EC33332 Tutorial 1

Why are financial markets important to the health of the economy?

Financial Markets Markets in which funds are transferred from people and firms
who have an excess of available funds to people and firms who have a need of funds

Promotes economic efficiency by producing an efficient allocation of capital,
which increases production
Directly improve the well-being of consumers by allowing them to time
purchases better

Some economists argue that the lack of well-developed financial markets is an
important reason accounting for the slow growth of developing economies. Does
this argument make sense?

How does risk sharing benefit the financial intermediaries and private investors?

Financial Intermediaries Institutions that borrow funds from people who have
saved and make loans to other people (e.g. Banks, insurance/finance companies,
mutual funds)
Lower transaction costs (time/money) due to:
o EOS (e.g. pool funds to undertake bigger investments)
o Expertise/ Specialized liquidity services (e.g. internet banking)
Reduce the exposure of investors to risk via risk sharing

Deal with asymmetric information problems
o Adverse Selection Avoid risky borrowers (Gather info about
potential borrowers)
o Moral Hazard Ensure borrower will not engage in activities that will
cause him to default (e.g. contracts with restrictive covenants,
collaterals)

In the absence of adverse selection in a lending situation, can the problem of moral
hazard exist?

Adverse Selection Before loan is given out, potential bad credit risks are the ones
most actively in seeking out loans thus, producing undesirable outcomes for the
lender

Moral Hazard After the loan is given out, lender runs the risk of the borrower
engaging in undesirable activities that would harm the lenders interests

Moral Hazard in
Equity (investment/ shares) Contracts Debt Markets
Principal-Agent Problem Borrowers have incentives to take on
projects that are riskier than the lender
would like
(High risk = High chance of default)
FM5:
Most of the time it is quite difficult to separate the three functions of money. Money
performs its three functions at all times, but sometimes we can stress one in
particular. For each of the following situations, identify which function of money is
emphasized.

a. Brooke accepts money in exchange for performing her daily tasks at her
office, since she knows she can use that money to buy goods and services.

b. Tim wants to calculate the relative value of oranges and apples, and
therefore checks the price per pound of each of these goods quoted in
currency units.

c. Maria is currently pregnant. She expects her expenditures to increase in the
future and decides to increase the balance in her savings account.

Medium of Exchange Unit of Account Store of Value
Eliminates the
trouble of finding a
double coincidence
of needs (remove
transaction costs)
Promotes
specialization

Used to measure
value of goods and
services in the
economy

Used to save
purchasing power
over time
Other assets serve
this function
Money is the more
liquid of all assets
(but values falls in
inflation)

Optional Question
How is the asymmetric information problem worsened by a conflict of interests?

Asymmetric Information a situation that arises when one partys insufficient
knowledge about the other party involved in a transaction makes it impossible to
make accurate decisions when conducting the transaction

Lemons Problem








Principal-Agent Problem Conflict of interest between the principal and agent
(e.g. Owners want profitability vs. Managers want personal benefits and power)
(e.g. Owners want funds vs. Stockholders want profitability)