ECS3701 - Monetary Economics possible_exam_questions.

1. Explain briefly and in general terms what is the meaning of a security and how it facilitates direct lending and borrowing. (5) A Security, also known as a financial instrument, is a claim on the issuers future income or assets. Borrowers are able to sell to lenders directly within financial markets. One type of financial market is the Bond market which is important because it enables government to borrow in order to finance their activities, bond markets are also where interest rates are determined. 2. Explain briefly what a common stock is, what purpose it serves and how it affects business investment decisions. (4) A Common stock represents a share of ownership in a corporation, it is a security claim on the earnings and assets of the corporation. Common stock is traded within the stock market and the price of shares affects the amounts of funds that can be raised by selling newly issued stock to finance spending. 3. List two ways in which the quantity of money may affect the economy. (2) a. Inflation – the more money within an economy the higher inflation, thus the more expensive goods and services become b. Business Cycles – with greater aggregate output we see a decrease in unemployment and thus a greater demand for money, however, with a declining aggregate output comes an increase in unemployment and as such a declining rate in money growth. 4. Explain the difference between nominal and real GDP and the purpose for which each should be used. (4) a. Nominal GDP is the total value of goods and services produced within a country in a given period, using current prices and without accounting for inflation. b. Real GDP is the total value of goods and services in terms of prices for an arbitrary base year and is used to measure the quantity of goods and services and do not change because prices have changed. 5. List and define three commonly used measures of the aggregate price level. (6) a. GDP Deflator = Nominal GDP / Real GDP b. PCE Deflator = Nominal Persons Consumption Expenditures / real PCE c. Consumer Price Index (PCI) 6. Briefly explain the function of financial markets, the meaning of direct and indirect financing and the meaning of a financial intermediary. (5) Financial markets facilitate the moving of funds from people who lack productive investment opportunities to those who have these opportunities. Direct financing is when borrowers and lenders interact directly with each other on the financial markets. Indirect financing requires the intermediary financing institutions such as commercial banks to facilitate the transactions between borrowers and lenders. 7. Explain the differences between debt and equity markets, primary and secondary markets, exchanges and OTC markets, and money and capital markets. (10) a. Primary market – is a financial market in which new issues of a security, such as bond or stock, are sold to the initial buyers by the corporation borrowing the funds. b. Secondary Market – is a financial market in which securities that have previously been issued can be resold. c. Exchanges and OTC Markets – Secondary markets can be organized in two ways i. Exchanges sees buyers and sellers in one central location to conduct trades ii. OTC sees dealers in different locations have the inventories of the securities ready to buy and sell and will do so to anyone willing to accept the prices. d. Money markets – is a financial market in which short-term debt instruments are traded, they tend to be more liquid. e. Capital markets – is a financial market in which longer-term debt and equity instruments are traded. 8. List and explain the operation of any three money market instruments. (3x5=15) These are short term instruments and therefore undergo least price fluctuations making them least risky a. Negotiable Bank Certificate of deposits – Certificate of deposits is a debt instruments sold by a bank to depositors that pays annual interest if a given amount at maturity pays back the original purchase price b. Repurchase agreements – Are effectively short-term loans for which treasury bills serve as collateral c. Treasury bills – are instruments issued by government to finance their activities, they pay a set amount at maturity and have no interest but issued at a discount. 9. List and explain the operation of any three capital market instruments. (3x5=15) These debt and equity instruments with maturities greater than a year. a. Stocks – are equity claims on the net income and assets of an organization b. Mortgage – are loans to households or firms to purchase land, housing or other real structures that can be used as collateral for the loans c. Corporate bonds – These are long-term bonds issued to corporations with very strong credit ratings 10. Explain the functions performed by financial intermediaries and how and why these promote economic efficiency in financial markets. (8) Financial intermediaries are the primary means for funds to be moved between borrower-spenders and lender-savers. Factors that promote economic efficiency through the indirect financing model includes a. Transaction costs – reflect on time and money spent, due to the banks expertise they are able to leverage of economies of scale to reduce transaction costs and provide services making it easier to conduct transactions b. Risk sharing – Financial intermediaries create and sell assets with risk characteristics that people are comfortable with. Risk sharing is also known as asset transformation as they are turned into safer assets. Diversification entails investing into a collection of assets with the result that risk is lower than a single asset. c. Asymmetrical information – is when one party does not have sufficient information on the other in order to make accurate decisions, this can create problems on two fronts i. Adverse selection – occurs before a transaction takes place and is when the potential borrowers are most likely to produce an undesirable outcome are the ones who actively seek out loans and are thus likely to be selected causing lenders not to make any loans. E.g. I will borrow money with no intention to repay as agreed. ii. Moral hazard – occurs after a transaction has taken place and is when the borrower might engage in activities that are undesirable from a enders point of view as the loan is less likely to be paid back. E.g I borrow money and then use it elsewhere like gambling instead of repaying debt. Financial intermediaries are better equipped to, than individuals, to screen out the bad credit risks from the good ones reducing the losses resulting from asymmetric information. d. Economies of scope - banks provides multiple financial services achieving aconomies of scope, in other words they are able to provide a lower cost of information as they are able to apply one information resource to many different services To conclude financial intermediaries play an important role in that they 1. Provide liquidity service 2. Promote risk sharing 3. Solve information problems 4. Channel funds from lender-saver to borrower-spenders 11. Explain the broad purpose and methods used in government regulation of the financial system. (6) The government regulates for two main reasons