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EC2010 Money and Banking Exam Solutions

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EC2010: Money and Banking
Final Examination, 2010-11
Time: Two Hours
The exam consists of three parts. Each part is compulsory and carries equal
weight. The total marks for the exam add up to 300. Each part counts for 100
marks.
Part I (100 marks): Give short answers to all four questions.
1) What do you understand by the term ‘moral hazard’? (25 marks)
A:
The concept of asymmetric information (AI), which treats the problem of 2 parties to
a transaction not having the same information about it, has two sub-concepts or
instances. Firstly, AI operates before a transaction to create adverse selection, for
example, in the case of finance, that the riskier borrowers enter the market first. (Students
may refer to the well-known example of Akerlof’s ‘lemons’ illustration concerning second
hand cars in an auction.) Secondly, AI operates after a transaction to create moral
hazard, meaning in a financial example that a borrower uses the money borrowed for
purposes or in ways not contemplated by and not visible to the lender. In both cases the
risk to the lender is increased. A specific dimension of moral hazard concerns the
perverse incentives it can engender on the part of managers, known as the principalagent problem.
2) Using simple examples, what is meant by ‘debt’ and ‘equity’? (25 marks)
A:
A balance sheet has two sides, assets and liabilities, that equal one another (A=L).
Liabilities, however, comprise two main types, debt and equity (A=D+E), often written as
A=L+E, although this is not strictly true. While equities are certainly assets on the
accounts of their owners, on the balance sheet of their issuers they are liabilities. Debt
covers loans and bonds, that is, funds lent to the business, comprising, albeit in different
combinations, a principal amount and an agreed revenue (interest) due to the lender
regardless of its profitability but not conferring ownership of the borrowing entity on the
lender. Equity, also known as ‘own capital’, refers to the shares in a company. These do
confer ownership on shareholders, but they are also ‘below the line’, meaning they are
treated in toto as ‘residual value’ which is only released to shareholders after profitability
and then only when the directors deem it prudent to release cash.
3) Regarding central banking, what is the difference between operational and
goal independence? (25 marks)
A:
Independence refers to the central bank’s independence in (a) setting its goals and
(b) achieving them. In the clearest example, a goal might be n% inflation; achieving that
goal could be a matter of setting interest rates through a monetary policy committee. The
arguments for and against central bank independence turn on whether or not (or to what
extent) economic governance should be free of political interference. If there is not to be a
‘democratic deficit’, to whom does a central bank governor report and is that
accountability meaningful? Generally, central bank independence is understood to mean
operational or instrumental independence, meaning the central bank is left free to set
interest rates in the context of a given inflation target, say 2%, this being in most people’s
mind synonymous with price stability. A long literature dating back to Henry Thornton in
1802 discusses this topic. Nowadays, the central banks of most democratic countries are
independent in the narrower sense.
4)
Explain ‘price stability’ and identify two advantages of it. (25 marks)
A:
Price stability refers to a constant low increase in the aggregate price level. Not
zero, but gently incremental to allow growth. It is measured in terms of the rate of
inflation, but it is achieved in the main by controlling the money supply, a nominal anchor
that helps guard against time inconsistency in monetary policy because it’s eye is kept on
the longer run, thus countering the short term fluctuations often associated with political
interference and its ‘cousin’, discretionary policy. Two advantages of price stability are (1)
it reduces uncertainty regarding the financial future which is crucial for income,
investment and general economic planning for business, government and individuals
alike, and (2) in its wake comes social stability because other important considerations
follow on such as the employment level, growth, and stability in financial markets and
foreign exchange markets. The, largely now achieved, general perception of price stability
as a public good is crucial to the concept’s acceptance by the population as a whole.
Part II (100 marks): Answer one of the following two questions.
(The remaining answers are given in essence because I assume students will give more
amplified answers. The point of these questions is to give the student the opportunity to (a)
reiterate ‘bare bones’ knowledge about how the financial system is understood and
conducted, but also (b) to show an understanding of the logic of modern finance, why it is
conceived and operated the way it is.)
5) A financial centre depends on the depth and breadth of its liquidity.
Describe (i) why this is so, (ii) how it is achieved and maintained.
A:
A financial centre depends for its business on the money passing in and out of it,
whether short term, as in money markets, or longer term as in capital markets. If money is
to enter, it has to be able to leave easily. For this to happen, assets held need to be
readily turned into cash, capable of becoming liquid. This is affected by many things – the
type, range and accessibility of markets, intermediaries and instruments and of
investments being best priced, so that there are always people willing to lend. They have
also to be able to freely on-sell their assets to other parties so that they can exit at will
and without hindrance.
Depth of liquidity refers not only to the amount of money but to the importance of respect
for property rights, the rule of law, and other attributes of a modern democracy, such that
one can be sure there will be no sequestrating, confiscating or plundering of assets, for
example. It also assumes that central bank independence is operating and that a
government’s fiscal objectives and/or party-political goals do not perturb or contradict
economic fundamentals.
Breadth of liquidity means being open to as many players as possible, for which reason
the lighter the regulation the better. Hence, for example, ‘Big Bang’ in mid 1980s London,
intended to create off-shore status on-shore and to protect London as a global financial
centre in a world that was rapidly becoming not only global but also virtual. Deregulation
of this kind often means excusing financial centres of any more highly regulated contexts
(concerning exchange controls or taxation, for example) that might otherwise exist in
order that they may be able to compete on a global level. On the other hand, to ensure
that banks do not take excessive risks, governments seek to regulate in terms of
restrictions on entry, disclosure, capital adequacy, etc.
6) Why is it in the interests of a bank’s shareholders that some of the bank’s
reserves are held in short term instruments?
A:
A bank’s shareholders, like all shareholders, are profit seeking and profit
maximising, and thus seek to maximise their return to capital. In that sense they would
not normally allow funds to lie fallow, but there is a trade-off to be considered between the
role of a capital cushion in safeguarding the bank’s overall operations and the reduced
direct overall return on invested capital this implies. In non-buoyant or uncertain times,
the capital cushion may be preferred because one takes the longer view. But in buoyant
times the bank’s profitability is enhanced the more it can, with safety, invest its funds in
such things as money market deposit accounts, which escape the net of reserve
requirements and thus being included in the money supply.
Part III (100 marks): Answer one of the following two questions.
7) Giving examples from the 20th century, describe the main exchange rate
regimes, then say which is best suited to today’s conditions.
A:
The main examples of exchange rate regimes are fixed, floating (flexible) and
managed float. They can be characterised as follows: Fixed – a currency is pegged to
another currency whose value is assumed to be immutable. Floating – where all
currencies float against all other currencies. Managed float – where governments make
foreign exchange interventions in order to achieve a specific exchange rate rather than
that given by the markets. To keep the parity of a currency fixed the central bank makes
FX interventions, e.g. buying its currency (selling FX) when its currency is over-valued so
as to effect interest rates, this the perceived value of its currency relative to others, thus
its exchange rate.
Examples of the first, fixed, are easily identified. The gold standard with an assayed
amount of gold at its centre or base, the Bretton Woods system based on the goldexchange standard where 35$ were equivalent to 1 oz of gold. The euro is also a fixed
exchange rate system internally, even though it floats against other currencies. Floating
exchange rates represent something of a theorem, even a utopia, since the idea
presupposes all currencies float against all others, so that market forces universally
operate and there is no government intervention. In practice, many of not most
governments intervene, if only to protect their economies from adverse payment
balances, unaffordable exports and so on.
Arguably, if fixed exchange rates are a thing of the past (even the euro floats against the
rest of the world), and if universally floating rates are utopian, there is little choice but to
opt for managed or ‘dirty’ floating (floating when it suits you or is possible). Exceptions
would be political regimes that have no truck with western democracy and countries that
either use a currency board to hook onto someone else’s ‘sound’ currency, or adopt
entirely the sound currency of another country (so-called dollarisation).
8) The supply of bonds shifts for three main reasons:
i) expected investment profitability
ii) inflation expectations
iii) governmental budgets
Discuss and depict (ii), known as the Fisher Effect.
A:
In the case of expected changes in inflation, because bond prices are negatively
related to interest rates, the argument runs that for a given interest rate and a given bond
price, when expected inflation increases/falls the real cost of borrowing falls/rises. Hence the
quantity of bonds supplied increases/decreases. If the expected rate rises to 10% the
expected return on bonds falls, so demand for bonds falls and the demand curve shifts to the
left, while the supply curve shifts to the right. In short, when there is an expected rise in
inflation interest rates will also rise. This is known as the Fisher Effect, after Irving Fisher, the
American economist who first described it. (Illustration required.)
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