ECS3701 EXAM PACK

ECS3701
EXAM PACK

,ECS3701 – MAY/JUNE 2013 MEMO

SECTION A: COMPULSORY QUESTION

Question 1

1.1 Distinguish between the following concepts:

(i) Direct vs Indirect Finance

 Direct finance: In this case, borrowers obtain funds straight from lenders by
issuing and selling financial instruments such as bonds or shares in the open
market.
 Indirect finance: Here, a financial intermediary such as a bank operates between
the lender (saver) and the borrower (spender). The intermediary mobilises funds
from savers and makes them available to borrowers.

(ii) Money Market vs Capital Market

 Money market: This is the marketplace for short-term financial instruments
(usually with maturities of less than one year). Securities traded here are highly
liquid and generally regarded as low-risk due to their short duration.
 Capital market: This market deals in long-term financial instruments, including
equities and long-term debt instruments. It facilitates investment in projects
requiring extended funding horizons.

1.2 Functions of financial intermediaries

(i) Reducing transaction costs
Transaction costs include the resources (time, effort, and money) spent in executing
financial deals. Because financial intermediaries benefit from economies of scale and
possess specialised expertise, they can lower these costs. As a result, they are able to
offer clients convenient and liquid services that simplify financial transactions.

,(ii) Addressing asymmetric information
Asymmetric information arises when one party in a financial transaction has more or
better information than the other. This imbalance creates two main problems:

 Adverse selection: Occurs before a transaction, when those most likely to default
on loans actively seek them out, discouraging lenders from issuing loans.
 Moral hazard: Occurs after the loan is granted, when borrowers might engage in
riskier behaviour since the lender bears much of the cost if the project fails.

Financial intermediaries are better placed than individuals to evaluate potential
borrowers and monitor their activities, thereby reducing losses caused by both adverse
selection and moral hazard.




1.3 Functions of Money
Money performs three core roles in an economy:

1. Medium of exchange: It facilitates the buying and selling of goods and services
without the complications of barter trade.
2. Unit of account: It serves as a standard measure to assign value to products and
services.
3. Store of value: It retains value over time, enabling people to save and defer
consumption to the future.




1.4 Contractionary Monetary Policy and Real Output (Y)

If the South African Reserve Bank (SARB) adopts a contractionary monetary policy, the
repo rate is raised. The consequences can be summarised as follows:

Credit channel mechanism:
An increase in the repo rate reduces bank reserves, leading to lower deposits

,  and fewer loans. With fewer loans available, investment spending (Inv) and
household consumption (C) decline, which in turn lowers real output (Y).
This effect is particularly significant for small and medium enterprises that
depend heavily on bank credit, as larger corporations can raise funds through
alternative methods such as issuing shares.
 Balance sheet channel:
Higher interest rates negatively affect the balance sheets of households and
firms. Cash flow weakens, asset values drop, and this worsens adverse selection
and moral hazard problems. Lenders respond by restricting credit availability,
which reduces investment and consumption further, leading to a fall in output (Y).