Econ 304 – Study Questions for Midterm Exam Spring 2021 1. List and explain the 4 main functions of the financial system ➔ Production efficiency- allowing for efficient allocation of capital ➔ Consumption smoothing- improves the wellbeing of consumers by allowing them to time purchases better ➔ asset/maturity transformation- transforms short term assets into long term ones ➔ Risk sharing/asset diversification- allows for appropriate allocation of risk, according to people risk preferences 2. List and explain 3 empirical facts connecting money, inflation and interest rates ➔ Over long periods of time money and inflation correlate very well ➔ Generally speaking as money grows faster interest rates go up correlate over long periods ➔ Fisher's equation- interest rate and inflation move together over time (long term) 3. List and explain the 3 most important functions performed by Commercial banks ➔ Act as intermediary (receive deposits and lend them out) ➔ Provide a payment system (debit and credit cards) ➔ Provide financial services (financial advising, mortgage loans, clearing checks) 4. List and explain 3 instruments used in Money Markets ➔ ➔ ➔ ➔ ➔ 5. Treasury Bills (government issues securities)- safest investment with guaranteed return CDs- debt instrument sold by banks similar to stocks that pay annual interest Commercial Paper- similar to CDs but can also be issued by companies repurchase agreements-Short term loans with treasury bills as collateral Fed Funds- and overnight loans from the federal reserve List and explain the 3 most important functions performed by investment banks ➔ Underwriting securities- acting as a broker connecting investors to firms, advertise benefits of the securities, securities sold in primary market or bank will buy the securities (Dealer) ➔ mergers and acquisitions- act as a consultant for a company, research about the market the other company, competitors, suppliers etc., SWOT analysis ➔ trading of securities on the secondary market- holds securities to sell later, bank will trade in secondary markets in already issued securities, bank will buy and sell securities 6. List and explain the 3 functions of Money 1. Medium of exchange- means of payments, can be exchanged for goods without cost to the holder 2. Store of value- shared with other assets such as gold/land 3. Unit of account- can make comparisons of what is expensive and what is cheap 7. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. List and explain the 10 properties of Money Durable- cannot be a perishable good Wide spread acceptability- has to be universally accepted in payments for goods or services Divisibility- can allow for payments or small medium and large Recognizability- must be accepted and recognized as money Transportability- can change hands Limited supply- unlimited supply is a free good so there is no money Scalability- money supply can change as the market grows/ shrinks Limited volatility in value- value of good has to have limited volatility (relatively stable) Integrity- difficult to counterfeit Fungibility- all the tokens/ bills have to be identical 8. Explain how gold fulfills the 10 properties of money. Make sure you identify and explain both the properties that gold fulfills well and the ones it does not fulfill well. ➔ Durable good ➔ Not widely accepted for small payments i.e fast food ➔ Easy to recognize ➔ Can divide gold ➔ Hard to transport large amounts of gold, metals are heavy ➔ Limited supply of gold ➔ Has no scalability ➔ Relatively volatile ➔ Hard to counterfeit ➔ Gold coins meh, gold bars Yes - depends on the format 9. Explain how the U.S. dollar fulfills the 10 properties of money. Make sure you identify and explain both the properties that the U.S. dollar fulfills well and the ones it does not fulfill well. ➔ Durable ➔ Divisible ➔ Accepted ➔ Recognized ➔ Transportability has increased as checks, debit and credit cards were created but physical money and coins are hard to transport ➔ Technically a limited supply- but CAN make more ➔ Since we can make more money it is scalable ➔ Relatively stable- moves in value a lot OVER TIME ➔ Relatively easily counterfeited ➔ Bills and coins have changed slightly overtime but ares till identical enough to be accepted 10. Explain how Bitcoin fulfills the 10 properties of money. Make sure you identify and explain both the properties that Bitcoin fulfills well and the ones it does not fulfill well. ➔ Durable ➔ Divisible ➔ Transferable ➔ Scarce ➔ Recognized as money ➔ Hard to counterfeit ➔ Not scalable ➔ Not widely accepted ➔ Extremely volatile ➔ Not a physical money so not really fungible 11. List and explain 5 positive feedback loops characterizing the operation of financial markets. a. Speculative demand: prices going up leads to higher demand b. Mark to market accounting: marking assets to most recent market values, which increases transparency (a good thing) c. Debt: using debt allows gains (and losses) to multiply d. Use of collateral- most important e. Price of assets have inertia 12. Explain the social value of prices according to Hayek and why the functions of prices may be compromised in financial markets. ➔ Prices have two important social functions ◆ Transmit information for free to buyers and sellers ◆ Provide incentives for free to buyers and sellers ➔ In a command economy inspectors are needed to enforce market clearing prices calculated by central planning board which requires a lot of money, and energy 13. Explain the two characteristics that Hayek market process fulfill. Do financial markets always fulfill these two characteristics. Why or why not? Explain. ➔ Prices clear markets by being fulling informative and providing correct incentives to buyer and sellers ➔ Price movement helps stabilize markets, which restores equilibrium conditions after disruptive shocks move markets to surplus or shortage ➔ Not always true because he is assuming all investors are seasoned and well informed 14. Explain the Financial Accelerator Principle. Who was the first economist who discovered the working of the financial accelerator principle? Who are the two contemporaneous economists that have studied the working of the financial accelerator in more detail? ➔ The ability to borrow depends on creditworthiness, which itself depends on the value of collateral assets (Albert Abram Aftalion) ➔ Ben bernake, Mark Gertler a. Financial accelerator: (first introduced by Albert Aftalion) credit worthiness determines borrowing, credit continues to increase or decrease based on collateral (asset) (Bernanke and Gertler learned this in the modern era): [higher borrower net worth leads to amplified upturn and downturn] b. Critical role collateral plays in creating bubbles and causing prices to plummet 15. Is the existence of speculation good or bad for the stability of financial markets? Make sure you consider both Friedman’s and Minsky’s view and explain under which circumstances one view may prevail over the other. a. Friedman- speculation good i. Investors are savvy, seasoned and experienced they behave in ways that require a lot of thought before a risky investment b. Minsky- speculation bad i. People who join the market last are the least informed, demand is flat so a tiny increase in price leads to huge jump in demand 16. List and explain Minsky’s 5 stages of a financial bubble. a. Displacement: any shock that redirects investors’ focus to new sectors b. Credit creation: lenders join the bandwagon and relax credit standards c. Euphoria: prices inflate, belief that one can “get rich quick” d. Critical moment: aka Minsky Moment, unexpected event causes reassessment of assets e. Panic: sellers outnumber buyers, prices collapse 17. List and explain two critiques that have been raised against Minsky’s ‘5 stages of the financial bubble’ model. a. Lack of rationality i.People cannot have knowledge of past crises as they would avoid making the same mistake. b. People cannot lose their human capital i.People continue to re enter the market to preserve their wealth, creating a new bubble 18. List and explain the two responses that have been formulated to the objections raised against Minsky’s ‘5 stages of the bubble’ model.
