Financial Sector

Question 1

What are the functions of the central bank

Answer 1

Issue Money (notes & coins)
Monetary policies (interest rates & money supply)
Ensure stability in the banking system
Lender of last resort to the government
Lender of last resort to commercial banks

Question 2

How can the central bank manipulate interest rates to reduce inflation

Answer 2

Increase interest rates-increase MPS and reduce MPC-reduced consumption-reduce AD-reduce demand pull inflation

Question 3

What is a financial market

Answer 3

Any exchange that facilitates the trading of financial instruments, such as stocks, bonds, foreign exchange, insurance and even commodities

Question 4

What are the functions of a financial market

Answer 4

-Facilitate savings by households and individuals
-Lend to businesses and individuals
-Facilitate the exchange of goods and services
-Provide forward markets in currencies and commodities (fix current price which is paid at a later date)
Provide a market for equities (shares in public companies)

Question 5

What are the different types of financial market failure

Answer 5

Asymmetric Information
Externalities
Moral Hazard
Speculation and Market Bubbles
Market Rigging

Question 6

Give examples of asymmetric information in the financial market

Answer 6

1.Borrowers may not reveal their poor borrowing history to lenders, leading to interest rates set too low
2.Lenders may not clarify all the details and clauses attached to a loan
3.Insurance companies don’t know the driver’s full driving ability, leading to an insurance set too low

Question 7

Give examples of externalities in the financial market

Answer 7

1.A change in interest rates will affect exchange rate through hot money flows, thus affecting imports and exports
2.When a bank fails, it could lead to:
-job losses
-central bank must bailout commercial bank
-reputational damage to the financial sector

Question 8

Give examples of moral hazard in the financial market

Answer 8

1.If a house is insured, the owner may be less careful knowing that they won’t fully bear the burden
2.Commercial banks could give out high risk loans to individuals knowing that the central bank will help to bail them out if anything goes wrong

Question 9

Explain how Speculation and Market Bubbles work in the financial market

Answer 9

1.People will anticipate a rise in value of a certain stock, asset, commodity etc
2.This causes it to be traded more and demand will exceed supply (herding behaviour)
3.This will lead to a market bubble, as the the value of the product is driven up well beyond its true value
4.The bubble will then burst and the price falls steeply
5.This causes panic and investors tend to sell their assets

Question 10

Explain how market rigging works in the financial market

Answer 10

This is when companies within a financial market operate under the conditions of an oligopoly and collude

Examples:
Fixed asset prices
Fixed interest rates