Exam (elaborations)
Exam (elaborations) ECS3701 - Monetary Economics (ECS3701)
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- University Of South Africa (Unisa)
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Briefly distinguish between money and income. (2)
Money is anything that is generally accepted in payment for goods and
services or in repayment of debts. Income is the flow of earnings over a
period of time. Money doesnot mean the same as wealth or income.
Distinguish between nominal and real interest rate (3)
The real interest rate is defined as the nominal interest minus the
expected rate of inflation. The real interest rate reflects the real cost of
borrowing and is likely to be a better indicator of the incentives to
borrow and lend.
The nominal interest rate ignores the effects of inflation and is
frequentlythe interest rate which is generally referred to in an economy.
Explain any TWO of the following money market instruments:
Treasury bills: short-term debt instrument issued by government. It is a
primary security. It represents a claim on the government payable at some
future date. TBs are fully secured and guaranteed by the government in
SA.
Negotiable certificates of deposit: a debt instrument sold by a bank to
depositors that pays annual interest of a given amount and at maturity
pays back the original purchase price. Negotiable NCDs are sold in the
secondary market.
Bankers’ acceptances: a bank draft (a promise of payment) issued by a
firm, payable at some future date, and guaranteed for a fee by the bank
that stamps it. The firm issuing the instrument is required to deposit the
required funds into its account with the bank to cover the draft.
List and explain the three primary functions of money. (2)
Medium of Exchange: money is used as a payment for goods and
services. It facilities the exchange of value between economic agents and
reduce the time taken for transactions to take place, therefore promotes
economic efficiency.
Unit of Account: it can be a medium through which value can be
exchanged because it the measure which value of all goods and
services can be expressed. Thus money is used to measure value of
goods and services in an economy. With value of all commodities
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expressed in monetary terms, this helps to reduce transaction costs.
Store of Value: with all goods possibly be measured in monetary
terms, it becomes clear that we can know the value of goods today and
tomorrow in monetary terms. As a result, people can at any time keep
the value of anything in money which serves as a store of purchasing
power. This can be from the time income is earned to the time it is
spent.
Explain the functions performed by financial intermediaries and how
they can promote economic efficiency in financial markets. (8)
The basic function of financial markets is to channel funds from savers
who have an excess of funds to borrowers (spenders) who have a
shortage of funds. Financial markets can do this either through direct
finance, or through indirect finance which involves a financial
intermediary. The intermediary acts by channeling funds from the surplus
unit to the deficit unit and helps to overcome some of the problems that
exist such as transactions costs and asymmetric information.
This channeling of funds helps improve the economic welfare of
everyone in society because it allows funds to move from people
who have no productive investment opportunities to those who have
such opportunities. In this way financial markets contribute to
economic efficiency. In addition the channeling of funds can directly
benefit consumers by allowing them to make purchases when they
need themmost.
Differentiate between Direct and indirect finance
-direct financing- borrowers borrow funds directly from lenders in the financial markets
by selling them securities
-Indirect finance- financial intermediary stands between lender-savers and borrower-
spenders and helps transfer funds from one to the other
Differentiate between Money market and capital market [4]
The money market is a financial market in which only short-term debt instruments
are traded. They are more widely traded and so tend to be more liquid. Short term
instruments also have smaller fluctuations making them safer instruments.
The capital market is the market in which longer-term debt and equity instruments
are traded.
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Financial intermediaries promote economic efficiency by performing a variety
ofservices. Explain the following functions of financial intermediaries.
(i) Lower transaction costs [2]
- transaction costs are the time and money spent in carrying out financial transactions.
Financial intermediaries reduce the transaction costs as they have the expertise and
can take advantage of economies of scale. The low cost allows financial
intermediaries to provide customers with liquid services, i.e. services that make it
easier to conduct transactions.
(ii) Asymmetric information
- Asymmetric information is when one party does not know enough about the other
party to make accurate decisions. Lack of information creates problems on two
fronts:
Adverse Selection – created by asymmetric selection before the transaction occurs. It
occurs when the potential borrows who are most likely to produce an undesirable
outcome (bad credit risks) are the ones who most actively seek out loansand thus are
likely to be selected causing lenders not to make any loans.
1. Moral Hazard- created by asymmetric selection after the transaction occurs. It is the
risk (hazard) that the borrower might engage in activities that are undesirable
(immoral) from a lenders point of view as the loan is less likely to be paid back.
Financial intermediaries are better equipped to than individuals to screen out the bad
credit risks from the good ones reducing the losses resulting from adverse
selection.
Derive the simple multiple deposit creation model (formula: ΔD =
1/rΔR). Explain its meaning, the underlying logic of the process, its
simplifying assumptions and its critique.
In the case of the USA, when the Federal Reserve supplies the banking
system with additional reserves, the deposits increase by a multiple of this
amount, this process is called multiple deposit creation.
Assumptions of the model (process):
In the case of the single bank: a single bank will not make loans
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