10 THE CREDIT MARKET

Question 1

What is the role of money in the economy, and how does it differ from the barter system?

Answer 1

Money acts as a medium of exchange, solving the double coincidence of wants problem in the barter system. It allows purchasing power to be transferred across people and time, facilitating trade and economic growth. Only banknotes and coins are legal tender, meaning they must be accepted by law for payment.

Question 2

Differentiate between wealth, income, depreciation, and net income.

Answer 2

Wealth: Total value of owned assets minus debts (e.g., money, land, buildings).
Income: The flow of money over time (from wages, investments, etc.).
Depreciation: The decline in asset value over time.
Net Income: The maximum consumption amount without reducing wealth, calculated as:
Net Income=Gross Income−Depreciation

Question 3

Explain the concepts of consumption smoothing and impatience.

Answer 3

Consumption Smoothing: Individuals prefer stable consumption patterns over time due to diminishing marginal returns—additional consumption is less valuable as consumption levels rise.
Impatience: The preference for immediate consumption over future consumption, influenced by
* Myopia (short sigtedness): People experience present satisfaction more strongly then the same satisfaction later
* Prudence: People know that they may not be around in the future, so they want to consume now.

Question 4

What is the interest rate, and how does it affect borrowing and saving decisions?

Answer 4

The interest rate (r) is the cost of bringing future consumption forward, calculated by:
r=RepaymentPrincipal−1
r=PrincipalRepayment​−1

It represents the trade-off between current and future consumption. A higher interest rate discourages borrowing and encourages saving, while a lower rate does the opposite.

Question 5

How do borrowing and saving influence an individual’s consumption over time?

Answer 5

Borrowing: Allows increased consumption today but requires future repayment with interest.
Saving: Involves deferring consumption today to consume more in the future, potentially earning interest.
Optimal Decision: Achieved when the individual’s marginal rate of substitution (MRS) between current and future consumption equals the market rate of transformation (MRT), determined by the interest rate.

Question 6

What are the key components of a balance sheet and how do borrowing and lending affect it?

Answer 6

Assets: Items of value owned (cash, property, investments).
Liabilities: Debts or obligations owed.
Net Worth (Equity):
Net Worth=Assets−Liabilities

Borrowing increases both assets and liabilities by the same amount, leaving net worth unchanged initially, while lending increases assets and potential future income.

Question 7

Describe how banks create money and the risks they face.

Answer 7

Money Creation: Commercial banks create bank money when they issue loans, expanding the broad money supply:
Broad Money=Base Money+Bank Money
Broad Money=Base Money+Bank Money
Risks:

Default Risk: Borrowers may fail to repay loans.
Liquidity Risk: Banks may not have enough liquid cash if many depositors withdraw simultaneously (bank run).

Maturity Transformation: Banks borrow short-term (deposits) and lend long-term (loans), exposing them to these risks.

Question 8

What role does the central bank play in the credit market?

Answer 8

The central bank manages the money supply and monetary policy by:

Issuing Base Money: Legal tender like banknotes and coins.
Setting Interest Rates: The policy interest rate influences borrowing, spending, and investment decisions across the economy.
Regulating Banks: Holds reserves for commercial banks and ensures financial stability.
By raising interest rates, borrowing becomes more expensive, reducing inflation. Lowering rates stimulates borrowing and investment.

Question 9

How do interest rates and financial policies affect the broader economy?

Answer 9

Interest Rates:

Higher rates: Discourage borrowing, reducing spending and slowing inflation.
Lower rates: Encourage borrowing, boosting spending and economic growth.

Financial Policies:

Monetary Policy: Controlled by the central bank to stabilize growth and control inflation.
Fiscal Policy: Government spending and taxation can also impact demand for credit and economic growth.
Overall, the credit market influences economic stability by determining how efficiently capital is allocated between savers and borrowers.

Question 10

Explain the principal-agent problem in the credit market and how it leads to credit rationing.

Answer 10

The principal-agent problem arises when a lender (principal) cannot observe how a borrower (agent) uses borrowed funds, leading to:

Hidden Action: Borrowers may not put in sufficient effort, increasing default risk.
Credit Rationing:
    Credit-Constrained: Borrowers get loans but on unfavorable terms.
    Credit-Excluded: Borrowers are denied loans entirely.
    Solutions: Requiring equity (borrower’s own funds) and collateral (assets pledged by the borrower) reduces the risk of default.