Exam

Question 1

Main features of the Central Bank

Answer 1

1. National payments and settlement systems
2. Prudential regulation/supervision
3. Insurance for deposits
4. Execute monetary policy —> inflation targeting
5. Exchange rate policy

Question 2

What is a foreign bond?

Answer 2

A bond sold in a foreign country, denominated in that country’s currency

Question 3

What is a Eurobond/Eurocurrency?

Answer 3

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

Question 4

What is organized exchange?

Answer 4

Exchange where buyers and sellers meet in one central location, e.g. a stock exchange

Question 5

What is over-the-counter exchange?

Answer 5

A market in which dealers at different locations is ready to buy/sell to whoever comes to them.

Question 6

Primary vs. secondary markets?

Answer 6

Primary: financial instruments are newly issued by borrowers

Secondary: financial instruments already exists and traded among lenders (stock exchange)

Question 7

Money markets vs. capital markets?

Answer 7

Money: only short term debt titles are traded

Capital: longer term debt and equity instruments are traded

Question 8

Main roles of financial system (Levine 2005)?

Answer 8

1. Producing information and allocating capital
2. Monitoring firms and exerting corporate governance
3. Risk amelioration (decrease risk)
4. Mobilizing and pool savings
5. Ease the exchange of goods and services

Question 9

The features of an effective financial system?

Answer 9

1. Transactions based on trust
2. Strong legal infrastructure
3. Save, reliable and efficient payment system

Question 10

Risk associated with the financial market:

Answer 10

Credit risk: danger of default

Market risk: loss by sudden changes in asset prices

Liquidity risk: unable to sell assets quickly without loss

Question 11

Market or government: Keynes?

Answer 11

Keynes believed market to be imperfect - no tendency towards optimal outcome

He believed government should intervene to ensure high levels of growth and employment

Question 12

Market or government: Fisher?

Answer 12

Crisis is integral part of business cycle, we should not intervene

Laissez-faire

Question 13

What was the outcome of the Bretton Woods conference in 1944?

Answer 13

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

Question 14

What is Mishkin’s (1996) problems of asymmetric information?

• adverse selection & moral hazard

Answer 14

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.

Question 15

What caused the Great Depression (1929 - 1939)?

Answer 15

1. Over production (agricultural and industrial)
2. Unequal distribution of wealth
3. Stock market crash & financial panic
4. High tariffs & war debt
5. Monetary policy (decrease money supply, increase interest rate = deflation)

Question 16

Economic theories to explain the Great Depression:

Answer 16

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

Question 17

What does the Lucas critique say?

Answer 17

One cannot draw conclusions on current macroeconomic phenomena based on events that happened in the past.

Question 18

What does the Scumpeterian growth theory say?

Answer 18

1. Growth generated by innovations
2. Innovations result from entrepreneurial investments motivated by prospect of monopoly rents
3. Innovation replace old technologies: growth involves creative destruction

Question 19

How do the financial sector influence growth?

Answer 19

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.

Question 20

What is creative destruction?

Answer 20

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

Question 21

Do the financial sector create growth?

Answer 21

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)

Question 22

What is pro-poor growth?

Answer 22

Growth that results in a significant increase in the income of the poor (hard to quantify significant?).

Question 23

What is the two ways to define pro-poor growth?

• Poverty and inequality
• Headcount poverty

Answer 23

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

Question 24

What do the Kuznet’s curve illustrate?

Answer 24

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

Question 25

What is the Gini index?

Answer 25

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

Question 26

What is Pareto efficiency?

Answer 26

A change that someone is better off with no one being worsen off.

Question 27

What is Pareto optimal?

Answer 27

State of allocation of ressources in which it is impossible to make any individual better off without making at least one individual worse off

Question 28

What is Kaldor-Hicks efficiency?

Answer 28

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.

Question 29

How do the financial sector affect inequality?

Answer 29

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.

Question 30

Explain the Harrod-Domar Model (HDM) of growth

Answer 30

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).

Question 31

Explain the Solow model of growth (neo-classical growth model NCM)

Answer 31

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)

Question 32

Explain the Endogenous growth model (new growth theory NGT)

Answer 32

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

Question 33

How can the financial sector reduce poverty? - Directly - Indirectly

Answer 33

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

Question 34

What are the 3 key factors influencing the financial sector?

Answer 34

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.

Question 35

What is the stock market's impact on economic growth?

Answer 35

Promoting economic growth Provide liquidity - facilitating long-term investment Enabling diversification of portfolios --> investment in higher risk assets

Question 36

What is the bond market's impact on economic growth?

Answer 36

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)

Question 37

What is the 3 circumstances where government intervention seems necessary in the economy?

Answer 37

1. Provision of public good and prevention of public bad 2. Correcting market failures 3. Redistribution

Question 38

What are the 2 forms of taxes that governments can apply to collect resources?

Answer 38

Direct taxation: Personal income tax (flat/progressive), corporation tax Indirect taxation: VAT (moms), excise taxes/duties & trade taxes

Question 39

What are the 3 instruments to conduct macroeconomic policy?

Answer 39

1. Monetary policy 2. Fiscal policy 3. Exchange rate policy

Question 40

What is financial repression?

Answer 40

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.

Question 41

What is financial liberalisation?

Answer 41

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.

Question 42

What is command economy?

Answer 42

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.

Question 43

What are the 6 key elements of financial repression?

Answer 43

1. Interest rates controlled by government 2. Credit control in place 3. Barriers to entry the financial sector in place 4. Government control of banking operations 5. Government ownership of banks 6. International capital flows restricted - can't take money out of the bank

Question 44

What are the financial costs associated with repression?

Answer 44

1. Deterioration of economic performance in terms of growth (restrictions limits performance) 2. Decline in the quality of lending (cap on interest rate) --> bank insolvencies (can loan money for a unprofitable project) 3. Goals of redistribution were not met 4. Negative real interest rates --> significant capital flights and dependence on external source capital 5. Excessive use of capital-intensive production due to low real interest rates

Question 45

What happened in practice with the financial liberalisation? With regards to: 1. Interest rates 2. Saving rates 3. Allocation of domestic financial resources 4. Allocation of international financial resources 5. Financial crisis

Answer 45

1. Interest rates Rose sharply, instead of steadily increasing (shock) 2. Saving rates Not all have access to credit markets, for low income families, interest rates are relatively insensitive to changes in interest rates 3. Allocation of domestic financial resources 3/4 correlation between financial intermediation and growth can be explained by a more efficient pattern of credit allocation 4. Allocation of international financial resources cyclical booms, where capital flows increase followed by "busts" 5. Financial crisis financial liberalization lead to an increased risk of financial crisis in developing countries

Question 46

What is the substitution effect? (saving/interest rates)

Answer 46

Increase in interest rates --> increase in savings rates = consumption is postponed

Question 47

What is the wealth effect? (saving/interest rates)

Answer 47

Increase in interest rates --> decrease in savings rates = most people prefer €100 today rather than tomorrow

Question 48

What are the two types of financial markets?

Answer 48

1. Debt market | 2. Equity market