Exam Flashcards
Main features of the Central Bank
- National payments and settlement systems
- Prudential regulation/supervision
- Insurance for deposits
- Execute monetary policy —> inflation targeting
- Exchange rate policy
What is a foreign bond?
A bond sold in a foreign country, denominated in that country’s currency
What is a Eurobond/Eurocurrency?
A bond issued in a currency other than the currency of the country or market in which it was issued
Foreign currencies deposited in banks outside the origin of the currency
What is organized exchange?
Exchange where buyers and sellers meet in one central location, e.g. a stock exchange
What is over-the-counter exchange?
A market in which dealers at different locations is ready to buy/sell to whoever comes to them.
Primary vs. secondary markets?
Primary: financial instruments are newly issued by borrowers
Secondary: financial instruments already exists and traded among lenders (stock exchange)
Money markets vs. capital markets?
Money: only short term debt titles are traded
Capital: longer term debt and equity instruments are traded
Main roles of financial system (Levine 2005)?
- Producing information and allocating capital
- Monitoring firms and exerting corporate governance
- Risk amelioration (decrease risk)
- Mobilizing and pool savings
- Ease the exchange of goods and services
The features of an effective financial system?
- Transactions based on trust
- Strong legal infrastructure
- Save, reliable and efficient payment system
Risk associated with the financial market:
Credit risk: danger of default
Market risk: loss by sudden changes in asset prices
Liquidity risk: unable to sell assets quickly without loss
Market or government: Keynes?
Keynes believed market to be imperfect - no tendency towards optimal outcome
He believed government should intervene to ensure high levels of growth and employment
Market or government: Fisher?
Crisis is integral part of business cycle, we should not intervene
Laissez-faire
What was the outcome of the Bretton Woods conference in 1944?
44 countries aimed to make an international economic system that would reduce instability of the financial system.
Currencies pegged to the dollar, dollar pegged to gold = stable exchange rates
What is Mishkin’s (1996) problems of asymmetric information?
- adverse selection & moral hazard
Adverse selection: in debt and equity markets lenders have no way to distinguish good borrowers from bad ones
Moral hazard: borrowers have an incentive to engage in high-risk strategies, because they do not bear the risk, the lenders does.
What caused the Great Depression (1929 - 1939)?
- Over production (agricultural and industrial)
- Unequal distribution of wealth
- Stock market crash & financial panic
- High tariffs & war debt
- Monetary policy (decrease money supply, increase interest rate = deflation)
Economic theories to explain the Great Depression:
Monetarism (Milton Friedmann): Government should keep money supply under control, so you let the market adjust by itself
Keynesianism (John Keynes): Government should intervene on demand side - interest rate too high, no firms buying
Karl Marx: Recession and depression inevitable under free-market capitalism
What does the Lucas critique say?
One cannot draw conclusions on current macroeconomic phenomena based on events that happened in the past.
What does the Scumpeterian growth theory say?
- Growth generated by innovations
- Innovations result from entrepreneurial investments motivated by prospect of monopoly rents
- Innovation replace old technologies: growth involves creative destruction
How do the financial sector influence growth?
According to the Schumpeterian growth theory, the financial sector is able to produce growth through funding that results in innovations. The Schumpeterian growth model says that growth is generated by innovation.
What is creative destruction?
When a product or technique is improved, the new good or method tends to displace the old one.
Not bad for the economy, e.g., when electricity replaced the steam engine, most nations experienced a net employment growth despite high levels of job destruction
Do the financial sector create growth?
Widely debated.
On the one hand it is evident that the financial sector is able to create short-term growth through investments in innovations (the Schumpeterian growth model).
On the other hand the effect seems to wear off if the financial sector grows too big (volatility, risk for crisis, misallocation of talents)
What is pro-poor growth?
Growth that results in a significant increase in the income of the poor (hard to quantify significant?).
What is the two ways to define pro-poor growth?
- Poverty and inequality
- Headcount poverty
Poverty and inequality: income of poor should increase more than the average growth of income, should reduce absolute inequality
Headcount poverty: increase in income of the poor, regardless the effect on inequality
What do the Kuznet’s curve illustrate?
The relationship between inequality and the maturity of an economy.
Early stage: income inequality tends to widen due to a structural change in which the economy experiences a shift from agricultural to industrial production
Over time: Inequality decreases, as the economy adjusts to this change and it matures
What is the Gini index?
Index measuring inequality.
Coefficient varies between 0 (complete equality) and 1 (complete inequality)
Measures income shares based on the Lorenz curve and the line of equality (45 degrees) - the (area) difference between the two of these curves are the Gini coefficient
What is Pareto efficiency?
A change that someone is better off with no one being worsen off.
What is Pareto optimal?
State of allocation of ressources in which it is impossible to make any individual better off without making at least one individual worse off
What is Kaldor-Hicks efficiency?
A change that does lead some people being worsen off - which in practice is far more likely to happen - but that those better off could, in theory, compensate the losers and still remain better off themselves.
Utility does not increase linearly. The more you consume, the less will it contribute to utility.
How do the financial sector affect inequality?
The financial sector has the potential to increase inequality. Only rich people have access to financial markets and are able to capitalise from the growth of the financial sector. They become more wealthy, while the poor people’s wealth remains unchanged. The inequality thus grows.
Explain the Harrod-Domar Model (HDM) of growth
Fundamental prediction: national growth rates are directly proportional to the level of investment in the economy
Production = combination of labour and capital in fixed proportions
No constraint on supply of labour
Physical capital is constrained
Productivity of capital (capital - output ratio) –> constant returns to scale
The only mean to generate growth: more physical capital, net investment
Higher income –> higher savings –> higher investment
The rate of growth is the savings rate divided by the measure of productiveness of the capital. E.g., a country with a savings rate of 20% and an alfa (productiveness) of 4 would be expected to grown at a rate of 5%
—> Growth should become self reinforcing, the key stage is the kick start (virtuous cycle of growth).
Explain the Solow model of growth (neo-classical growth model NCM)
Relaxing the unrealistic assumptions of HDM (no fixed ratios of ‘capital-labour’ and ‘capital-output’)
Diminishing returns to capital
A function of technological progress (A) timed with capital and labour (F(K,L)): Y=A∗F(K,L)
Technological advances rise the productivity of capital - growth can be maintained above the rate of population growth (R&D)
Technological progress is exogenous to the model (an external input)
Explain the Endogenous growth model (new growth theory NGT)
Growth is endogenous and can be influenced by policy
Firms can have different growth despite having the same technology.
Productivity is a function of the level of knowledge. 2 levels of knowledge: R&D, spillovers
Investment in R&D and human capital could be suboptimal in market economies
How can the financial sector reduce poverty?
- Directly
- Indirectly
Directly: providing financial services to the poor, place them in a secure place by providing insurance
Indirectly: positive impact on growth rates - impact may vary
What are the 3 key factors influencing the financial sector?
Regulations:
robust system of financial regulation is pre-requisite for the financial liberation. (accounting standards, deposit insurance & restriction of bank activity)
Contractual saving institutions:
pension funds, insurance companies etc. Demand for shares and long term bonds gives a positive impact on growth.
Private ownership:
Creates a supply for the demand of the contractual savings institutions.
What is the stock market’s impact on economic growth?
Promoting economic growth
Provide liquidity - facilitating long-term investment
Enabling diversification of portfolios –> investment in higher risk assets
What is the bond market’s impact on economic growth?
Little academic evidence to link bond market development to economic growth
‘Upside’ is limited to the interest, ‘downside’ is that the principal may not be paid (default)
What is the 3 circumstances where government intervention seems necessary in the economy?
- Provision of public good and prevention of public bad
- Correcting market failures
- Redistribution
What are the 2 forms of taxes that governments can apply to collect resources?
Direct taxation:
Personal income tax (flat/progressive), corporation tax
Indirect taxation:
VAT (moms), excise taxes/duties & trade taxes
What are the 3 instruments to conduct macroeconomic policy?
- Monetary policy
- Fiscal policy
- Exchange rate policy
What is financial repression?
Replacement of market mechanisms by direct government intervention in the determining of the level of financial variables and the allocation of credit at prices determined by the state.
What is financial liberalisation?
The opposite of financial repression - the economy is left to the market mechanisms.
The key elements of the repression is not controlled by the state, but left to the market.
What is command economy?
Government, rather than the free market, determines what goods should be produced, how much should be produced and the price (faith in the power of the state) - close to communism. Adopted during the after-war years.
What are the 6 key elements of financial repression?
- Interest rates controlled by government
- Credit control in place
- Barriers to entry the financial sector in place
- Government control of banking operations
- Government ownership of banks
- International capital flows restricted - can’t take money out of the bank
What are the financial costs associated with repression?
- Deterioration of economic performance in terms of growth (restrictions limits performance)
- Decline in the quality of lending (cap on interest rate) –> bank insolvencies (can loan money for a unprofitable project)
- Goals of redistribution were not met
- Negative real interest rates –> significant capital flights and dependence on external source capital
- Excessive use of capital-intensive production due to low real interest rates
What happened in practice with the financial liberalisation?
With regards to:
- Interest rates
- Saving rates
- Allocation of domestic financial resources
- Allocation of international financial resources
- Financial crisis
- Interest rates
Rose sharply, instead of steadily increasing (shock) - Saving rates
Not all have access to credit markets, for low income families, interest rates are relatively insensitive to changes in interest rates - Allocation of domestic financial resources
3/4 correlation between financial intermediation and growth can be explained by a more efficient pattern of credit allocation - Allocation of international financial resources
cyclical booms, where capital flows increase followed by “busts” - Financial crisis
financial liberalization lead to an increased risk of financial crisis in developing countries
What is the substitution effect? (saving/interest rates)
Increase in interest rates –> increase in savings rates = consumption is postponed
What is the wealth effect? (saving/interest rates)
Increase in interest rates –> decrease in savings rates = most people prefer €100 today rather than tomorrow
What are the two types of financial markets?
- Debt market
2. Equity market
