EC33332 Tutorial 1

Why are financial markets important to the health of the economy?

Financial Markets – Markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds

Promotes economic efficiency by producing an efficient allocation of capital, which increases production

Directly improve the well-being of consumers by allowing them to time purchases better

Some economists argue that the lack of well-developed financial markets is an important reason accounting for the slow growth of developing economies. Does this argument make sense?

How does risk sharing benefit the financial intermediaries and private investors?

Financial Intermediaries – Institutions that borrow funds from people who have saved and make loans to other people (e.g. Banks, insurance/finance companies, mutual funds)

Lower transaction costs (time/money) due to:o EOS (e.g. pool funds to undertake bigger investments)o Expertise/ Specialized liquidity services (e.g. internet banking)

Reduce the exposure of investors to risk via risk sharing

Deal with asymmetric information problemso Adverse Selection Avoid risky borrowers (Gather info about

potential borrowers)o Moral Hazard Ensure borrower will not engage in activities that will

cause him to default (e.g. contracts with restrictive covenants, collaterals)

In the absence of adverse selection in a lending situation, can the problem of moral hazard exist?

Adverse Selection – Before loan is given out, potential bad credit risks are the ones most actively in seeking out loans thus, producing undesirable outcomes for the lender

Moral Hazard – After the loan is given out, lender runs the risk of the borrower engaging in undesirable activities that would harm the lender’s interests

Moral Hazard in …Equity (investment/ shares) Contracts Debt MarketsPrincipal-Agent Problem Borrowers have incentives to take on

projects that are riskier than the lender would like(High risk = High chance of default)

FM5: Most of the time it is quite difficult to separate the three functions of money. Money performs its three functions at all times, but sometimes we can stress one in particular. For each of the following situations, identify which function of money is emphasized.

a. Brooke accepts money in exchange for performing her daily tasks at her office, since she knows she can use that money to buy goods and services.

b. Tim wants to calculate the relative value of oranges and apples, and therefore checks the price per pound of each of these goods quoted in currency units.

c. Maria is currently pregnant. She expects her expenditures to increase in the future and decides to increase the balance in her savings account.

Medium of Exchange Unit of Account Store of Value Eliminates the

trouble of finding a double coincidence of needs (remove transaction costs)

Promotes specialization

Used to measure value of goods and services in the economy

Used to save purchasing power over time

Other assets serve this function

Money is the more liquid of all assets (but values falls in inflation)

Optional Question How is the asymmetric information problem worsened by a conflict of interests?

Asymmetric Information – a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction

Lemons Problem

Principal-Agent Problem – Conflict of interest between the principal and agent(e.g. Owners want profitability vs. Managers want personal benefits and power)(e.g. Owners want funds vs. Stockholders want profitability)