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EC102: CLASS 9 LTChristina Ammon
Financial Systems
Financial systems: the institutions in the economy that facilitate the flow of funds between and among households and firm
Financial markets vs. financial intermediaries• Bond & Stock markets vs. banks and insurances
What is the purpose of financial markets& intermediaries? 1. Financing investment
2. Sharing risk
What is the purpose of intermediaries• Overcoming asymmetric information
Quiz Question 1
Financial markets allow households to _____ provide resources for investment, while financial intermediaries allow households to _____ provide resources for investment.
A. directly; indirectly B. indirectly; directly C. productively; unproductively D. unproductively; productively
Quiz Question 2
All of the following are examples of financial intermediaries except:
A. commercial banks. B. stock exchanges. C. pension funds. D. insurance companies.
Essay 7
Basic setup:
A farmer’s harvest will be worth £200 if she can borrow £100 worth of fertilizer, and £0 otherwise.
The fertilizer needs to be applied now and harvest will take place in six months’ time.
There are N>100 other people in the village, each of whom has saved £1.
Essay 7 Question aIs there a role for a financial system in this economy? Briefly describe a few types of financial arrangements that you might observe in this economy.
Without financial systems: Borrow (<)1$ from 100 (+) villagers
Possible, but costly
Financial system allows farmer easier access to savings of villagers
If financial markets present: Could issue bonds or stocks If financial intermediaries present: villagers deposit savings
and bank gives loan to farmer
Essay 7 Question b
Suppose an enterprising villager starts a new bank (with 0 capital), collects all of the villagers’ savings, and lends the £100 to the farmer. How will this bank’s balance sheet look like?
What does a balance sheet consist of? Assets = Liabilities (+equity)
Assets Liabilities+ Equity
Loans 100$ Deposits: N$
Reserves N$-100$ Equity
Essay 7 Question c
Suppose now that each of the savers faces some chance that there will be an emergency such as they will absolutely need access to their £1 three months from now. Is there still a role for a financial system?
Without financial markets - will the farmer be able to finance his investment?
What about if we only have financial markets?
Essay 7 Question d
Suppose that the probability that any investor faces the emergency is p. What is the minimum value of N such that the financial system can viably allow the farmer to buy the fertilizer?
Pool of savings: N*1$ But p*N*1$ will need to be withdrawn in expectation Hence the savings to reach the farmer will be (1-p)N$ Needs to be >=100$ => need N>100(1-p) Similar with financial intermediaries: need to keep p*N*1$ as
reserves
Essay 7 Question e
On the basis of this example, can you see what economists mean when they say banks are engaged in maturity transformation?
Depositors willing to provide short term debt Banks take short term debt and issue long term debt for
investment Can be problematic!
Quiz Question 5
Falling house prices generate widespread insolvency of financial institutions by:
A. reducing the value of collateral assets. B. reducing the value of liabilities. C. increasing the value of assets. D. increasing capital
Quiz Question 4
To the extent that mortgage defaults contributed to the financial crisis of 2008–2009, blame for these actions lies with: A. homebuyers who borrowed more than they could afford to
repay. B. mortgage brokers who encouraged households to borrow
excessively. C. financial intermediaries who held large positions in
mortgage-related assets D. all of the above
Quiz Question 3
A credit crunch reduces aggregate demand by:
A. increasing the exchange rate. B. increasing interest rates. C. reducing consumption and investment spending. D. reducing the money supply.