ECS3701_ EXAM PACK 2021 (Selected Examination Questions and suggested solutions).

ECS3701_ EXAM PACK 2021 (Selected Examination Questions and suggested solutions). Use the theory of asset demand to explain how both (i) and (ii) below will influence the supply of and demand for bonds, the price of bonds and the equilibrium quantity of bonds. (Please answer each question separately.) (i) Higher expected future interest rates. (4) The interaction of supply and demand for bonds is one of the ways in which interest rates are determined. If it is expected that interest rates will rise in the future, then the demand for bonds will decrease and the demand curve for bonds will shift to the left. This is because the increasing interest rate implies a decreasing price and therefore the expectation of lower returns. The equilibrium price and quantity of bonds will decrease, ceteris paribus. (ii) An increase in the expected inflation rate (6) When inflation is expected to rise it lowers the expected return on bonds and so demand will decrease. The returns on other assets tend to increase in times on inflation and therefore bonds become less attractive. An increase in expected inflation also impacts on the supply of bonds. For a given interest rate, when the expected inflation increases, the real cost of borrowing falls and so the quantity of bonds supplied will increase. Yield to Maturity Term to Maturity Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 4 The overall impact of the above on the price and quantity of bonds is that the equilibrium price of bonds will decrease (and interest rates will rise), but the effect on the quantity of bonds is uncertain. 2.3 Explain the assumptions and predictions of the expectations theory and how well it explains the three empirical observations of the yield curve. (Hint: Write down the formula for the long term interest rate). (10) Expectations theory: the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. The expectations theory is able to explain empirical facts (1) and (2) but is unable to explain fact (3). The three empirical facts are:  Interest rates on bonds of differing maturities move together over time. [A rise in short-term rates (STR) will raise people’s expectations of future short-term rates. Because long-term rates (LTR) are the average of expected future short-term rates, the rise in STRs will lead to rise in LTRs causing LTRs and STRs to move together.]  When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rate are high, yield curves are more likely to slope downwards and be inverted. [When STRs are high people will generally expect them to fall in the future and so LTRs will be lower than STRs because the average of expected future STRs would be lower than current STRs and the yield curve slopes downwards.]  Yield curves almost always slope upward. [Expectations theory suggests that the typical yield curve should be flat rather than upward sloping] Part 3: Financial institutions (15 marks) Answer question 3.1. 3.1 (i) Explain in detail the difference between adverse selection and moral hazard. Provide an example of each to substantiate your answer. (5) Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 5 Adverse selection occurs before the transaction takes place. Because of asymmetric information it is difficult to make a decision on who to lend to and if a bank finds that it has insufficient information on which to make a good decision it might decide not to grant loans to anyone, even those who would be able to pay the loans back. Moral hazard occurs after the transaction has taken place. For example if the bank decides an individual or firm is a worthy credit risk and extends the required credit. If the firm or individual do not use the funds for the reasons they specified to the bank and perhaps are reckless or negligent and then get into financial trouble as a result, this would be moral hazard. (ii) Explain what is collateral and why it is important in debt contracts (3) Collateral is property that is pledged to the lender to guarantee payment in the event that the borrower is unable to make debt repayments. In the case of debt contracts, even if a borrower defaults the value of the assets held as collateral would be able to cover the amounts that are owing. The fact that the borrower might have to give up valuable assets tends to reduce the moral hazard in debt contracts. (iii) List two types of restrictive covenants which could appear in debt contracts. (2) Any two of: covenants to discourage undesirable behaviour; covenants to encourage desirable behaviour; covenants to keep collateral valuable; covenants to provide information. Answer any one of the following two questions: 3.2 List five of the major items which appear on the balance sheet of a commercial bank, classified according to assets and liabilities. (5) Assets Liabilities Reserves Securities Loans Deposits Borrowing of banks Capital OR Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 6 3.3 Briefly explain the meaning of credit risk and discuss two possible strategies for banks to manage it. (5) Credit risk is the risk arising from the possibility that borrowers may default on the repayment of loans. To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan default more likely. There are a number of ways they can do this:  Screening and monitoring: adverse selection in loan markets requires that lenders screen out the bad credit risks from the goods ones so that loans are profitable. Lenders must, therefore, collect reliable information from prospective borrowers. Effective screening and information collection together form an important principle of credit risk management. Banks often specialize in lending to firms in a particular industry. This goes against the idea of diversification but at the same time makes some sense. By concentrating on leading firms in a specific industry the bank becomes knowledgeable about that specific industry and is better able to make informed decisions. Once a loan has been made there is still the risk of moral hazard. In order to reduce the likelihood of this occurring, financial institutions should adhere to the principle of managing credit risk and write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities.  Long-term customer relationships: such relationships reduce the costs of collecting information and make it easier to screen out bad credit risks. This has the added advantage of the customer wishing to ensure that he/she can preserve a good relationship with the bank for future loan requirements and so reduces the chances of the customer doing anything to jeopardize the situation.  Loan commitments: an agreement between the bank and a firm to grant loan requirements up to an agreed amount at an interest rate that is linked to a market rate. The advantage to the firm is a secure source of credit and to the bank a long-term relationships which facilitates the collection of information.  Collateral and compensating balance: collateral requirements are important credit risk management tools. One particular form of collateral required by a bank when it makes a commercial loan, is called compensating balances: a firm receiving the loan must keep a required minimum amount of funds in a chequing account with Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 7 the bank. This helps the bank to monitor the client and reduce the risk of moral hazard.  Credit rationing: refusing to make loans even though customers are willing to pay the required interest rate. There are two forms: (i) refusal to make any loan and (ii) restricting the size of the loans made. Part 4: Central banking and the conduct of monetary policy (25 Marks) Answer EITHER question 4.1 or 4.2. 4.1 (i) The money multiplier equation is given by: M = [ 1 + c]/[r + e + c] (MB) What do the variables r, e and c represent? What will be the effect of an increase in r on the multiplier? (5) r : the required reserve ratio. The required reserve ratio is the percentage of liabilities that all banks are required to keep in an account with the central bank. The required reserve ratio is set by the central bank at less than 1 and the level of required reserves can be stated as r x D. When the required reserve ratio increases then multiple deposit expansion falls. e : this represents the portion of all demand deposits (D) that banks choose to hold as excess reserves (ER). This is voluntary and is not prescribed by the central bank. When banks choose to increase e then multiple deposit expansion falls. c : represents the currency ratio and indicates the portion of all demand deposits (D) that people choose to hold in the form of currency (c x D). When individuals convert demand deposits into currency, holding the monetary base and other variables constant, the multiple expansion declines and money supply falls. Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 8 (ii) With reference to the bank panics in the USA during the Great Depression (1930 – 1933), explain briefly the reasons why the variables c and e in the money multiplier equation changed during this period, and how these led to a contraction in the money supply. During the bank panics in the USA during the 1930s when a bank failed depositors would only receive a portion of their deposits. Depositors therefore shifted their holdings from demand deposits to cash holdings. This means that there was an increase in c. The increased withdrawals meant that banks were forced to increase their excess reserves in order to meet the outflows and so e also increased. The impact of this on the money supply: as c and e continued to rise the money supply declined. This decline occurred despite a 20% rise in the monetary base. This illustrates the fact that the central bank’s job of conducting monetary policy can be complicated by depositor and bank behaviour. 4.2 (i) List the five elements of inflation targeting. (5) (1) public announcement of medium term numerical targets for inflation; (2) an institutional commitment to price stability as the primary, longrun goal of monetary policy and a commitment to achieve the inflation goal; (3) an information-inclusive approach in which many variables are used in making decisions about monetary policy; (4) increased transparency of monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers; (5) increased accountability of the central bank for attaining its inflation objectives. (ii) Give five advantages of inflation targeting (5).  Allows the monetary authorities to use all available information, not just one variable, to determine the best settings for monetary policy.  It is readily understood by the public and highly transparent.  It has the likelihood of reducing the problem of time-inconsistency of central bank trying to increase output and employment in the short run.  It helps focus the political debate on what a central bank can do in the long run (control inflation). Downloaded by: francisbryanodonovan | Distribution of this document is illegal S - The study-notes marketplace Prepared by Douglas Museva from prescribed Unisa material Page 9  Encourages frequent communication with the public. Answer EITHER question 4.3 or 4.4: 4.3 Explain the South African Reserve Bank’s Accommodation Policy in detail. In your answer, discuss the role of open market operations and liquidity shortages, the repo rate and repo auctions. (15) In the broadest sense, accommodation granted by a central bank refers to the forms of credit extension made available by a central bank to parties in the economy, which includes banks. Through its refinancing or accommodation policy, the South African Reserve Bank (SARB) provides liquidity to the banks and so enables them to meet their daily liquidity requirements. This refinancing system of the SARB is the main mechanism it uses for implementing monetary policy. The main facility for refinancing the liquidity requirement is the weekly repurchase transactions between the SARB and the commercial banks which take place through repo auctions. At these auctions, held on Wednesdays, the SARB invites tenders for its refinancing auction. Through this mechanism the SARB provides liquidity to the banks by means of repurchase agreements (repos) involving mainly government bonds, treasury bills, SARB debentures and Land bank bills. Banks sell these securities to the SARB for a period of one week, in return for reserves. Banks pay the repo interest rate on these reserves. SARB conducts its open market operations (OMOs) in such a way that it ensures that the banks do not obtain all the reserves they need to meet their reserve requirements. The aim is to force the banks to supplement their reserves by seeking to borrow (borrowed reserves) from SARB at the repo rate. Because SARB meets all these requests unconditionally, the interest rate it sets (the repo rate) becomes the pivotal rate that dominates the interbank cash funds rate and ultimately the rate banks charge their borrowers. Once SARB has estimated the banks’ overall liquidity requirements, it offers various securities and maturities on auction at varying interest rates. The bulk of the OMOs currently consist of transactions in long-term government stock. In the case of an OMO sale, the central bank sells bonds to the banks and thereby removes money from the economy and so the liquidity deficit increases.