AUE2601
EXAM PACK
,ECS3701 – May/June 2025
Question 1
1.1 Distinguishing Key Financial Concepts
Direct vs Indirect Finance
Direct finance occurs when borrowers obtain funds straight from lenders by
selling securities such as bonds or shares in the financial market.
Indirect finance involves a financial intermediary, such as a bank, that channels
funds from savers to borrowers. Here, the intermediary plays a bridging role,
collecting deposits and providing credit.
Money Market vs Capital Market
The money market is where short-term financial instruments (with maturities
under one year) are traded. These securities are highly liquid and generally carry
low risk due to their short lifespan.
The capital market facilitates the issuance and trading of long-term securities
such as equities and bonds, supporting investment projects that require extended
funding.
1.2 Functions of Financial Intermediaries
Reducing transaction costs
Engaging in financial transactions involves costs in terms of time, resources, and effort.
Intermediaries benefit from economies of scale and expertise, allowing them to reduce
these costs and provide clients with more efficient and liquid services.
,Managing asymmetric information
In financial transactions, one party may have more or better information than the other,
creating inefficiencies. Two main problems arise:
Adverse selection occurs before a transaction, when high-risk borrowers are
more eager to obtain loans, discouraging lenders.
Moral hazard occurs after a loan is granted, when borrowers may take on
excessive risk knowing the lender bears much of the downside.
Financial intermediaries are better equipped than individuals to screen and monitor
borrowers, reducing these risks.
1.3 Functions of Money
Money performs three central roles within an economy:
1. Medium of exchange – it simplifies trade by removing the limitations of barter.
2. Unit of account – it provides a standard measure for valuing goods and
services.
3. Store of value – it retains worth over time, enabling saving and future
consumption.
1.4 Contractionary Monetary Policy and Output (Y)
When the South African Reserve Bank (SARB) raises the repo rate to implement a
contractionary monetary policy, credit conditions tighten. The effects can be seen
through two channels:
Credit channel:
Higher repo rates reduce bank reserves, limiting deposits and the availability of
, loans. With fewer loans, investment and consumption spending decline, leading
to a fall in real output (Y). Small and medium-sized businesses are especially
vulnerable, as they rely heavily on bank credit.
Balance sheet channel:
An increase in interest rates weakens household and firm balance sheets by
reducing cash flow and asset values. This exacerbates problems of adverse
selection and moral hazard, prompting banks to restrict lending. As a result,
investment and consumption shrink further, lowering output (Y).
South Africa’s Refinancing System Compared to the USA
In the United States, the Federal Reserve primarily manages interest rates through
open market operations (OMOs), which determine the supply of reserves in the
interbank market and influence the federal funds rate. Discount loans are rarely used
and typically carry higher interest rates than market rates.
South Africa’s system is different. The domestic interbank market is too small due to the
concentration of a few large banks, preventing competitive rate-setting. The SARB
therefore ensures that banks cannot meet all their reserve needs via OMOs, forcing
them to obtain accommodation loans directly from the central bank. Because the SARB
always provides these loans, the repo rate it sets becomes the key benchmark rate for
the financial system, influencing both interbank and lending rates.
Question 5
The Importance of Price Stability, Nominal Anchors, and the Time Inconsistency
Problem
Why price stability matters
EXAM PACK
,ECS3701 – May/June 2025
Question 1
1.1 Distinguishing Key Financial Concepts
Direct vs Indirect Finance
Direct finance occurs when borrowers obtain funds straight from lenders by
selling securities such as bonds or shares in the financial market.
Indirect finance involves a financial intermediary, such as a bank, that channels
funds from savers to borrowers. Here, the intermediary plays a bridging role,
collecting deposits and providing credit.
Money Market vs Capital Market
The money market is where short-term financial instruments (with maturities
under one year) are traded. These securities are highly liquid and generally carry
low risk due to their short lifespan.
The capital market facilitates the issuance and trading of long-term securities
such as equities and bonds, supporting investment projects that require extended
funding.
1.2 Functions of Financial Intermediaries
Reducing transaction costs
Engaging in financial transactions involves costs in terms of time, resources, and effort.
Intermediaries benefit from economies of scale and expertise, allowing them to reduce
these costs and provide clients with more efficient and liquid services.
,Managing asymmetric information
In financial transactions, one party may have more or better information than the other,
creating inefficiencies. Two main problems arise:
Adverse selection occurs before a transaction, when high-risk borrowers are
more eager to obtain loans, discouraging lenders.
Moral hazard occurs after a loan is granted, when borrowers may take on
excessive risk knowing the lender bears much of the downside.
Financial intermediaries are better equipped than individuals to screen and monitor
borrowers, reducing these risks.
1.3 Functions of Money
Money performs three central roles within an economy:
1. Medium of exchange – it simplifies trade by removing the limitations of barter.
2. Unit of account – it provides a standard measure for valuing goods and
services.
3. Store of value – it retains worth over time, enabling saving and future
consumption.
1.4 Contractionary Monetary Policy and Output (Y)
When the South African Reserve Bank (SARB) raises the repo rate to implement a
contractionary monetary policy, credit conditions tighten. The effects can be seen
through two channels:
Credit channel:
Higher repo rates reduce bank reserves, limiting deposits and the availability of
, loans. With fewer loans, investment and consumption spending decline, leading
to a fall in real output (Y). Small and medium-sized businesses are especially
vulnerable, as they rely heavily on bank credit.
Balance sheet channel:
An increase in interest rates weakens household and firm balance sheets by
reducing cash flow and asset values. This exacerbates problems of adverse
selection and moral hazard, prompting banks to restrict lending. As a result,
investment and consumption shrink further, lowering output (Y).
South Africa’s Refinancing System Compared to the USA
In the United States, the Federal Reserve primarily manages interest rates through
open market operations (OMOs), which determine the supply of reserves in the
interbank market and influence the federal funds rate. Discount loans are rarely used
and typically carry higher interest rates than market rates.
South Africa’s system is different. The domestic interbank market is too small due to the
concentration of a few large banks, preventing competitive rate-setting. The SARB
therefore ensures that banks cannot meet all their reserve needs via OMOs, forcing
them to obtain accommodation loans directly from the central bank. Because the SARB
always provides these loans, the repo rate it sets becomes the key benchmark rate for
the financial system, influencing both interbank and lending rates.
Question 5
The Importance of Price Stability, Nominal Anchors, and the Time Inconsistency
Problem
Why price stability matters
