Economics for Business: UK Banking Crisis Factors and Monetary Policy

This report delves into the economic factors that could trigger future banking crises in the UK, focusing on the credit creation theory of banking and the quantity theory of credit. It examines how excessive credit booms, unstable macroeconomic policies, and financialization contribute to financial instability. The report further analyzes the monetary transmission mechanism, particularly how interest rate reductions impact economic growth. It uses the example of a decline in the Bank of England's base rate to illustrate how lower interest rates can stimulate borrowing, investment, and production of goods and services. The report highlights the interconnectedness of monetary policy, market rates, asset prices, and the exchange rate, providing a comprehensive overview of these economic concepts.

ECONOMICS FOR
BUSINESS

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
PART A...........................................................................................................................................3
Explaining the important factor that may cause future banking crisis in UK.............................3
PART 2............................................................................................................................................6
Use of monetary transmission mechanism to explain how an interest rate reduction can
improve the rate of economic growth of real economy..............................................................6
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Business economics is the field which studied the financial, organizational and market
related issues faced by the corporation or government. The present study will highlight the
importance of credit creation theory of banking and quantity theory of credit in order to explain
the important factors which causes future banking crisis. Further, by using monetary
transmission mechanism theory, study will determine how the interest rate reduction can
improve the rate of economic growth in the real economy by considering the interest rate decline
from 5.75% to 0.05%.
PART A
Explaining the important factor that may cause future banking crisis in UK
Majority of the money in the economy is creates by the commercial banks such that
around 3% of the money in circulation. Research also indicate that around 97% of the money
within UK economy is consist of money which circulated by commercial banks, not Bank of
England. It is evaluated that there is a range of money available in UK which includes bank
deposits.
It has been evaluated that money supply is directly related with gross domestic product
(GDP). Thus, as he GDP increases there is a increase the Broad money in the market of UK. In

May 2018, the GDP of the country is 500 thousand billion pound and there is a direct
relationship within broad money. The red line of the graph indicates the broad money which was
constant from 1963 to 1984 with relation to GDP. The reason is divergence between money
supply and GDP increase proportion of money.
There are two theories which help banks to create money through banking system such
that Bank deposit multiplier and Credit creation theory. It must be celared that bank do not create
money but banking system does. Fractional reserve banking system stated that banks only
maintain small portion of customer deposit in liquid assets which enable them to use them as a
loan that help to attain the financial return (Tailab, 2020). As per the Credit creation theory of
banking, bank does not solely lend out money deposited with bank. Also, the bank deposits also
referred as credit money because banks issuing new loans through this amount. Further, bank
have an ability to create the money that is also termed as credit money which is the significant
consequence of range of factors.
In this, non-cash transaction accounts for more than 95% of all the transaction which are
conducted through an economy and the same will be settled through non-cash transfers within a
specific banking system. Thus, it is reflected that bank acts as an accountant of record which
helps bank to create fiction that borrower deposited money. Moreover, the capability of a bank
also creates credit money which is another consequence of being exempt from the client money
rules. Government of UK also made different regulation in the form of client money rules which
protect banks to create credit money, as bank require lot of records that separate from non-bank
organization’s assets (Ahmed, Bangassa and Akbar, 2020). However, it has been analyzed that
that there is no specific law mentioned by the government which allows bank to reclassify their
liabilities which also turn the banks into financial crisis. As per the Seigniorage traditionally
which refers to the profit that received by central bank by creates new money and also calculated
the difference between cost of producing physical money and purchasing power of newly created
money within economy.
Hence, as per the theory of Credit creation of banking it can be stated that excessive
credit boom can be consider the financial crisis because investors started invest within bank and
its causes adverse impact in order to make the flow of money. Thus, it is indicate that entire
system of bank is depend upon the credit and though bank deposit minimum reserve to meet the
demand of its depositor and then lend out remaining in order to earn income. If such is not

followed then banking leads towards crisis which directly affected the GDP of UK because
money is interlinked with GDP.
On the other side, Quantity Theory of Credit further proposes banks to lend for business
investment to private non-financial business in order to grow within economic activity. Also,
only 15.5% off lending by UK financial institution directed towards non-financial firms. The
theory stated that banking crisis tend to increases when there is an increase in asset prices
(Utilising the Quantity Theory of Credit to Understand the Causes of the 2007 Financial
Crisis,2020). For that , it also refer the term known as Minsky moment which is all about a
sudden fall in asset prices that is further followed the heavy use of credit to purchase assets.
Apart from this, another consequence for financial crisis is related to Financialisation which is
increase dominance of economy, politics by financial interest. This is reflects when all the
financial sector of UK are wealthy and further influence the economy of a country along with
political institutions.
The government of UK also allocate the sectors into different manner as defined under
the pie-chart. However, past records shows that there is a fallen of financial institution by 21%
since 2008, while lending to unincorporated business fallen by 41% since 2008.

In addition to this, lending of UK is direct towards the existing property and financial
assets which further contribute towards UK economy, it is also evaluated that if increase in
purchasing power was directed towards purchase of current assets which is relatively fixed in
supply. Due to Brexit and 2007 financial crisis was consider the biggest consequence of
commercial bank that also encourage the speculators to buy current properties with an intention
of profit from increasing an asset values. Jordana and Triviño‐Salazar(2020) shared that Bank of
England must implement new regulations which in turn assist to reduce their lending and credit
money creation that helps to rebalancing the asset purchase, further help to grow economy as
well. On the other sideTunay, Yüceyılmaz and Çilesiz(2020) argued to lower down the interest
rate which further increase borrowing by firm and households due to future cost of repaying
debts is minimized.
Also, it is reflected that by using the theory of Credit Creation theory of banking and
qquantity theory of credit, it can be stated that there are many factors that causes banking crisis
in UK which includes unstable macro- economic policies and excessive credit booms, large
capital inflows in which range of financial corporate affected. As a result, non-performing loans
also increases frequently which affect overall banking system of UK. There is a need to make
control of such aspects in order to maintain the flow of money within market, as there is a direct
relationship identified within GDP and broad money.
PART 2
Use of monetary transmission mechanism to explain how an interest rate reduction can improve
the rate of economic growth of real economy
The monetary transmission mechanism is being defined as the process through which
monetary policy is been prepared this is a powerful tool which assist in taking decisions relating
to economic growth prices and other related aspects of the economy (Baker, Kumar and Pandey,
2021). The images are stated below simplifies the monetary transmission mechanism which is
discussed below the image-

With the evaluation of the image it is clear that the official rate is informed by the central
bank. This official rate is for the divided into different aspects like fixed income rate asset
valuations expectations and the exchange rate. The exchange rate is imposed over the import
prices because of the reason that this is inter country transaction. In addition to this the other
three aspects that is fixed in complete asset valuation in the expectation is for the demand of
goods and services. By combining both the demand for goods and services and import prices the
inflation is being caused. Central bank is the bank through which all the other banks share the
similar objectives. The predominant objective of the central bank is the stability of the prices in
addition to this unemployment and sustained economic growth is also a major objective of the
business.
In order to reach the goals of the bill Bank the central bank has several monetary policies
like interest rate, quantitative easing and tightening reserve requirement and the interest on
reserves. All these monetary policies been implemented at used by the Central Bank in order to
manage and maintain the price stability. For the effective working of the whole world economy
the central bank works continuously on the price stability and to ensure that there is proper flow
of money within the economy. The interest rate is the major monetary transmission mechanism
which is being used by Central Bank in order to effect and influence the economy and its
working (Demirel and et.al., 2019). The monetary transmission mechanism mainly operates and
works with the analysis of the interest rate officially said by the central bank. If there is any
change in the official interest rate it is usually transmitted to the economy with help of four
interconnected channels which are the market rate expectations asset price and the exchange rate.

Further in case the central bank decreases the interest rate than this will have a good
impact over the export import prices as well. The reason underlying this part is that when the
easy loan will be available then people will take loan and try to export the goods and services to
other countries and will earn a good amount of profit (Lawrence, 2018). As a result of this there
will be more flow of foreign currency within the economy and this will increase the profitability
of the economy and the flow of money will also be increased. For the more in addition to this if
the official interest rate will be decreased then people can borrow the money and try to invest
within the assets. This is pertaining to the fact that when the rate of interest will be low then
more of the people will take loans and will fulfil their investment needs. The reason underlying
this fact is that the investment will in turn provides more income to the people and hence they
will take loan in order to invest within the money. With the income from the investment the
people can repay the loans in instalments and also the interest.
Discussing the ways in which lower interest rates will promote an increase in production of
goods and services within currency area
In the present case the bank of England base rate has declined from 5.75% to 0.5 % on
5th March 2009. This lowering the rate of interest assists in promoting and increasing the
production of goods and services within the country. The major reason pertaining to this factor
start if the interest rates are being lower than this affects the economy in positive manner. This is
majorly because of the reason that if the central bank decreases the official interest rate than the
lending rates of bank will fall and this will result in increased borrowings. This is pertaining to
the fact that in case the interest rates by the central bank have been decreased then the regional
banks and other banks will charge less interest rate. If the interest rate will be decrease the more
of the people will take loan from the financial institutions. And in case of the more loans is being
taken then this will be invested within the increase of the production of goods and services. In
addition to this it will increase the production of goods and services because easy nose will be
available at cheaper rate and this will assist the people in earning more of the profits. In case
people will earn more of the profits then they will take more loans and as a result of this there
will be economic profit and good flow of money within the economy (Cleff, 2019).
Hence with the evaluation of the above data it is clear that lowering the interest rate will
definitely promote an increase within the production of goods and services in that particular
country. The reason behind this fact is that if the interest rate will be lower than more people will

be attracted towards taking loans. As a result of increase in the loans there will be more flow of
money within the country. Hence as a result of this the economic growth of the country will be
more as more people will be investing money within production of goods and services.
CONCLUSION
In the end from the above report it is concluded that business economics is being defined
as the field of studying the financial market related and organisational related issues being faced
by the government of the corporation's. With the evaluation of this study it was evaluated that for
the better economic working and conditions in a country the government has to take many
measures in steps. The above study highlighted the fact that it is very important for the
government to apply credit creation theory of banking and the quantity theory of credit. This is
necessary in order to explain the important factors which may cause the banking crisis to happen
in future. For the it also highlighted the fact that the use of monetary transmission mechanism
theory is very essential to understand the fact that how interest rate reduction can improve the
rate of economic growth within the economy.

REFERENCES
Books and Journals
Ahmed, S., Bangassa, K. and Akbar, S., 2020. A study on trust restoration efforts in the UK
retail banking industry. The British Accounting Review. 52(1). p.100871.
Baker, H.K., Kumar, S. and Pandey, N., 2021. Thirty years of Small Business Economics: A
bibliometric overview. Small Business Economics, 56(1), pp.487-517.
Cleff, T., 2019. Applied statistics and multivariate data analysis for business and economics.
Springer International Publishing.
Demirel, P., Li, Q.C., Rentocchini, F. and Tamvada, J.P., 2019. Born to be green: new insights
into the economics and management of green entrepreneurship. Small Business
Economics, 52(4), pp.759-771.
Jordana, J. and Triviño‐Salazar, J.C., 2020. EU agencies' involvement in transboundary crisis
response: Supporting efforts or leading coordination?. Public Administration. 98(2).
pp.515-529.
Lawrence, R.J., 2018. Applications in economics and business. In Lognormal Distributions (pp.
229-266). Routledge.
Tailab, M.M.K., 2020. Using Importance-Performance Matrix Analysis to Evaluate the Financial
Performance of American Banks During the Financial Crisis. SAGE Open. 10(1).
p.2158244020902079.
Tunay, K.B., Yüceyılmaz, H.F. and Çilesiz, A., 2020. In emerging economies, the effect of
excessive credit growth and non-performing loans on banking crisis. Contaduría y
administración. 65(1). p.15.
Online
Utilising the Quantity Theory of Credit to Understand the Causes of the 2007 Financial Crisis.
2020. [Online]. Available through:
<https://www.economicsnetwork.ac.uk/archive/starkey_banking2#:~:text=The
%20Quantity%20Theory%20of%20Credit%20proposes%20that%20increasing%20the
%20allocation,%3B%20Werner%20R.%20A.%2C%202005). >.