ECS3701 MAY/JUN 2013 MEMO
SECTION A COMPULSORY QUESTION
QUESTION 1
1.1 Differentiate between the following
(i) Direct and indirect finance [4]
-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
(ii) 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.
1.2 Financial intermediaries promote economic efficiency by performing a variety of
services. 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 [8]
- 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:
1. Adverse Selection – created by asymmetric selection before the transaction
occurs. It occurs when the potential borrows who are most likely to produce an
ECS3701 EXAM PACK
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,undesirable outcome (bad credit risks) are the ones who most actively seek out loans
and thus are likely to be selected causing lenders not to make any loans .
2. 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.
1.3 List and explain the three functions of money [6]
-medium of exchange – means of making payments and receiving goods and services
in return
-unit of account- used to ascertaining the value of a product or service
-store of value
1.4 Assume that at an MPC meeting at the South African Reserve Bank decides to
have a contractionary monetary policy. What impact will this have on real production
(Y)? Motivate your answer by discussing the credit channel transmission mechanism,
in the South African context. [16]
-The monetary policy effect is represented as:
↑repo rate → ↓bank deposits → ↓bank loans → (↓Inv, ↓C) → ↓Y
-This channel operates, firstly, through bank lending. Certain borrowers will not
have access to credit markets unless they borrow from banks. Contractionary
monetary policy reduces bank reserves and bank deposits, thus decreasing the
amount of loans available. This decrease in loans will cause fixed capital formation
and consumer spending to drop.
-A significant implication is that monetary policy through this channel will have a
greater effect on those more reliant on bank loans, such as smaller firms, since
larger firms have recourse to obtaining funds by issuing new share capital. As
circumstances and restrictive regulatory frameworks change to restrict banks from the
ability to raise funds, the potency of this channel will be reduced.
Secondly, credit affects the balance sheets of households and firms and also arises
ECS3701 EXAM PACK
2
,from asymmetric information in credit markets:
↑repo rate → ↓price expectations → ↓cash flow → ↑adverse selection →
→ ↑moral hazard → ↓lending → (↓Inv, ↓C) → ↓Y
Detailed logical sequence of events will earn the student full marks.
SECTION B OPTIONAL QUESTIONS
Question 2
2.1 With the aid of diagrams and explanations, explain how a higher expected rate of
inflation will influence:
(i) the demand for and supply of bonds
(ii) the equilibrium price of bonds
(iii)the equilibrium quantity of bonds [15]
Maximum of 6 marks for correct graph
The figure shows the effect on the equilibrium interest rate of an increase in the
expected inflation.
If expected inflation is initially 5% and the initial supply and demand curves intersect
at 1 where equilibrium bond price is P1.
1. If expected inflation rises to 10%, the expected return on bonds relative to real
assets falls and the demand curve shifts to the left from 𝐵1𝑑 to 𝐵2𝑑 .
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, 2. The rise in inflation also shifts the supply curve, the real cost of borrowing has
declined causing the bonds supplied to increase shifting the supply curve to the
left from 𝐵1𝑠 to 𝐵2𝑠 .
3. There is a new equilibrium at point 2, the bond price has fallen to P2 and
because the bond price is negatively related to the inflation rate, this means
interest has not risen. The quantity of bonds could also rise or fall with inflation.
2.2 The money multiplier is given by:
1+𝑐
𝑀= ( 𝑀𝐵)
𝑟𝑟 + 𝑒 + 𝑐
What do the variables r, e and c represent? What will be the effect of a decrease in r
on the multiplier? [5]
-r is reserve requirement ratio
-e is the excess reserves ratio
-c is the currency ratio
-a decrease in r results in a lower multiplier
Question 3
3.1 Illustrate with the aid of a diagram the flow of funds through the financial system.
(Hint: Show and explain all the direction of flows) [10]
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SECTION A COMPULSORY QUESTION
QUESTION 1
1.1 Differentiate between the following
(i) Direct and indirect finance [4]
-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
(ii) 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.
1.2 Financial intermediaries promote economic efficiency by performing a variety of
services. 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 [8]
- 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:
1. Adverse Selection – created by asymmetric selection before the transaction
occurs. It occurs when the potential borrows who are most likely to produce an
ECS3701 EXAM PACK
1
,undesirable outcome (bad credit risks) are the ones who most actively seek out loans
and thus are likely to be selected causing lenders not to make any loans .
2. 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.
1.3 List and explain the three functions of money [6]
-medium of exchange – means of making payments and receiving goods and services
in return
-unit of account- used to ascertaining the value of a product or service
-store of value
1.4 Assume that at an MPC meeting at the South African Reserve Bank decides to
have a contractionary monetary policy. What impact will this have on real production
(Y)? Motivate your answer by discussing the credit channel transmission mechanism,
in the South African context. [16]
-The monetary policy effect is represented as:
↑repo rate → ↓bank deposits → ↓bank loans → (↓Inv, ↓C) → ↓Y
-This channel operates, firstly, through bank lending. Certain borrowers will not
have access to credit markets unless they borrow from banks. Contractionary
monetary policy reduces bank reserves and bank deposits, thus decreasing the
amount of loans available. This decrease in loans will cause fixed capital formation
and consumer spending to drop.
-A significant implication is that monetary policy through this channel will have a
greater effect on those more reliant on bank loans, such as smaller firms, since
larger firms have recourse to obtaining funds by issuing new share capital. As
circumstances and restrictive regulatory frameworks change to restrict banks from the
ability to raise funds, the potency of this channel will be reduced.
Secondly, credit affects the balance sheets of households and firms and also arises
ECS3701 EXAM PACK
2
,from asymmetric information in credit markets:
↑repo rate → ↓price expectations → ↓cash flow → ↑adverse selection →
→ ↑moral hazard → ↓lending → (↓Inv, ↓C) → ↓Y
Detailed logical sequence of events will earn the student full marks.
SECTION B OPTIONAL QUESTIONS
Question 2
2.1 With the aid of diagrams and explanations, explain how a higher expected rate of
inflation will influence:
(i) the demand for and supply of bonds
(ii) the equilibrium price of bonds
(iii)the equilibrium quantity of bonds [15]
Maximum of 6 marks for correct graph
The figure shows the effect on the equilibrium interest rate of an increase in the
expected inflation.
If expected inflation is initially 5% and the initial supply and demand curves intersect
at 1 where equilibrium bond price is P1.
1. If expected inflation rises to 10%, the expected return on bonds relative to real
assets falls and the demand curve shifts to the left from 𝐵1𝑑 to 𝐵2𝑑 .
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3
, 2. The rise in inflation also shifts the supply curve, the real cost of borrowing has
declined causing the bonds supplied to increase shifting the supply curve to the
left from 𝐵1𝑠 to 𝐵2𝑠 .
3. There is a new equilibrium at point 2, the bond price has fallen to P2 and
because the bond price is negatively related to the inflation rate, this means
interest has not risen. The quantity of bonds could also rise or fall with inflation.
2.2 The money multiplier is given by:
1+𝑐
𝑀= ( 𝑀𝐵)
𝑟𝑟 + 𝑒 + 𝑐
What do the variables r, e and c represent? What will be the effect of a decrease in r
on the multiplier? [5]
-r is reserve requirement ratio
-e is the excess reserves ratio
-c is the currency ratio
-a decrease in r results in a lower multiplier
Question 3
3.1 Illustrate with the aid of a diagram the flow of funds through the financial system.
(Hint: Show and explain all the direction of flows) [10]
ECS3701 EXAM PACK
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