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ECS3701 JULY 2021 EXAM PACK DESIGNED TO CATER FOR OCTO/NOV 2021 ONLINE EXAM
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ECS3701 JULY 2021 EXAM PACK DESIGNED TO CATER FOR OCTO/NOV 2021 ONLINE EXAM
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ECS3701MAY/JUNE 2021
EXAM MEMO
Question 1 [20 marks]
1.1 One of the reasons why some less developed economies grow so slowly is
that they do not have well-developed financial markets. Is this statement true or
false? Support your answer. [4]
False
The growth of developed countries has been significant over the past decade and the
reason is because of a well functioning financial market. The reason is that there is a
strong positive relationship between financial market development and economic growth.
Financial markets in the developed world help to efficiently direct the flow of savings
and investment in the economy in ways that facilitate the accumulation of capital and
the production of goods and services.
1.2 If you were a private investor, would you and/or financial intermediaries
benefit from risk-sharing? Explain which party will benefit and why. [7]
Financial institutions help reduce the exposure of investors to risk that is, uncertainty
about the returns investors will earn on assets. Financial intermediaries do this through
the process known as risk sharing, they create and sell assets with risk characteristics
that people are comfortable with, and the intermediaries then use the funds they acquire
by selling these assets to purchase other assets that may have far more risk.
Low transaction costs allow financial intermediaries to share risk at low cost, enabling
them to earn a profit on the spread between the returns they earn on risky assets and
the payments they make on the assets they have sold. This process of risk sharing is
also sometimes referred to as asset transformation, because in a sense, risky assets
are turned into safer assets for investors.
Financial intermediaries also promote risk sharing by helping individuals to diversify and
thereby lower the amount of risk to which they are exposed. Diversification entails
, investing in a collection (portfolio) of assets whose returns do not always move together,
with the result that overall risk is lower than for individual assets.
1.3 In relation to interest rate:
(i) is everybody worse off when interest rates rise? Explain your answer to
highlight those that are worse off and those that are not. [5]
No, not everybody is worse off when interest rates rise. People who borrow to purchase
a house or a car are worse off because it costs them more to finance their purchase;
however, savers benefit because they can earn higher interest rates on their savings.
Of course net savers who also have existing portfolios of debt instruments (bonds) will
see the current value of their portfolio decrease because when interest rates rise bond
prices fall.
(ii) when interest rates decrease, explain how businesses and consumers might
change their economic behavior. [4]
When interest rates are low, consumers tend to borrow more money, and they put that
money back into the economy by spending more on products and services. Lowered
interest rates mean the cost of paying back a loan is less than it used to be, and then
the savings people gain creates more disposable income.
Businesses also benefit from lower interest rates, as it encourages them to make large
equipment purchases due to the low cost of borrowing.
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