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: Borrowers raise funds directly from lenders by selling financial
securities (such as shares or bonds) in the financial markets.
 Indirect finance: In this case, financial intermediaries (e.g., banks) stand
between savers and borrowers. They gather deposits from savers and lend them
out to borrowers.

(ii) Money Market vs Capital Market

 Money market: Deals with short-term financial instruments (maturing within a
year). Instruments are highly liquid and generally low risk.
 Capital market: Facilitates the trading of long-term securities such as equities
and bonds, helping to finance long-term investment projects.

1.2 Functions of Financial Intermediaries

(i) Lowering transaction costs
Carrying out financial transactions requires resources such as time and money.
Because intermediaries operate on a large scale and have expertise, they can reduce
these costs, making financial services more accessible and efficient.

(ii) Managing asymmetric information
In financial transactions, one party may possess more information than the other, which
can cause problems:

,  Adverse selection: Happens before a loan is issued. Borrowers with high
default risk are more eager to take loans, discouraging lenders.
 Moral hazard: Happens after the loan is granted. Borrowers may take excessive
risks since lenders bear part of the losses.

Financial intermediaries help minimize these issues by screening borrowers and
monitoring their activities.

1.3 Functions of Money
Money plays three essential roles:

1. Medium of exchange: Makes trade easier by eliminating the inefficiencies of
barter.
2. Unit of account: Provides a common standard for valuing goods and services.
3. Store of value: Preserves value for future use, enabling saving and deferred
consumption.

1.4 Contractionary Monetary Policy and Real Output (Y)

When the South African Reserve Bank (SARB) tightens monetary policy by increasing
the repo rate, the following occurs:

 Credit channel mechanism:
A higher repo rate reduces bank reserves, which lowers deposits and the
availability of loans. With fewer loans, investment and household consumption
decline, leading to a fall in real output (Y). Small and medium firms are most
affected as they depend heavily on bank financing.
 Balance sheet channel:
Higher interest rates weaken the financial position of households and firms.
Asset values fall, cash flows shrink, and risk of default rises. This worsens
adverse selection and moral hazard, making lenders restrict credit. The result is
reduced consumption and investment, causing output (Y) to drop further.

, South Africa’s Refinancing System vs the USA

 In the USA, the Federal Reserve mainly relies on open market operations
(OMOs) to regulate the federal funds rate (the rate banks charge each other for
overnight loans). Discount loans are used only in exceptional cases and are
usually more expensive than market rates.
 In South Africa, the interbank market is too small to function effectively due to
the dominance of a few large banks. As a result, the SARB ensures that banks
cannot meet all reserve requirements through OMOs. This forces banks to
borrow directly from the SARB through accommodation loans. The repo rate set
by the SARB therefore becomes the key interest rate in the system.

Question 5

Why Price Stability is Desirable & the Role of a Nominal Anchor

 Importance of price stability:
o In the long run, it supports sustainable economic growth, encourages
investment, and stabilizes financial and interest rate markets.
o In the short run, however, it may conflict with goals like high employment
or output growth. For example, during a boom, raising interest rates to
curb inflation may reduce output growth.
 Nominal anchor:
A nominal anchor (such as an inflation target) provides a reference point that
helps policymakers and the public form stable expectations about prices. It ties
down inflation and prevents excessive fluctuations in monetary policy.
 Time inconsistency problem:
Policymakers may be tempted to stimulate the economy through unexpected
inflation in the short term (e.g., to boost employment). However, if the public
anticipates this, inflation expectations rise, making policy less effective and
leading to persistent inflation without long-term gains in output.