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ECOS2004 2022 Second mid-semester exam

Sample questions and answer guide

The following are examples of questions from an earlier year.

They are not meant as an exact guide to the topics for 2022, but will give you an idea of the sorts of questions that could be asked.

Each question is followed by a list of key points that could be covered. A good answer would be one that incorporates all or most of the relevant points in a well-structured essay.

1. How does the existence of money help to make the economy more efficient than would be the case if all transactions had to occur through direct (barter) exchange?

· Money helps solve the problem of ‘double coincidence of wants’

o A good answer should demonstrate a common-sense grasp of what this means

o Barter exchange would mean that you have to find someone who wants to engage in an equal and opposite exchange to the one you want

o Barter also suffers from a problem of divisibility, eg you can’t pay for something with half a cow

· It does this by allowing indirect exchange to occur – you exchange a product for money and then use the money to buy what you want

· This makes exchange more efficient

· It also facilitates specialisation in production, because you can exchange what you produce more easily to buy what you consume

· A good answer might also set out the functions of money

o Medium of exchange

o Unit of account

o Store of value

· And the characteristics for money to perform these efficiently

o Divisible

o Portable

o Widely accepted

2. Suppose there is a new financial company called Easyloan that has just started up. Its strategy is to attract deposits by offering higher deposit rates than the banks, and to make a profit by charging higher loan interest rates than the banks. What problems is Easyloan likely to face that could affect the success of this strategy?

· The central concept here is adverse selection

· By offering loans at a higher interest rate, it is likely that the pool of borrowers applying for a loan will be disproportionately made up of people who couldn’t get a loan from a bank

· Therefore Easyloan is likely to experience a higher default rates on its loans than banks

· The strategy will only be profitable if the higher interest rate is enough to compensate for the likely higher default rate

· It is uncertain whether this can succeed, because the higher the loan rate is raised, the more strongly the adverse selection effect works to worsen the pool of borrowers

· Easyloan could try to mitigate this risk by having careful credit assessments of prospective borrowers (eg verify stability of their income and their repayment history)

· Another problem is that Easyloan may have trouble attracting deposits even with higher interest rates, if depositors perceive that this is a risky business model and so their deposits might not be as safe as in a bank.

3. In the 1970s and 1980s, a money supply target was the centrepiece of monetary policy in Australia. Yet in more recent decades, monetary policy announcements by the RBA have rarely mentioned the money supply at all. Why has this change occurred?

· The central issue here is quantity-setting versus rate-setting in monetary policy

· Answers might include a reference to the Macfarlane speech which dealt with this

· Quantity setting was abandoned because the demand for money was too unstable, so any effort to control the money supply would result in unacceptable volatility in interest rates

· As a result, central banks adopted a rate-setting approach, using changes in the policy interest rate to directly influence the economy to achieve the desired objectives

· Inflation targets developed in the 1990s provide the strategic framework to guide rate-setting decisions

· The money supply is rarely mentioned in policy announcements because it is not relevant to this framework

· Changes in the money supply are seen as consequences of economic developments rather than causes

· In addition, because of instability of the money demand function, changes in the money supply are not closely related to other economic variables and so have little information value

4. Why does a system of discretionary decision-making lead to a problem of inflationary bias in monetary policy? How does this support the case for inflation targeting?

· The central concept here is time consistency

· A good answer should demonstrate a grasp of that concept

· A simple definition is: it may not be optimal in a given period to stick to an optimal multi-period plan

· In monetary policy, the optimal multi-period plan is, always aim for low inflation

· But in any individual period, it is optimal to aim for higher-than expected inflation to get the temporary boost to output and employment that comes with that

· But, economic agents will rationally expect the policymaker to attempt to do this

· The result is higher inflation without the output boost

· The remedy for this incentive problem is a pre-commitment mechanism, which makes it harder for the policymaker to deviate from the optimal multiperiod plan

· By constraining the central bank with a numerical target and various accountability mechanisms, an inflation target achieves this

5. Explain the role of poor lending practices in the lead up to the GFC. What were the most risky practices that were occurring, and how did these contribute to the crisis?

· US mortgage lenders were increasingly engaged in sub-prime lending

· This means, lending to borrowers who don’t meet standard criteria for creditworthiness, such as a stable source of income, conservative loan to valuation ratio, debt serviceability tests or sound loan repayment history

· Lenders were able to do this because of the growing use of originate-to distribute lending

· This is where the lender packages loans into asset-backed securities (sometimes with complex structures that made it hard for investors to evaluate their risk characteristics

· Credit rating agencies facilitated this by providing ratings and also providing advice on how to design some of the complex structures to ensure they would be more highly rated

· They faced a conflict of interest in this business because the rating agencies are hired and paid by the issuers

· This pattern led to risks being understated on many of these securities

· Purchasers of these securities such as investment banks lost money when the underlying loans went into default

· Sometime they may have borrowed money from banks in order to buy these securities, which meant they were unable to repay bank loans

· In this way the losses spread across financial institutions