Edexcel A-Level Economics A (9EC0) · Theme 4
Specification points
- The role of financial markets and the reasons they exist.
- Market failure in the financial sector.
- The role of central banks.
The role of financial markets
Financial markets channel funds from savers to borrowers and support the real economy. Their main roles are to:
- Facilitate saving and lend to households and firms.
- Allocate funds to productive investment.
- Provide a payments system and enable trade.
- Provide forward (futures) markets to manage risk and price volatility.
Market failure in the financial sector
The 2008 crisis highlighted why finance can fail:
- Asymmetric information — lenders misjudge borrower risk; savers misjudge products.
- Externalities — one bank's failure threatens the whole system (systemic risk).
- Moral hazard — banks take excessive risk expecting bailouts ("too big to fail").
- Speculation and market bubbles — asset prices detach from fundamentals.
- Market rigging — manipulation of prices or rates.
Key definitions
| Term | Definition |
|---|---|
| Systemic risk | The risk that the failure of one institution collapses the whole system. |
| Moral hazard | Taking greater risk because the cost falls on others. |
| Central bank | The institution responsible for monetary policy and financial stability. |
The role of central banks
A central bank (e.g. the Bank of England) has three core functions:
- Monetary policy — setting interest rates and using quantitative easing to hit the inflation target.
- Banker to the government and to banks — managing government accounts and the payments system.
- Financial stability / regulation — acting as lender of last resort and supervising the banking system to prevent crises.
Worked example
Before 2008, banks lent heavily to risky borrowers, mispricing risk (asymmetric information) and assuming they were "too big to fail" (moral hazard). When defaults rose, systemic risk spread and governments bailed banks out. In response, central banks and regulators raised capital requirements — a response to the sector's market failures.
Common exam mistakes
- Listing financial market roles without linking to the real economy.
- Confusing moral hazard with adverse selection.
- Forgetting the central bank's financial-stability role alongside monetary policy.
Exam technique
Explain each role or failure with a real example, and evaluate regulation using moral hazard, systemic risk and information problems.
Quick revision
- Financial markets: saving, lending, allocation, payments, risk management.
- Failures: asymmetric information, systemic risk, moral hazard, speculation.
- Central bank: monetary policy, banker, financial stability (lender of last resort).