Section 1

Question 1

What are the main applications of macro-economic theory?

Answer 1

1. Understanding relations between employment, growth, inflation and the business cycle so policies can be made more efficient for governments
2. design policies to encourage economic growth, boost productivity and decrease poverty
3. International aspects of macro econ
4. Businesses –> anticipating impact of future government policies on the corporate sector and forecasting future investment needs
5. Consumers who are trying to plan personal finances and anticipate employment and market opportunities
6. Central to governments in: planning budgets; raising taxes; quantifying expenditures; making policy decisions which interact with impact of central bank monetary policies

Question 2

when does a financial crisis occur?

Answer 2

when there is a sharp fall in the value of financial and real (business) assets.

Consumers and businesses are unable to pay their debts which leads to financial institutions struggling with liquidity shortages as depositors run away from banks when they fear for the safety of their savings

Question 3

what is the opposite to a financial crisis?

Answer 3

financial bubble - but these can burst causing crashes

Question 4

What factors may cause a financial crisis?

Answer 4

In general assets or institutions become overvalued

• a stock market whose trailing price-earnings (PE) ratio is, say, twice that of the historical average
• a ratio of average house price to average disposable income surpassing all previous historical values

A sudden trigger (possibly bad macro-economic news heralding a recession) may lead to individuals or institutions selling assets, even with prices falling rapidly

Question 5

In an economic and behavioural context what factors do financial crises often contain?

Answer 5

• incentives to take on too much risk (e.g. bonus schemes)
• a lax regulatory environment which encourages excessive borrowing
• herd like behaviour by economic agents who are not making independent ‘rational’ analyses of situations

Question 6

What is financial amnesia?

Answer 6

a phenomenon where financial market participants behave in a way which suggests they have forgotten the lessons of financial market history.

participants may be both individuals and institutions as well as regulators

Question 7

when usually do certain asset prices become divorced from their fundamental drivers of value?

Answer 7

after a prolonged period of stable economic growth

Question 8

give e.g’s of asset prices becoming divorced from their fundamental drivers of value?

Answer 8

• Equity prices can rise so high that dividend and earning yields become very low and the only possibly positive return for investors is if prices continue rising
• IN the housing market, house prices may diverge substantially from delivering historically sensible rental yields

Question 9

Give drivers of why market discipline may not be maintained

Answer 9

• Incentive structures for senior management, which may encourage unsustainable activity detrimental to the wider financial system
• moral hazards with the wider economy carrying the cost of excessive risk-taking by the financial sector
• key aspects of behavioural finance including
• regulatory failure possibly due to organisational or resource constraints

Question 10

list key aspects of behavioural finance that might lead to market discipline not being maintained

Answer 10

• cognitive dissonance (or the dismissal of inconvenient evidence)
• herding and groupthink
• the illusion of control and overconfidence
• the disposition effect (the reluctance to take losses and change behaviour)

Question 11

how can financial amnesia and bubbles be guarded against?

Answer 11

• eduction on the history of financial markets
• research into measures of ‘excess’ to flag up problems before they arise
• improved corporate governance among financial firms
• independent and well-informed regulators with a healthy appreciation of supervision as well as regulation