ECS3701 ECP JUNE EXAM VERIFIED Q AND A

1.1 One of the reasons why some less developed economies grow so slowly is that they do not have well-developed financial markets. Is this statement true or false? Support your answer. This statement is TRUE. The basic function of financial markets is to channel funds from savers who have an excess of funds to borrowers who have a shortage of funds. Financial markets can do this either through direct finance or through indirect finance which involves a financial intermediary. This channelling 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. Underdeveloped financial system leads to a low state of economic development and economic growth. Difficulties faced include: - The system of property rights functions poorly, making it difficult to use these tools to help solve the adverse selection and moral hazard problems. - Poorly developed or corrupt legal system may make it extremely difficult for lenders to enforce restrictive covenants. - Banks in many transition and developing countries are owned by their governments and because of the absence of the profit motive, these state-owned banks have little incentive to allocate their capital to the most productive uses. - Many developing countries have an underdeveloped regulatory apparatus that prevents the provision of adequate information to the marketplace - Governments often use the financial systems to direct credit to themselves or to favoured sectors of the economy. This study source was downloaded by from CourseH on 04-23-2022 19:50:20 GMT -05:00 1.2 If you were a private investor, would you and/or financial intermediaries benefit from risk-sharing? Explain which party will benefit and why. Financial Intermediaries are institutions that borrow funds from people (surplus units) who have saved and in turn make loans to others (deficit units). In terms of risk sharing, financial intermediaries can help reduce the exposure of investors to risk through the process of risk sharing. They create and sell assets with risk characteristics that people are comfortable with and then the financial intermediaries can use these funds to buy and sell other assets that are riskier. Both I as the private investor and the financial intermediary will thus benefit from risk- sharing. The private investor’s exposure to risk is reduced and the financial intermediary are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This may also be referred to as asset transformation. Risk sharing is also made possible by diversification which entails investing in a collection (portfolio) of assets, the returns of which do not all move in the same direction. 1.3 In relation to interest rate: (i) is everybody worse off when interest rates rise? Explain your answer to highlight those that are worse off and those that are not. Interest rate - cost of borrowing or the price paid for the rental of funds. “The” interest rate is made up of a number of different interest rates that exist in an economy. Not everyone is worse off when interest rate rises. Banks and investors will not be worse off because they will make higher returns from the high interest. Consumers and businesses will be worse off because they debt will cost more. (ii) when interest rates decrease, explain how businesses and consumers might change their economic behavior. When real interest rates are low there are greater incentives to borrow and fewer incentives to lend. Therefore, businesses and consumers would be more likely to borrow more and also spend more because there’d be more disposable income. A decrease in interest rate leads to an increase in Investment spending (real fixed capital formation). Businesses and consumers alter their investment and spending patterns and this will lead to an increase in aggregate demand. This study source was downloaded by from CourseH on 04-23-2022 19:50:20 GMT -05:00 Question 2 2.1 Mention the 5 money market instruments and describe who issues each of the money market instruments mentioned. - Treasury Bills