ECS3701-EXAM-PACK.

ECS3701-EXAM-PACK. SUCCESS. ECS3701 EXAM PACK 1 ECS3701 MAY/JUN 2013 MEMO SECTION A COMPULSORY QUESTION QUESTION 1 1.1 Differentiate between the following (i) Direct and indirect finance [4] -direct financing- borrowers borrow funds directly from lenders in the financial markets by selling them securities  -Indirect finance- financial intermediary stands between lender-savers and borrowerspenders and helps transfer funds from one to the other  (ii) Money market and capital market [4] The money market is a financial market in which only short-term debt instruments are traded. They are more widely traded and so tend to be more liquid. Short term instruments also have smaller fluctuations making them safer instruments . The capital market is the market in which longer-term debt and equity instruments are traded.  1.2 Financial intermediaries promote economic efficiency by performing a variety of services. Explain the following functions of financial intermediaries. (i) Lower transaction costs [2] - transaction costs are the time and money spent in carrying out financial transactions. Financial intermediaries reduce the transaction costs as they have the expertise and can take advantage of economies of scale . The low cost allows financial intermediaries to provide customers with liquid services, i.e. services that make it easier to conduct transactions.  (ii) Asymmetric information [8] - Asymmetric information is when one party does not know enough about the other party to make accurate decisions . Lack of information creates problems on two fronts: 1. Adverse Selection – created by asymmetric selection before the transaction occurs . It occurs when the potential borrows who are most likely to produce an ECS3701 EXAM PACK 2 undesirable outcome (bad credit risks) are the ones who most actively seek out loans and thus are likely to be selected causing lenders not to make any loans . 2. Moral Hazard- created by asymmetric selection after the transaction occurs . It is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from a lenders point of view as the loan is less likely to be paid back . Financial intermediaries are better equipped to than individuals to screen out the bad credit risks from the good ones reducing the losses resulting from adverse selection. 1.3 List and explain the three functions of money [6] -medium of exchange – means of making payments and receiving goods and services in return  -unit of account- used to ascertaining the value of a product or service  -store of value  1.4 Assume that at an MPC meeting at the South African Reserve Bank decides to have a contractionary monetary policy. What impact will this have on real production (Y)? Motivate your answer by discussing the credit channel transmission mechanism, in the South African context. [16] -The monetary policy effect is represented as: ↑ repo rate → ↓ bank deposits → ↓ bank loans →( ↓ Inv, ↓ C) → ↓ Y -This channel operates, firstly, through bank lending. Certain borrowers will not have access to credit markets unless they borrow from banks. Contractionary monetary policy reduces bank reserves and bank deposits, thus decreasing the amount of loans available. This decrease in loans will cause fixed capital formation and consumer spending to drop. -A significant implication is that monetary policy through this channel will have a greater effect on those more reliant on bank loans, such as smaller firms, since larger firms have recourse to obtaining funds by issuing new share capital. As circumstances and restrictive regulatory frameworks change to restrict banks from the ability to raise funds, the potency of this channel will be reduced. Secondly, credit affects the balance sheets of households and firms and also arises ECS3701 EXAM PACK 3 from asymmetric information in credit markets: ↑ repo rate → ↓ price expectations → ↓ cash flow → ↑ adverse selection → → ↑ moral hazard → ↓ lending →( ↓ Inv, ↓ C) → ↓ Y Detailed logical sequence of events will earn the student full marks. SECTION B OPTIONAL QUESTIONS Question 2 2.1 With the aid of diagrams and explanations, explain how a higher expected rate of inflation will influence: (i) the demand for and supply of bonds (ii) the equilibrium price of bonds (iii)the equilibrium quantity of bonds [15] Maximum of 6 marks for correct graph The figure shows the effect on the equilibrium interest rate of an increase in the expected inflation. If expected inflation is initially 5% and the initial supply and demand curves intersect at 1 where equilibrium bond price is P1. 1. If expected inflation rises to 10%, the expected return on bonds relative to real assets falls and the demand curve shifts to the left from