ECS 3701exam prep. VERIFIED Q AND A.

ECS 3701exam prep. VERIFIED Q AND A. SUCCESS 1 LIST THE THREE MONETARY POLICY INSTRUMENTS USED BY THE SOUTH AFRICAN RESERVE BANK. [3] -Accommodation policy (repo rate)  -open market operations  -reserve requirement ratio  2 DIFFERENTIATE BETWEEN A SECURITY AND A BOND. [4] - A security (also called a financial instrument) is a claim on the issuer’s future income or assets whilst a bond is a debt that promises to make payments periodically for a specific period of time.  -a security earns dividends, whilst is not a liability to the institution as it may defer payments, however, bonds earn interest which is a liability and, if deferred, may attract penalties and liability will accumulate.  3 WHAT IS A FINANCIAL CRISIS? [3] - A major disruption in financial markets that is characterized by sharp declines in asset prices and   the failures of many financial and non-financial firms.  4. DEFINE THE FOLLOWING TERMS: (a) Money Supply- money supply is defined as anything that is generally accepted in payment for  goods or services or in the repayment of debts  (b) Business Cycle- The business cycle is the fluctuation in economic activity that an economy  experiences over a period of time . A business cycle is basically defined in terms of periods of  expansion or recession (c) Aggregate Income- also known as GDP. It is the total value of a final goods and services produced in a country, in a given time.  (d) Inflation- persistent and continuous rise in the general price level .   (e) Monetary theory- The theory that relates the changes in the quantity of money to changes in  economic activity.  5. SECONDARY MARKETS CAN BE ORGANIZED THROUGH THE METHODS OF EXCHANGE AND OVERTHE-COUNTER (OTC) MARKETS. DEFINE THESE TWO METHODS. -exchanges is conducted through centralised locations where buyers and sellers of securities meet to conduct trades.  -OTC market is a market in which dealers at different locations have an inventory of securities ready to buy or sell ‘over-the-counter’ to anyone who comes to them and is willing to accept their prices 6. KEYNES IDENTIFIED THREE MOTIVES (FACTORS) BEHIND THE DEMAND FOR MONEY. LIST THESE THREE FACTORS, AND EXPLAIN BASED ON EACH OF THEM HOW THEY PREDICT THAT BOTH NOMINAL INTEREST RATES AND NOMINAL INCOME AFFECT DEMAND FOR MONEY [10] Transactionary motive . People engage in their daily activities like paying rent, bills, transport costs,  engaging in projects and other businesses . To conduct these transactions, individuals will have to  hold money, hence the transactionary motive. Under this motive, money serves the function as a medium of exchange, and therefore it’s an active balance. Demand for money for transactionary balances is relatively interest inelastic, but more income elastic. The theory argues that the higher  the national income, the more transactions are done, hence more money has to be held as transactionary balances . Therefore, transactionary demand for money is a positive function of  national income. Precautionary motive . Individuals also set money aside for unforeseen contingencies like  unemployment and sicknesses. These are balances held by individuals for precautionary reasons, hence precautionary motive. Empirical evidence backing the theory also states that precautionary balances are positively related to national income. Money demanded for precautionary reasons is  also an active balance. Speculative motive . Individuals also hold money in speculation on favourable changes in the  interest rates. Money is demanded as a store of value under this motive, hence a passive balance. Interest rates, an opportunity cost for holding money are negatively related to demand for money for speculative reasons as holding money in periods of high interest rates will result in higher opportunity costs .  These motives put together, explains the demand for money. Demand for money is inversely related to interest rates and positively related to national income. The following functions explains the demand for money: =( ,)−+ Where i are interest rates and Y is national income . rom the model, the conclusion was drawn   that money demand is unpredictable and unstable. 7. EXPLAIN THE MEANING OF CREDIT RISK. LIST HOW BANKS CAN ATTEMPT TO MANAGE OR SOLVE THEIR CREDIT RISK [7] Credit risk is the risk of defaulting payments, this is mainly due to asymmetric information when conducting transactions . Banks can solve credit risk through any of the following ways:  -screening and monitoring  -long-term relationships  -credit rationing  -loan commitments  -collateral and compensating balances  8. IS THE SOUTH AFRICAN RESERVE BANK (SARB) INDEPENDENT? EXPLAIN YOUR ANSWER BASED ON THE TWO TYPES OF INDEPENDENCE: GOAL INDEPENDENCE AND OPERATIONAL (INSTRUMENT) INDEPENDENCE [10] South Africa currently uses an inflation targeting policy framework in which monetary policy seeks  to keep the inflation rate within a predefined target range (3-6%) . This inflation target is set in  consultation between the Governor of the SARB and the Minister of inance . This means that the   SARB does not have goal independence . This is not necessarily bad. Inflation can only be beaten  when it has the support of all of government, firms and labour .  The SARB does, however, have operational (instrument) independence , that is, the choice of  instruments and the autonomy to adjust such instruments in monetary policy decisions aimed at achieving the target . The SARB s decision-making process, as far as the execution of monetary   policy is concerned, is independent of political interference. The SARB is accountable to Parliament  via the Minister of inance  9. WHICH FIRMS ARE MOST LIKELY TO USE BANK FINANCING RATHER THAN TO ISSUE BONDS OR STOCKS TO FINANCE THEIR ACTIVITIES? WHY? Smaller firms that are not well known are the most to use bank financing. Since it is harder for investors to acquire information about these firms, it will be hard for the firms to sell securities in the financial markets. Banks that specialize in collecting information about smaller firms will then be the only outlet these firms have for financing their activities. 10. THE THEORY OF PORTFOLIO CHOICE INDICATES THAT OTHER FACTORS BESIDES INCOME AND NOMINAL INTEREST RATE CAN DETERMINE THE DEMAND FOR MONEY. LIST THESE THREE FACTORS, AND EXPLAIN BASED ON EACH OF THEM HOW THEY PREDICT THAT BOTH NOMINAL INTEREST RATES AND NOMINAL INCOME AFFECT DEMAND FOR MONEY[10] WEALTH. The theory of portfolio choice posits that as wealth increases, investors have more resources to purchase assets, increasing the demand for money. However, when income is held constant, greater wealth has only a small effect on the demand for money. In general, investors will hold only a small amount of money in their investment portfolio, preferring interest-bearing assets with similar risk and liquidity profiles, such as money market mutual funds, that are not included in measures of money such as M1. Currency and checkable deposits are sometimes said to be dominated assets, because investors can hold other assets that pay higher returns and yet are perceived to be just as safe. RISK. It’s hard to imagine an asset less risky than money. Currency will always be accepted, unless there’s a revolution and the new government does not accept the old government’s currency. And bank deposits are safe as long as deposit insurance exists. In the theory of portfolio choice, however, risk is always measured relative to another asset. Thus, if the stock market becomes more volatile, money can become less risky relative to stocks and demand for it will increase. In addition, although money is extremely safe on a nominal basis, its real return (the nominal return minus expected