ECS301 [New ECS3701]
SELECTED EXAMINATION QUESTIONS AND SUGGESTED
SOLUTIONS
MAY/JUNE 2011
Part 1: Definition and functions of money (15 Marks)
Answer all questions in part 1.
1.1 List and explain the three primary functions of money. (2)
Medium of Exchange: money serves as a medium of exchan...
,ECS301 [New ECS3701]
SELECTED EXAMINATION QUESTIONS AND SUGGESTED
SOLUTIONS
MAY/JUNE 2011
Part 1: Definition and functions of money (15 Marks)
Answer all questions in part 1.
1.1 List and explain the three primary functions of money. (2)
Medium of Exchange: money serves as a medium of exchange allowing
it to be used as payment for goods and services. As such it promotes
economic efficiency by reducing the time taken for transactions to take
place.
Unit of Account: used to measure value of goods and services in an
economy and helps to reduce transaction costs.
Store of Value: serves as a store of purchasing power from the time
the income is earned to the time it is spent.
1.2 What is the difference between primary and secondary financial
markets: (2)
Primary and Secondary markets: Primary market is the market in which
financial instruments are issued, while the secondary market is the market
in which financial instruments are traded.
1.3 What is fiat money? (3)
Fiat Money: paper currency decreed by government as legal tender. It is
largely dependent upon trust of the value of the currency.
1.4 How is the M2 money stock measured in South Africa? List ALL the
components. (4)
M2 consists of M1 plus deposits which are almost money. Apart from
coins, banknotes and demand deposits it also includes short-term and
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medium-term deposits held by the private domestic sector at monetary
institutions, commercial banks and savings institutions.
Part 2: Financial markets (20 Marks)
Answer question 2.1.
2.1
(i) Explain the difference between the yield to maturity of a bond and the
return on a bond. Please provide the relevant formulas to substantiate
your answer. (5)
Yield to Maturity: of the several common ways to calculate interest rates,
the most important is the yield to maturity. The key to calculating the
yield to maturity for any credit market instrument, is to equate today’s
value of the credit instrument with the present value (PV) of all of its
future cash flow payments. The bond price and the yield to maturity are
negatively related.
The formula used to calculate the yield to maturity depends upon the
specific credit instrument being considered. In this case the yield to
maturity on a bond, refer to the formula in the textbook.
[P = C/(1 + i) + C/(1 + i)2 .......... C/(1 + i)n + F/(1 + i)n]
The return on a security shows how well you have done by holding this
security over a stated period of time and it can differ substantially from the
interest rate measured by the yield to maturity. The rate of return is
defined as the payments to the owner plus the change in its value expressed
as a fraction of its purchase price. Because of fluctuating interest rates,
the capital gains and losses on long-term bonds can be large.
(ii) Provide a definition for the yield curve and draw a normal yield curve.
Please clearly label your graph and axes. (5)
When the yields on bonds with differing terms to maturity but the same
risk, liquidity and tax considerations are plotted on a graph, this is called
a yield curve. Normal yield curves are upward-sloping and this means
that the long-term interest rates are above the short-term interest rates.
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A normal yield curve:
Yield to Maturity
Term to Maturity
Answer any one of the following two questions :
2.2 Use the theory of asset demand to explain how both (i) and (ii) below
will influence the supply of and demand for bonds, the price of bonds
and the equilibrium quantity of bonds. (Please answer each question
separately.)
(i) Higher expected future interest rates. (4)
The interaction of supply and demand for bonds is one of the ways
in which interest rates are determined. If it is expected that
interest rates will rise in the future, then the demand for bonds will
decrease and the demand curve for bonds will shift to the left. This
is because the increasing interest rate implies a decreasing price
and therefore the expectation of lower returns. The equilibrium
price and quantity of bonds will decrease, ceteris paribus.
(ii) An increase in the expected inflation rate (6)
When inflation is expected to rise it lowers the expected return on
bonds and so demand will decrease. The returns on other assets
tend to increase in times on inflation and therefore bonds become
less attractive.
An increase in expected inflation also impacts on the supply of
bonds. For a given interest rate, when the expected inflation
increases, the real cost of borrowing falls and so the quantity of
bonds supplied will increase.
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