Money and banking (3)
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1.
Question 3
The Bank of England has employed quantitative easing on multiple occasions. Using a diagram, explain how quantitative easing is intended to affect the money supply and interest rates. Discuss the potential limitations of this policy.
Diagram:
[Image missing: QE Diagram] |
Explanation:
The diagram illustrates how QE is intended to affect the money supply and interest rates. The Bank of England purchases government bonds from commercial banks and other financial institutions. This increases the reserves held by these institutions, effectively increasing the money supply. This increase in reserves puts downward pressure on longer-term interest rates, as banks are more willing to lend out their excess reserves. The lower interest rates stimulate investment and consumption, leading to increased aggregate demand.
Limitations of QE:
- Liquidity Trap: If interest rates are already very low, QE may be ineffective in stimulating the economy. This is known as a liquidity trap, where additional liquidity simply sits idle in the banking system.
- Inflation Risk: As mentioned previously, QE can lead to inflation if the money supply grows too rapidly.
- Asset Bubbles: QE can inflate asset bubbles, creating instability in financial markets.
- Distributional Effects: The benefits of QE tend to accrue disproportionately to those who own assets, potentially exacerbating inequality.
- Political Constraints: QE can be politically controversial, particularly if it is perceived to benefit certain groups at the expense of others.
Conclusion: While QE can be a useful monetary policy tool, it is not a panacea. Its effectiveness is limited by factors such as the state of the economy, the credibility of the central bank, and potential unintended consequences.
2.
(a) Explain the difference between a demand deposit account and a savings account. (6 marks)
A demand deposit account (DDA), also known as a current account, is an account held with a bank where the depositor can withdraw money at any time without penalty. It typically offers low or no interest. DDAs are primarily used for everyday transactions, such as paying bills and receiving wages.
A savings account is an account held with a bank where the depositor can deposit money and earn interest. However, there may be restrictions on the number of withdrawals allowed per period, and penalties may apply for exceeding these limits. Savings accounts are designed to encourage saving and provide a secure place to store funds for the future.
Key Differences:
- Liquidity: DDAs offer high liquidity (easy access to funds), while savings accounts offer lower liquidity.
- Interest Rates: DDAs typically have low or no interest, while savings accounts offer interest.
- Withdrawal Restrictions: DDAs have no withdrawal restrictions, while savings accounts may have restrictions.
- Purpose: DDAs are for transactions, savings accounts are for saving.
3.
Question 1
The demand for overdraft facilities has been increasing in recent years. Explain, using economic theory, the factors that might lead to this increase in demand. Assess the potential benefits and drawbacks of banks providing overdraft facilities to consumers.
Factors leading to increased demand for overdrafts:
- Increased consumer spending: Rising inflation and wage growth can lead to higher disposable incomes and increased consumer spending. Overdrafts provide a readily available source of funds to support this spending, even if short-term.
- Changing consumer behaviour: A greater acceptance of short-term debt and a reduced emphasis on saving could contribute to higher overdraft usage. The ease of access to overdrafts encourages this behaviour.
- Economic uncertainty: During periods of economic uncertainty, consumers may be more likely to rely on overdrafts as a safety net for unexpected expenses or income fluctuations.
- Convenience and accessibility: Overdrafts are readily available and easy to access, making them a convenient option for managing short-term cash flow problems. This is particularly true with the rise of digital banking.
Potential Benefits of Overdraft Facilities:
- Consumer convenience: Provides a readily available source of funds for unexpected expenses, avoiding potential disruptions to spending.
- Financial safety net: Acts as a buffer against temporary income shortfalls.
- Facilitates spending: Allows consumers to maintain a certain level of spending even when funds are temporarily unavailable.
Potential Drawbacks of Overdraft Facilities:
- High interest rates: Overdrafts typically carry high interest rates, making them an expensive form of borrowing.
- Debt trap: The high cost of overdrafts can lead to a debt trap, where consumers struggle to repay the balance and accumulate further interest charges.
- Encourages irresponsible spending: Easy access to credit can encourage overspending and poor financial management.
- Potential for financial distress: Reliance on overdrafts can exacerbate financial difficulties during periods of economic hardship.
Assessment: While overdrafts offer convenience and a safety net, the high cost of borrowing and the potential for debt accumulation mean that consumers must exercise caution. Regulation by the Bank of England is important to ensure fair lending practices and prevent exploitation.