PETER	HOWELLS
Fifth Edition
		FINANCIAL MARKETS AND INSTITUTIONS

	KEITH BAIN
FINANCIAL
MARKETSAND
INSTITUTIONS

With its clear and accessible style, Financial Markets and Institutions will help students make sense of the nancial
activity that is so widely and prominently reported in the media. Looking at the subject from the economists perspective,
the book takes a practical, applied approach and theory is covered only where absolutely necessary in order to help	PETER HOWELLS
students understand events as they happen in the real world.

This fth edition has been thoroughly updated to re ect the changes that have occurred in the nancial system in recent		KEITH BAIN
years.	Fifth Edition

		Financial Markets and Institutions will be
Key	Features	appropriate for a wide range of courses in	FINANCIAL
		money, banking and nance.
•	New! Chapter 12 Financial Market Failure and Financial
	Crises puts forward arguments concerning for example,
		Students taking nancial markets and	MARKETS AND
	the ability of small rms to borrow, the problems of
		institutions courses as part of accounting,
	nancial exclusion and inadequate long-term saving and
		nance, economics and business studies
	the tendency in nancial markets to bubbles and crashes.
		degrees will nd this book ideally suited to
•	New! Thoroughly updated to include new gures and
		their needs.
	recent legislative and regulatory changes.		INSTITUTIONS
•	Provides a comprehensive coverage of the workings of	The book will also be suitable for professional
	nancial markets.	courses in business, banking and nance.

•	Contains suf cient theory to enable students to make
		Peter Howells is Professor of Monetary
	sense of current events.
		Economics at the University of the West of
•	Up-to-date coverage of the role of central banks and the
		England.
	regulation of nancial systems.
		Fifth
		Keith Bain is formerly of the University of
•	Focuses on UK and European nancial activity, context	East London where he specialised in monetary Edition
	and constraints.	economics and macroeconomic policy.
•	Offers a wealth of statistical information to illustrate and
		BAINHOWELLS
	support the text.
		Visit www.pearsoned.co.uk/howells to nd
•	Extensive pedagogy includes revised boxes, illustrations,	online learning support.
	keywords/concepts, discussion questions, chapter
	openers, chapter summaries and numerous worked
	examples.

•	Frequent use of material from the Financial Times.

•	Regularly maintained and updated Companion Website containing valuable teaching and learning material.

	www.pearson-books.com
an imprint of

9780273709190_COVER.indd

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Financial Markets and Institutions

Visit the Financial Markets and Institutions, fth edition

Companion Website at www.pearsoned.co.uk/howellsto nd

valuable studentlearning material including:

l	Multiple choice questions to test your learning
l	Written answer questions providing the opportunity to answerlonger questions
l	Annotated links to valuable sites of interest on the web

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We work with leading authors to develop the strongest

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FINM_A01.qxd 1/18/07 11:02 AM Page iii

FINANCIAL MARKETS

AND INSTITUTIONS

Fifth Edition

Peter Howells and Keith Bain

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Pearson Education Limited

Edinburgh Gate

Harlow

Essex CM20 2JE

England

and Associated Companies throughout the world

Visit us on the World Wide Web at:

www.pearsoned.co.uk

First published under the Longman imprint 1990

Fifth edition published 2007

© Pearson Education Limited 2007

The rights of Peter Howells and Keith Bain to be identied as authors of this work

have been asserted by them in accordance with the Copyright, Designs and

Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without either the prior written

permission of the publishers or a licence permitting restricted copying in the United

Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby

Street, London EC1N 8TS.

All trademarks used herein are the property of their respective owners. The use of

any trademark in this text does not vest in the author or publisher any trademark

ownership rights in such trademarks, nor does the use of such trademarks imply

any afliation with or endorsement of this book by such owners.

ISBN-13: 978-0-273-70919-0

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Howells, P.G.A., 1947–

Financial markets and institutions / Peter Howells and Keith Bain. — 5th ed.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-0-273-70919-0

ISBN-10: 0-273-70919-4

1.Financial institutions—Great Britain.2.Finance—Great Britain.

I.Bain, K., 1942–II.Title.

HG186.G7H68 2007
332.10941—dc22
	2006051240

10987654321

1110090807

Typeset in 9.5/13pt Stone Serif by 35

Printed by bound by Ashford Colour Press, Gosport

The publisher’s policy is to use paper manufactured from sustainable forests.

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Contents

Preface to the fth edition	xi
Guided tour	xii
Acknowledgements	xiv
Terms used in equations	xv

1

Introduction: the nancial system

1

1.1	Financial institutions	4
	1.1.1Financial institutions as rms	4
	1.1.2Financial institutions as ‘intermediaries’	6
	1.1.3The creation of assets and liabilities	7
	1.1.4Portfolio equilibrium	15

1.2	Financial markets	17
	1.2.1Types of product	17
	1.2.2The supply of nancial instruments	20
	1.2.3The demand for nancial instruments	20
	1.2.4Stocks and ows in nancial markets	21

1.3	Lenders and borrowers	23
	1.3.1Saving and lending	23
	1.3.2Borrowing	25
	1.3.3Lending, borrowing and wealth	26

1.4Summary	27
Questions for discussion	28
Further reading	28

2

The nancial system and the real economy

29

2.1

Lending, borrowing and national income

30

2.2	Financial activity and the level of aggregate demand	37
	2.2.1Money and spending	37
	2.2.2Liquid assets and spending	39
	2.2.3Financial wealth and spending	40

2.3The composition of aggregate demand	41
2.4The nancial system and resource allocation	43
2.5Summary	47
Questions for discussion	48
Further reading	48

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Contents

3

Deposit-taking institutions

49

3.1	The Bank of England	52
	3.1.1The conduct of monetary policy	53
	3.1.2Banker to the commercial banking system	55
	3.1.3Banker to the government	57
	3.1.4Supervisor of the banking system	57
	3.1.5Management of the national debt	59
	3.1.6Manager of the foreign exchange reserves	60
	3.1.7Currency issue	60

3.2

Banks

61

3.3	Banks and the creation of money	66
	3.3.1Why banks create money	67
	3.3.2How banks create money	69

3.4	Constraints on bank lending	73
	3.4.1The demand for bank lending	73
	3.4.2The demand for money	74
	3.4.3The monetary base	75

3.5Building societies	82
3.6Liability management	85
Questions for discussion	88
Further reading	88
Answers to exercises	89
Appendix to Chapter 3: A history of UK monetary aggregates	90

4

Non-deposit-taking institutions

92

4.1Insurance companies	93
4.2Pension funds	100
4.3Unit trusts	106
4.4Investment trusts	111
4.5NDTIs and the ow of funds	114
4.6Summary	115
Questions for discussion	115
Further reading	116

5

The money markets

117

5.1

The discount market

120

5.2	The ‘parallel’ markets	129
	5.2.1The interbank market	129
	5.2.2The market for certicates of deposit	130

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Contents

5.2.3	The commercial paper market	132
5.2.4	The local authority market	133
5.2.5	Repurchase agreements	133
5.2.6	The euromarkets	134
5.2.7	The signicance of the parallel markets	136

5.3Monetary policy and the money markets	138
5.4Summary	146
Questions for discussion	147
Further reading	147
Answers to exercises	148

6

The capital markets

149

6.1

The importance of capital markets

150

6.2	Characteristics of bonds and equities	151
	6.2.1Bonds	151
	6.2.2Equities	155
	6.2.3The trading of bonds and equities	157

6.3Bonds: supply, demand and price	164
6.4Equities: supply, demand and price	176
6.5The behaviour of security prices	184
6.6Reading the nancial press	193
6.7Summary	198
Questions for discussion	199
Further reading	199
Answers to exercises	200

7

Interest rates

201

7.1

The rate of interest

202

7.2	The loanable funds theory of real interest rates	204
	7.2.1Loanable funds and nominal interest rates	207
	7.2.2Problems with the loanable funds theory	209

7.3	Loanable funds in an uncertain economy	211
7.4	The liquidity preference theory of interest rates	213
7.5	Loanable funds and liquidity preference	215
7.6	The monetary authorities and the rate of interest	215

7.7	The structure of interest rates	220
	7.7.1The term structure of interest rates	221
	7.7.2The pure expectations theory of interest rate structure	222
	7.7.3Term premiums	224

vii

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Contents

7.7.4	Market segmentation	228
7.7.5	Preferred habitat	229
7.7.6	A summary of views on maturity substitutability	229

7.8The signicance of term structure theories	229
7.9Summary	232
Questions for discussion	233
Further reading	233
Answer to exercise	233

8

Foreign exchange markets

234

8.1	The nature of forex markets	235
8.2	Interest rate parity	241

8.3	Other foreign exchange market rules245 8.3.1Differences in interest rates among countries – the Fisher effect245 8.3.2The determinants of spot exchange rates – purchasing power parity246 8.3.3Equilibrium in the forex markets247

8.4	Alternative views of forex markets	248
8.5	Fixed exchange rate systems	251

8.6	Monetary union in Europe	252
	8.6.1The single currency in practice 1999–2006	256
	8.6.2The UK and the euro	257

8.7Summary	258
Questions for discussion	259
Further reading	260
Answers to exercises	260

9	Exchange rate risk, derivatives markets
	and speculation	261

9.1	Forms of exposure to exchange rate risk	262
9.2	Exchange rate risk management techniques	264

9.3	Derivatives markets	265
	9.3.1Financial futures	266
	9.3.2Options	273
	9.3.3Exotic options	278
	9.3.4Other related products	278

9.4	Comparing different types of derivatives	279
	9.4.1Exchange-traded versus OTC products	279
	9.4.2Forward versus futures contracts	279
	9.4.3Forward and futures contracts versus options	280

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Contents

9.5The use and abuse of derivatives	281
9.6Summary	285
Questions for discussion	286
Further reading	287
Answers to exercises	287

10

International capital markets

288

10.1

The world capital market

289

10.2	Eurocurrencies	290
	10.2.1The growth of the eurocurrency markets	292
	10.2.2The nature of the market	294
	10.2.3Issues relating to eurocurrency markets	296

10.3Techniques and instruments in the eurobond and euronote markets	299
10.4Summary	305
Questions for discussion	306
Further reading	307
Answers to exercises	307

11

Government borrowing and nancial markets

308

11.1

The measurement of public decits and debt

309

11.2	Financing the PSNCR31711.2.1The PSNCR and interest rates31811.2.2The sale of bonds to banks32311.2.3The sale of bonds overseas32411.2.4PSNCR, interest rates and the money supply – a conclusion324

11.3Attitudes to public debt in the European Union	326
11.4The public debt and open market operations	328
11.5Debt management and interest rate structure	329
11.6Summary	329
Questions for discussion	330
Further reading	331
Answers to exercise	331

12

Financial market failure and nancial crises

332

12.1	Borrowing and lending problems in nancial intermediation	333
	12.1.1The nancing needs of rms and attempted remedies	333
	12.1.2Financial market exclusion	338
	12.1.3The nancial system and long-term saving	339
	12.1.4The nancial system and household indebtedness	345

12.2

Financial instability: bubbles and crises

347

ix

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Contents

12.3Fraudulent behaviour and scandals in nancial markets	351
12.4The damaging effects of international markets?	356
12.5Summary	358
Questions for discussion	359
Further reading	359

13

The regulation of nancial markets

361

13.1

The theory of regulation

365

13.2	Financial regulation in the UK	367
	13.2.1Regulatory changes in the 1980s	369
	13.2.2Supervision of the banking system	372
	13.2.3The 1998 reforms	376
	13.2.4The Financial Services Authority (FSA)	377

13.3	The European Union and nancial regulation	381
	13.3.1Regulation of the banking industry in the EU	384
	13.3.2Regulation of the securities markets in the EU	385
	13.3.3Regulation of insurance services in the EU	388

13.4	The problems of globalisation and the growing complexity of
	derivatives markets	389

13.5Summary	398
Questions for discussion	399
Further reading	399

Appendix I: Portfolio theory	401
Appendix II: Present and future value tables	419
Index	425

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FINM_A01.qxd 1/18/07 11:02 AM Page xi

Preface to the fth edition

The principal objective of this book is to help students make sense of the nancial

activity which these days is so prominently reported in the media. Making sense of

anything requires some grasp of theory and principles. We have done what we can

to minimise the use of theory, but because we want the book to be particularly use-

ful to students on A-level and rst degree courses, we have felt it necessary to explain

some basic ideas in nance and economics. Much of this is in Appendix 1: Portfolio

theory.

We try to ‘make sense of’ nancial activity from the economist’s perspective.

Thus, we go to some lengths to show how nancial activity has its origins in the real

economy and in the need to lend and to borrow to enable real investment to take

place. Similarly, when we talk about the shortcomings of nancial markets and insti-

tutions, we are concerned with the effects that these shortcomings have on the func-

tioning of the real economy. We have not produced a consumers’ guide to nancial

products and services. Financial advisers, both actual and potential, should nd

much of interest here, but it is not a guide to nancial products and services.

Because we want students to understand the events which they will come across,

we have made frequent use of material from the Financial Timesand from readily

available statistical sources. We have gone to some pains to explain how to interpret

the data from such sources. We hope this will encourage some students to update

the evidence we have provided.

In preparing this latest edition, we have taken the opportunity to update gures and

tables and to replace older with more recent illustrations. In response to readers’

comments we have also added a new chapter on the malfunctioning of the nancial

system (Chapter 12) and we have restructured Chapter 6 in order to treat the pricing

of bonds and equities separately.

PGAH

KB

	xi
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Guided tour

5.2 The ‘parallel’ markets

CHAPTER5	Box 5.4	London money market rates
		UK INTEREST RATES
The money markets		May 31Over-7 daysOneThreeSixOne
		nightnoticemonthmonthsmonthsyear
		11921921923525111527
		Interbank Sterling4–4–4–4–4–4–4–4–4–4–4–4–
		16163216321632832161632
		212121232515
		BBA Sterling4–4–4–4–4–4–
		323232323216
		51911213231529
		Sterling CDs4–4–4–4–4–4–4–4–
		83216324321632
		5191121
		Treasury Bills4–4–4–4–
		8321632
		5191121
		Bank Bills4–4–4–4–
		8321632
		5159115311157
		†Local authority deps.4–4–4–4–4–4–4–4–4–4–
		82816168416168
Objectives		21959
		Discount Market deps.4–4–4–4–
		3216816
		Av. tndr rate of discount May 26, 4.5129pc. ECGD xed rate Stlg. Export Finance. make up day Apr 29, 2006. Reference rate for
What you will learn in this chapter:
		period Apr 29, 2006 to May 31, 2005, Scheme V 4.701%. Finance House Base Rate 5pc for Apr 2006
		1
lWho uses the money markets and for what purpose		UK clearing bank base lending rate 4–per cent from Aug 4, 2005
		2
lWhat the various money markets are		Up to 11–33–66–99–12
		monthmonthsmonthsmonthsmonths
lHow different money market instruments are priced
		11
		Certs of Tax dep. (£100,000)13–3–33
lWhy ‘money market operations’ are important to central banks		24
		1
lHow to read, interpret and analyse data relating to the money market		Certs of Tax dep. under £100,000 is1pc. Deposits withdrawn for cash –pc.
		2

	FT
	Source: Reuters, RBS, †Tradition (UK) Ltd.
In Chapters 3 and 4 we have been looking at the major groups of institutions that
participate in the nancial system. In this chapter, and in Chapters 6, 8 and 9, we
shall look at the markets in which these institutions operate. Financial institutions
are not the only participants, of course. All nancial markets (not just the money	5.2The ‘parallel’ markets
markets) involve brokers, market-makers, speculators, as well as the ultimate borrowers
and lenders – rms, governments and occasionally households. Box 5.1 provides a	The parallel markets are also markets for short-term money. They therefore share
list of the major market participants and their functions. The box makes it clear why	many of the characteristics of the traditional, discount, market. Deals are done for
nancial markets tend to be dominated by institutions (DTIs and NDTIs) rather than	very large sums at very small rates of prot. Most of the participants, banks and
individuals.	discount houses, are common to both the traditional and parallel markets. In this
It is common to talk of two groups of domestic nancial markets: the money	section we shall provide a brief description of each of the markets and follow that
markets and the capital markets. In one sense this is misleading. In both markets	with a discussion of the signicance of the parallel markets as a group.
what is offered for sale is debts or claims, in exchange for money. In both markets
it is money that is being borrowed. The difference which justies the labels is the
	5.2.1The interbank market
period to maturity of the debts or, more simply, the length of time for which the
funds are borrowed. In the money markets, funds are borrowed for a short period,	As its name suggests, the interbank market is a market through which banks lend to
i.e. less than one year; in the capital markets, funds are borrowed for long-term use,	each other. Like the discount market this provides individual banks with an outlet
in some cases indeed with no promise of ever being repaid. Although the distinction	for surplus funds and a source of borrowing when their reserves are low. It is a
is useful and well recognised, it does not of course constrain people’s behaviour. Some	wholesale market. Deals are usually measured in £ms. The market developed in the
institutions – banks and building societies, for example – are accustomed to working	1960s, involving rstly overseas banks, and later merchant banks and discount houses.
in money markets, while others, like pension funds, are accustomed to capital markets,	Now it is used by all types of banks and it is not uncommon for NDTIs as well to
but these boundaries are occasionally crossed when commercial circumstances require.	lend surplus funds through this market.
Certainly, ultimate borrowers and lenders are free to switch as the advantage of doing	The loans are normally for very short periods, from overnight to fourteen days,
so presents itself. Firms may, as a rule, prefer to raise capital by issuing long-term bonds,	though some lending for three, six months and one year occurs. Naturally, given

117

129

..

Chapter Objectives– bullet points at the start of each	Boxes – provide different ways of illustrating and
chapter show what you can expect to learn from that	consolidating key points in the chapter. For example,
chapter, and highlight the core coverage.	Box 5.4 above provides information from the FT about
	selected instruments in the London money markets.

Chapter 5 • The money markets	6.3 Bonds: supply, demand and price
security and a secondary market, as though they were somehow different in location,design and rules.	Thus it follows that the value of the whole stream of payments is the sum of this progression. If P is the present value or price of the bond, then

	n
	1
	P∑C(6.3)
Primary market:A market for newlyissuedsecurities.	t
	(1 i)
	t1
Secondary market:The market for existingsecurities.
	In the case of an irredeemable bond, the payments go on for ever and t tends to
	innity. This means that the series
While the way in which a market fulls its primary
ant to borrowers, every market is dominated by secondary	1
	C(6.4)
In section 5.1 we shall look at the characteristics	i)t
	(1
at this in some detail for two reasons. Firstly, until very
	is converging on zero and the present value Pof the sum of the series can be more
was the money market in which the Bank of England
	conveniently written as
activities, and it remains important from that point
we learn about the discount market can be carried	PC/i(6.5)
our discussion of the parallel money markets in section
	This can be conrmed by taking the coupon of any undated government bond
at the way in which central banks, and the Bank of England
	from the Financial Timesand dividing it by the current long-term rate of interest.
their power in the money markets to set short-term

5.1	The discount market	Exercise 6.1(a)On 6 May 2006, long-term interest rates were about 4.6 per cent. Calculate a price
		1
		for the undated bonds ‘Treasury 2/2%’ on that day.
	In the discount market funds are raised by issuing bills, ‘at a discount’ to their eventual
		(b)What would the price have been if long-term interest rates had been 1.6 per cent?
	redemption or maturity value. We shall look at the characteristics of bills more carefully
	in a moment. Transactions in the discount market are normally very large, enabling	Answers at end of chapter
	prots to be made from deals involving differentials in discount rates of small fractions
	of 1 per cent. The market has no physical location, relying almost exclusively on
		However, most bonds in fact mature and so our formula has to include a valu-
	telephone contact between operators and, therefore, on verbal contracts.
		ation of the payment received on maturity. In this case Pis found as follows:
	As with any market, we can think in terms of a source of supply and a source of
	demand. In theory, bills can be issued by anyone, but in practice they are issued	n
		1G1J
		P∑CM(6.6)
		
	mainly by large corporations (commercial bills) and by the government (treasury bills).	tIi)nL
		(1 i)(1 
		t1
	The main buyers and holders of bills used to be a highly specialised group of banks
	known as discount houses. Their central role came about because traditionally the	where Mis the maturity value of the bond.
	Bank of England dealt only with the discount houses (rather than with the banks	Or, more compactly,
	or nancial institutions as a whole). In 1997, when the Bank began dealing directly
		CM
	with a wide range of banks, retail and wholesale, the discount houses lost their	P(6.7)
		∑tn
		(1 i)(1 i)
	special position and were generally absorbed into the banks that we described in
	Chapter 3 as investment banks. This means that treasury and other eligible bills are	Remember that in calculating Pwe have assumed that the next coupon payment
	now widely held throughout the banking system. As we said in section 3.3, this is	is one year away. This is a way of saying that the last coupon payment has just been
	one of the reasons why banks can manage with such a low ratio of primary reserves.	made. In practice, however, we shall often want to price bonds at dates which lie
	The existence of an active discount market, together with the distinctive characteristics	between two coupon payments. We might want to price a bond, for example, where
	of bills (we look at these in a moment), means that these assets are highly liquid. In	three months have elapsed since the last coupon payment (and there are three months
	the event of a shortage of primary reserves (cash and deposits with the central bank)	to run to the next half-coupon payment, or nine months to the next full payment).
	banks can sell bills very quickly and for a price which is virtually certain.	If we continue with our assumption of single, annual coupon payments, it is clear that
	Bills are certicates containing a promise to pay a specied sum of money to the	if we buy a bond three months after its last coupon payment, we have to wait only
	holder at a specied time in the future. After issue they can be traded (they are thus	nine months to get the next coupon, and waiting nine months for a given payment

120

169

..

....

Key terms– provide clear definitions of key concepts in	Exercises– boxed in colour and interspersed throughout
each chapter, highlighted in colour where first introduced.	every chapter, providing an opportunity to practise the
	new calculations you will learn in each chapter. Answers
	to the exercises are provided at the end of each chapter.

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Guided Tour

Chapter 4 • Non-deposit-taking institutions

5.3 Monetary policy and the money markets

were persuaded to switch to private provision. It was always unlikely that personal pension products could provide larger benets than occupational schemes, since an employee in an occupational scheme beneted from the fact that the employer also contributed. Furthermore, using the terms that we have explained above, these private pensions were all funded schemes based on dened contributions. Inevitably, therefore, some of those who switched to a private pension scheme gave up not only their employer’s contribution to their retirement income but also his willingness to bear the risk that the fund might not be large enough to pay the target income. Fortunately, it is possible to establish retrospectively those cases where personal pen- sions were ‘missold’. In 1995, the Personal Investment Authority (see Chapter 13) insisted that pension funds should do precisely that and it estimated that there were more than 300,000 ‘priority’ cases where compensation was urgently required. As with other intermediaries, the nature of pension fund liabilities inuences the composition of the asset portfolio. If the purpose of the fund is to collect ‘lifetime’ contributions in order to pay a pension that is related to nal salary or earnings, it is obviously a fundamental requirement that an employee’s contributions be invested in a manner which keeps their value at least in line with rising real earnings. As we saw with long-term insurance funds, this inevitably means an emphasis uponFigures– offer graphicalcompany securities. Figure 4.2 shows the composition of pension funds’ portfolios in 2004. Notice rstly that at £761bn the market value of pension fund assets at the end of 2004 wasrepresentation of, forsecond only to that of long-term insurance funds. Of this total, UK company secur- ities accounted for over 29 per cent, and overseas securities, by far the greater partexample, data andof which are also company shares, accounted for nearly 23 per cent. UK government instruments discussed in each chapter. Figure 4.2Pension fund asset holdings at end 2004 (£bn) Source: Adapted from ONS, Financial Statistics, April 2006. Table 5.1B

Figure 5.2 To understand the difference involved in choosing between these instruments, consider Figure 5.2. At one end of the spectrum, the central bank can set the quantity of reserves and refuse to adjust it in response to any changes in demand. In this case, the supply of reserves is shown by the vertical supply curve Sin the diagram and 1 the quantity of reserves is R*. Banks’ demand for these reserves is shown by the demand curve, D. Notice that the demand curve is drawn steeply. Provided that 1 banks offer free convertibility between deposits and notes and coin (and we saw in Chapter 3 that their ability to do this is crucial to condence in the system), their demand for reserves is very inelastic. To begin with, we have an equilibrium position at a (short-term nominal) rate of interest at i*. Suppose now that banks demand more reserves. Remember: this could be because their clients are making net payments to government or it could simply be that they have increased their lending (for com- mercial reasons) and now need additional reserves to hold against the extra deposits. The demand curve shifts outwards to D. Given the inelasticity of demand, interest 2 rates could rise very quickly indeed and to very high levels. i′is the example in the diagram. Demand is inelastic because banks must be able to ensure convertibility. And since their liquidity position is calculated when interbank settlements take place at the end of each day, they need the reserves instantly. Faced with a shortage of reserves, banks will bid aggressively for short-term funds. For every £1 gained in customer deposits, there is an equal gain in deposits at the central bank. This one- for-one gain raises the D/Dratio. But in a situation where reserves are in generally bp short supply, bidding for deposits will not solve the problem. What one bank gains, another bank loses. But while attempts by individual banks to gain reserves will be self-defeating, they will push up short-term rates sharply. At the other end of the spectrum, the central bank may respond to the increase in demand by providing additional reserves which completely accommodate the demand. This it mustdo if it wishes the rate of interest, i*, to continue. Such a situation is shown in the diagram by the supply curve S, drawn horizontally at the going rate 2 of interest.

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Chapter 2 • The nancial system and the real economy

Questions for discussion

1Distinguish between ‘saving’, ‘lending’ and a ‘nancial surplus’.

2A nancial surplus mustresult in the net acquisition of nancial assets. Assume that

you are in normal employment and that you regularly run a nancial surplus. Assume

further that you make no conscious decision to buy nancial assets. What nancial

assets will you inevitably acquire?

3If your income and capital account showed that you had made a ‘negative net

acquisition of nancial assets’, what would this mean in practice?

4Using the latest available gures, nd the value of households’ net acquisition of UK

ordinary company shares. How does this acquisition gure compare with the stock of

ordinary company shares already held? What were the most popular assets acquired

by households?

5Outline three ways in which the behaviour of the nancial system could affect the level

of aggregate demand in the economy.

6Suppose that prices in the US stock market suffer a major collapse. What effect would

you expect this to have upon the rest of the US economy and the economies of other

developed countries?

7Why does a company’s share price matter in a takeover battle? If you were the nancial

director of a predator rm, what would you want to happen to your rm’s share price?

Might you be able to inuence it in any way?

8Why might nancial systems fail to allocate resources to their most desirable use?

Further reading

AD Bain, The Financial System(Oxford: Blackwell, 2e, 1992) ch. 2

M Buckle and J Thompson, The UK Financial System(Manchester: Manchester UP, 4e, 2004)

chs. 1 and 16

PGA Howells and K Bain, The Economics of Money, Banking and Finance(Harlow: Financial

Times Prentice Hall, 3e, 2005) ch. 1

PJ Montiel, Macroeconomics in Emerging Markets(Cambridge: CUP, 2003) ch. 12

AM Santomero and DF Babbell, Financial Markets, Instruments and Institutions(McGraw-

Hill, 2e, 2001) chs. 1 and 2

Answers to exercises

2.1(a) £83.8 million (or 16.8%); (b) £7m; (c) £76.8 million.

2.2(a) Initial velocity was 0.888; (b) it was expected to fall to about 0.870 (i.e. by about 2 per cent).

2.3Initial average holdings of money are £2,000 and velocity is 1.0. After the change, money holdings

are £1,100 and velocity is 1.82. The loan will nance £1,636 of spending.

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Questions for discussion– at the end of each

chapter are longer questions to ponder over and

discuss amongst your peers in class. Answers

for these can be found on the companion

website.

Further reading– provides full details of

sources to refer to for further information on the

topics covered in the chapter.

Answers to exercises– provide answers to the

boxed exercise in the chapter.

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Acknowledgements

The publishers are grateful to the Financial Times Limited for permission to reprint the

followingmaterial:

Box 4.3 Unit trust prices and yields, © Financial Times, 10/11 May 2003; Box 5.4 London

money market rates, © Financial Times, 7 May 2003; Box 6.8 Fed’s comments result

in a tumble, © Financial Times, 10/11 May 2003; Box 6.9 Rally sends FTSE past...,

© Financial Times, 7 May 2003; Box 6.10 UK Gilts – cash market, © Financial Times,

10/11 May 2003; Box 6.11 Food and drug retailers, © Financial Times, 7 May 2003;

Box 7.6 UK interest rate cut surprises gilt traders, from FT.com, © Financial Times,

6 February 2003; Box 8.2 The market interpretation of news, © Financial Times,

7 February 2003; Box 9.2 Interest rate futures, © Financial Times, 19 March 2003.

We are grateful to the following for permission to reproduce copyright material:

Tables 2.1, 2.2 and 2.3 adapted from Annual Accounts, 2002 (Ofce of National Statistics

2002) Crown copyright material is reproduced with the permission of the Controller

of HMSO and the Queen’s Printer for Scotland; Tables 3.2, 3.3 and 3.5 adapted from

Monetary and Financial Statistics, January 2003(Bank of England 2003) (all percentages

are calculated by Pearson Education and not the Bank of England); Table 3.4 adapted

from Financial Statistics, December 2002(Ofce of National Statistics 2002) Crown

copyright material is reproduced with the permission of the Controller of HMSO and

the Queen’s Printer for Scotland; Figures 4.1, 4.2, 4.3 and 4.4 adapted from Financial

Statistics, February 2003(Ofce of National Statistics 2003) Crown copyright material

is reproduced with the permission of the Controller of HMSO and the Queen’s Printer

for Scotland; Tables 4.1, 6.1 and 6.2 adapted from Financial Statistics, April 2003

(Ofce of National Statistics 2003) Crown copyright material is reproduced with the

permission of the Controller of HMSO and the Queen’s Printer for Scotland; Table 11.2

adapted from UK Budget Report 2003(HM Treasury at www.hm-treasury.gov.uk 2003)

Crown copyright material is reproduced with the permission of the Controller of

HMSO and the Queen’s Printer for Scotland; Table 11.3 adapted from Quarterly Bulletin

(Bank of England Winter 2001).

In some instances we have been unable to trace the owners of copyright material,

and we would appreciate any information that would enable us to do so.

The authors would like to thank colleagues and students at the Universities of East

London and the West of England who made numerous suggestions, spotted errors,

criticised and encouraged. Our thanks go especially to Murray Glickman, Iris Biefang-

FrisanchoMariscal and Derick Boyd.

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Terms used in equations

B	monetary base
c	coupon rate
C	coupon payment
d	rate of discount
g	growth rate of earnings
i	nominal rate of interest
K	the actual return on an asset
C	the expected return on an asset
A	the required return on an asset

Kthe rate of return on the ‘whole market’ portfolio or a whole market index fund

m

K	the risk-free rate of return, usually equivalent to iand, in practice, normally
rf	the rate of interest on treasury bills or government bonds

M	the maturity value (of a bond or bill)

M	money stock
s

nperiod to maturity

Pthe purchase or market price (the price level, in the aggregate)

Gthe rate of ination

G^ethe expected rate of ination

rthe real rate of interest

Rredemption value

the standard deviation (of an asset’s return)

2

the variance (of an asset’s return)

yyield

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Supporting resources

Visit www.pearsoned.co.uk/howellsto find valuable online resources

Companion Website for students

lMultiple choice questions to test your learning

lWritten answer questions providing the opportunity to answer longer

questions

lAnnotated links to valuable sites of interest on the web

For instructors

lInstructor’s Manual consisting of detailed outlines of each chapter’s

objectives, answers to the questions for discussion at the end of each

chapter, notes on how to use weblinks and other resources

lTaking it further supplement containing notes and extra questions for each

chapter, stretching the subject further and providing more advanced material

Also:The Companion Website provides the following features:

l	Search tool to help locate specific items of content
l	E-mail results and profile tools to send results of quizzes to instructors
l	Online help and support to assist with website usage and troubleshooting

For more information please contact your local Pearson Education sales

representative or visit www.pearsoned.co.uk/howells

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CHAPTER1