FM W8

Question 1

what is unsterilised foreign exchange intervention

Answer 1

sell domestic currency, purchase foreign assets so international reserves increase. money supply increases, depreciation of domestic currency.

Question 2

explain the Bretton Woods system

Answer 2

a fixed ER using USD as a reserve currency. ER adjusted only when experiencing a fundamental disequilibrium.

Question 3

explain the Monetary approach under fixed ERs

Answer 3

BoP surplus results from excess stock of money demanded. Bop deficit results from excess in stock of money supplied. Md = kPY, Ms = m(D+F). BoP disequilibrium results from an international flow of money or reserves.

Question 4

explain the Monetary approach under flexible ERs

Answer 4

BoP disequilibrium immediately corrected by automatic changes in ERs without international flow of money or reserves. Control over its money supply and monetary policy. BoP deficit results in a depreciation. BoP surplus results in an appreciation.

Question 5

explain the Portfolio Balance model

Answer 5

ER determined by money supply and demand but also expected inflation and expected changes. Domestic and foreign bonds are imperfect substitutes. Domestic investors require a higher return to compensate for the risk of holding foreign bonds.

Question 6

How does adverse selection affect financial structure

Answer 6

if quality cannot be assessed, the buyer is willing to pay at most the average price of the good, the seller won’t want to sell for the average price, therefore buyer will decide not to buy.

Question 7

tools to help solve adverse selection problems

Answer 7

1. Sale of information and private production - stocks aren’t most important form of external financing. Free-rider problem.
2. Government regulation to increase information - highly regulated sector.

Question 8

how does moral hazard affect financial structure

Answer 8

borrowers have incentive to take on projects with more risk than lenders would like.

Question 9

tools to help solve moral hazard problems

Answer 9

1. Government regulation to increase info - highly regulated sector.
2. Financial intermediation - indirect finance is more important than direct finance.

Question 10

explain the tyranny of collateral

Answer 10

to use property as collateral you must own it, however expensive and time consuming to to legally own property. if financial system can’t use collateral, adverse selection worsens, as the lender needs even more information about the quality of the borrower. little lending will take place in transactions that involve collateral.

Question 11

what are the drawbacks of the government safety net

Answer 11

1. Moral hazard - financial institutions have a greater incentive to make riskier decisions.
2. Adverse selection - depositors have little reason to monitor financial institutions.

Question 12

what are 2 types of financial regulation

Answer 12

1. Restrictions on asset holdings- Attempts to restrict financial institutions from too much risk taking.
2. Capital requirements - minimising moral hazard at financial institutions.

Question 13

What are the 2 types of financial supervision

Answer 13

1. Prompt corrective action - FDIC intervene early when bank gets in trouble.
2. Chartering and examinations - monitor requirements like asset quality and earnings.

Question 14

what are the benefits and negatives of bank consolidation

Answer 14

Benefits:
1. Increased competition.
2. Increased efficiency of economies of scale.
3. Decrease probability of bank failure.
Negatives:
1. Less lending to small businesses.
2. Increase risks from expanding into new areas.