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TEST 1

ECO 551/553

QUESTION 1
a)

Describe the following terms/concepts:


i.
business cycles
ii.
recession
iii.
budget deficit
iv.
inflation

b)

Explain how money is related to the economic activities.


(20 marks)

QUESTION 2
a)

Distinguish between
i)
barter economies and monetary economies..
ii)
primary markets and secondary markets.
iii)
money markets and capital markets

b)

Using flows of funds charts, describe the direct finance and indirect finance.
(20 marks)

QUESTION 3
a)

Using the bond market and the money market, explain how the equilibrium
rate of interest is determined.
(5 marks)

b)

Suppose the economy moves into recession and there is general pessimism
about the future economic growth, how will this sentiment affect the
equilibrium rate of interest. Use bond and money market to explain your
answer.
(15 marks)

Test 1 (Answer)
QUESTION 1 (a) Describe the following terms / concepts:
i)

Business cycles describes the phases of growth and decline in


an economy. The goal of economic policy is to keep the economy
in a healthy growth rate fast enough to create jobs for everyone
who wants one, but slow enough to avoid inflation.
Unfortunately, life is not so simple. Many factors can cause an
economy to spin out of control, or settle into depression.

ii)

Recession is a periods when aggregate output is declining. A


recession is a business cycle contraction. It is a general
slowdown in economic activity. Macroeconomic indicators such as
GDP (gross domestic product), investment spending, capacity
utilization, household income, business profits, and inflation fall,
while bankruptcies and the unemployment rate rise.

iii)

Budget deficit is when a country's government spends more


than it takes in from taxes or other forms of revenue. Although
individuals, companies and other organizations can run deficits,
the term usually applies to governments. That's because there
are immediate penalties for most organizations that run
persistent deficits. If an individual or family does so, their
creditors come calling. As the bills go unpaid, their lose a good
credit score, which makes new credit more expensive.
Eventually, they may have to declare bankruptcy. The same
applies to companies who have ongoing budget deficits. Their
bond rating is lowered, and they have to pay higher interest to
get any loans at all.

iv)

Inflation is a sustained increase in the general price level of


goods and services in an economy over a period of time. When
the general price level rises, each unit of currency buys fewer
goods and services. Consequently, inflation reflects a reduction
in the purchasing power per unit of money a loss of real value
in the medium of exchange and unit of account within the
economy. A chief measure of price inflation is the inflation rate,

the annualized percentage change in a general price index


(normally the consumer price index) over time.

b. Explain how money is related to the economic activities.


Money is any item or verifiable record that is generally accepted
as payment for goods and services and repayment of debts in a
particular country or socio-economic context. The main functions of
money are distinguished as: a medium of exchange; a unit of account;
a store of value; and, perhaps, a standard of deferred payment. Any
item or verifiable record that fulfills these functions can be considered
money.
Economic activities are related to production, distribution, exchange
and consumption of goods and services.
The primary aim of the economic activity is the production of goods
and services with a view to make them available to consumer.
"Human activities which are performed in exchange for money or
money's worth are called economic activities."
In other words, economic activities are those efforts which are
undertaken by man to earn Income, Money, and Wealth for his life and
to secure maximum satisfaction of wants with limited and scarce
means.
E.g. A worker works in a factory and gets wages.
How money is related to the economic activities because the
relationship between money and economic activity depends on
whether changes in the money stock are due to shifts in money supply
or money demand. For example, increases in money supply spur
economic activity, while increases in money demand tend to dampen
economic activity. And, these shifts in money supply and demand
affect output indirectly, through their effects on interest rates.
MONEY SUPPLY. Shifts in money supply are positively associated with
output through their effect on interest rates. Money supply increases,
for example, drive down interest rates to persuade investors to hold
the additional money balances. The decline in interest rates, in turn,
boosts interest-sensitive components of spending, such as investment.

Thus, increases in money supply reduce interest rates and increase


output.

Question 2
a)
i)

Distinguish between
Barter economies and monetary economies.

There are two types of barter economies:


Pure Barter Economies
Trading-Post Economies (Organized Barter)
Barter economies are a direct exchange of a goods and
services for other goods and services. The existence of a problem i.e.
double coincidence of wants. This mean that two individuals must, by
coincidence, own, and desire to trade, goods and services.
Three shortcomings of a barter economy:
1. Absence of a method of storing generalized purchasing power.
Money carries a generalized purchasing power as opposed
to specific purchasing power in the form of shoes,
potatoes, etc.
2. Absence of a common unit of measure and value .
Absence of a standardized unit as opposed to money.
3. Absence of a designated unit to use in writing contracts requiring
future payments.
Trading-Post Economies (Organized Barter)

To eliminate or lessen double coincidence of wants, society


establishes trading posts-organization of specific trading
arrangements.

Monetary Economies is a branch of economics that provides a


framework for analyzing money in its functions as a medium of
exchange, store of value, and unit of account. It considers how money,
for example fiat currency, can gain acceptance purely because of its
convenience as a public good. Its divided into two:
1. Commodity Money economies
Commodity money is physical commodities used as
commodity monies. Its intrinsic or physical value as great
as its face value.

Examples of commodity money are like boats, wool, sheep


and corn. All have monetary as well as nonmonetary
values.

Later, with the advancement in knowledge, people started


using metals like gold and silver especially since the onset
of industrial revolution in 1800s.

2. Commodity Standard
Minted coins with non-monetary values developed. Face
value is equal to its market value.it can be legally melted for
non-monetary uses. This category of money is called fullbodied money.

Later on, the development of commodity standard


occurred i.e. the used of tokens rather that actual
physical commodities in exchange for goods and

services. Token money is money whose metallic value is


lower than the face value. An example of token money is
shillings issued by BNM.
Under a commodity standard ,tokens whose values are
fully or partially related to, or backed by, the value of
physical commodity (such as gold and silver) are used.
Currently Fiat Money is used in our daily lives. The former
has a commodity value much less than its value as
money. Examples of Fiat Money are coins and paper
money issued by BNM.
Fiat Money can be issued by government (like coins and
notes)and depositary institutions(like cheque or credit
cards).Fiat money is also called the Currency.
If money is issued by bank it is known as bank money. As
example of bank money is cheque.
Electronic Monies (e-money ) are becoming increasingly
important.

There are several forms of e-money: Debit Cards


Stored-value Cards
Electronic Cash
Electronic Cheques.
2 (a) ii Distinguish between primary market and secondary market.
Primary Market is a financial market in which new issues of a security
such as a bond or a stock are sold to initial buyers by the corporation
or government agency borrowing the funds.
Secondary market is a financial market in which securities that have
been previously issued (second hand) can be resold.
Securities brokers and dealers are crucial to a well-functioning
secondary market. Brokers are agents of investors who match buyers
with sellers of securities. Dealers link buyers and sellers by buying and
selling securities at stated prices.
Exchange Over-the-counter

Secondary market can be organized in two ways. One is to organized


exchanges, where buyers and sellers of securities (or their agents or
brokers) meet in one central location to conduct traders. Example in
Malaysia is the KLSE.

(a) ii Distinguish between money market and capital market.


Money market is a financial market in which only short term-debt
instruments are traded. This market is usually more widely traded thus
tend to be more liquid. In addition, short-term securities has smaller
fluctuations in prices than long-term securities, making them safer
investments.
Capital Market involves longer-term securities (usually more than one
year) and equity instruments. Capital market securities are often held
by financial intermediaries such as insurance company and pensions
funds, which have little uncertainty about the amount of funds they will
have available in the future.

The capital markets transactions include trading of securities with m


mortgage markets (property), corporate bonds market and the
governments securities markets. Event securities and the market in
stock and shares, including other corporate securities.
The money market consist of securities issued in principal for one year
or less i.e. short-term securities. These market typically apply to the

trading of credit instruments (financial instruments) issued for less


than one year.
Examples of securities
being traded are treasury bills, negotiable certificate of deposits
(NCDs), commercial papers, bankers acceptance and repurchase
agreements.

FINANCIAL MARKET INSTRUMENTS

FINANCIAL MARKETS

PRIMARY

CAPITAL MARKETS

SECONDARY

MONEY MARKETS

DEBT MARKETS

EXCHANGE OVER-THE
-COUNTER MARKETS

EQUITY MARKET

c)

Financial instruments are traded by both individual


households
and
firms
by
financial
institutions in a wide variety of financial markets.
Basically the markets are categorized into two board
markets i.e the primary market and secondary markets.
The issuance of stocks and bonds for the first time usually
take place in the primary securities market (IPOs)
When securities are bought or sold after the initial offering,
they are being negotiated in the secondary markets
(examples in Malaysia are KLSE and KLOFFE).
Both financial markets(primary and secondary) can be
further
classified
according
to
certain
characteristics(usually in term of maturity of securities)

Using flow of funds charts, describe the direct finance and


indirect finance.

INDIRECT

FINANCE

FINANCIAL
INTERMEDIARIES
FUNDS
FUNDS
FUNDS

SURPLUS UNITS
1.HOUSEHOLDS
2.BUSINESS
3.GOVERMNMENT
4.FOREIGNERS

FINANCIAL
MARKETS

DEFICITS UNIT
1.HOUSEHOLDS
2.BUSINESS
3.GOVERNMENT
4.FOREIGNERS

FUNDS

FUNDS

DIRECT

FINANCE

Direct finance

Funds are obtained by borrowers directly from lenders in financial


market by selling them (lenders) securities / financial
instruments, which are claim on borrowers future income or
assets. Securities are assets for the person who buys them but
liabilities (IOUs or debts) for the individual or firms that sells
(issues) them.
An example of a direct
finance is the issuance of common
stocks or bonds. These securities are first issued in primary
market and then resold in secondary market.

Indirect finance

Indirect finance occurs as a result of financial intermediation,


that is, a process where governments, commercial banks,
savings and loan association, mutual savings banks, credit
unions, insurance companies, pension funds, and mutual funds
transfer funds from saver to investors (borrowers).
Financial institutions act as intermediaries, channeling funds
from savers (landers) to investors (borrowers). Financial
intermediaries (indirect finance) are a far more important source
of financing for corporations than securities markets are (direct
finance) in many countries.

QUESTION 3
a) Using the bond market and the money market, explain how the
equilibrium rate of interest is determined.
Money demand curve tells us how much money people want to hold at
each interest rate. Equilibrium in money market occurs when quantity
of money people are actually holding (quantity supplied) is equal to
quantity of money they want to hold (quantity demanded) Can we
have faith that interest rate will reach its equilibrium value in money
market? Yes

(b) Suppose the economy moves into recession and there is general pessimism about the
future economic growth, how will this sentiment affect the equilibrium rate of
interest. Use bond and money market to explain your answer.
Interest rate

Money market
When economy moves into recession there is general pessimism about the future
economic growth. At this point Equilibrium is equal to Money Supply and Money
Demand.
Equilibrium =Ms=Md
When there is business cycle expansion the aggregate output will increase.
When aggregate income increase, money demand will increase.
So as a conclusion, when we have business expansion the interest rate will increase.