rate acts as the cost of borrowing; therefore, with a greater supply of funding, the cost of borrowing decreases.
This is not a market failure because if somebody is a low-risk borrower, a lower cost of borrowing would be the right representation of their risk. A low risk borrower does not pose a threat to the welfare of society, unlike a higher risk (sub-prime) borrower.
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Suggested Reading:
Learn about the financial sector. Understand and learn more about how the financial market failure. Learn more about systemic risk, market bubbles, externalities, asymmetric information and market rigging. Revise using Mr Banks's A-level economics revision pages at mrbanks.co.uk. Attend our A-level economics revision courses!