SCHOOL OF POSTGRADUATE STUDIES

GFS714- MONEY AND BANKING

TAKE HOME TEST- PART TIME STUDENTS ONLY
Instructions: a) Please answer all questions b) The scripts must be sent on email to
bennybanda325@yahoo.com before 17:00hrs on WEDNESDAY 21/0/2022. C) Ensure that
you receive confirmation of receipt for your submission by the next day.

Questıon One

a. Using your knowledge of Money and Banking, provide an assessment of the benefits of the
Independence of the Central Bank in Zambia. Drawing on the experience of other markets,
how can the Central Bank in Zambia be made more independent? [5 MARKS]
Solution

Liquidity reflects a financial institution’s ability to fund assets and meet financial obligations. Liquidity is
essential in all banks to meet customer withdrawals, compensate for balance sheet fluctuations, and
provide funds for growth.

Liquidity risk reflects the possibility an institution will be unable to obtain funds, such as customer
deposits or borrowed funds, at a reasonable price or within a necessary period to meet its financial
obligations. Failure to adequately manage liquidity risk can quickly result in negative consequences for
an institution despite strong capital and profitability levels. Management must maintain sound policies
and procedures to effectively measure, monitor, and control liquidity risks. 

b. You have been appointed to Head one of Zambia’s leading commercial Banks. Provide a
demonstration of some of the pitfalls in poor liquidity management on the balance sheet of a
commercial Bank. [5 MARKS]
Solution
Some of the pitfalls in the poor liquidity management on the balance sheet of a commercial Bank can be
demonstrated as follows:

1) Disposing off liquid assets: Not having proper measures to sell off trade receivables, market securities
to other banks, or other commercial units will result in idle funds tied up in current assets of a bank, and
may lead to not enough liquidity available to meet prompt due obligations.

2) Decrease in short term borrowings: Not having reliant measures to increase short term borrowings
from other banks, central bank, or money market instruments, will also present from a balance sheet, a
poor liquidity position of a bank.

3) Increase holdings of less liquid assets: When banks funds are tied up in assets like lending to poor
credit history customers. These assets may soon turn into Non performing assets (NPA), this may be due
various reasons like having complacent credit lending policies, or over reliance on past data etc. As a
result banks most of assets from balance sheet do not necessarily reflect correct liquidity position.

4) Decrease in term nature liabilities: Commercial banks policy makers may sometimes not comply with
having to raise long term debt to finance their business operations. As a result liquidity of bank gets
affected. And is reflected on balance sheet.

5) Decrease in capital funds: Raising an adequate amount of capital is very essential for commercial
banks as it acts as a cushion to mitigate the risks arising from many sources, one such source is the
liquidity risk. So it is essential to maintain the capital at a rate where the commercial bank is in a position
to counter the risks. Such a rate is also known as capital adequacy rate.

c. Demonstrate using the Equation of exchange that inflation is lately driven by money supply.
Ensure to provide a rationale for this assertion based on your interrogation of the equation of
exchange. [5 MARKS]
Solution

Inflation is always and everywhere a monetary phenomenon”.  suggests that a dramatic increase in

central bank cash can achieve inflation or transform deflation into inflation.

Most present-day central banks focus on the pace of inflation in a country as their essential
measurement for money-related strategy. Assuming that costs rise quicker than their objective, central
banks fix money-related approaches by expanding loan fees or other hawkish strategies. Higher loan
fees make acquiring more costly, diminishing both utilization and venture, the two of which depend
intensely on layaway. In like manner, in the event that inflation falls and monetary result declines, the
central bank will bring down loan fees and make getting less expensive, alongside a few other
conceivable inflationary strategy devices.
As a methodology, inflation focuses on seeing the essential objective of the central bank as keeping up
with cost security. Each of the devices of money-related strategy that a central bank has, including open
market tasks and rebate loaning, can be utilized in an overall system of inflation focusing on. inflation
focusing can be differentiated to systems of central banks focused on different proportions of monetary
execution as their essential objectives, for example, focusing on cash trade rates, the joblessness rate, or
the pace of ostensible GDP (Gross domestic product) development.

Question Two
a. Explain under what circumstances a country can pursue objectives for both economic growth
and price stability and where this may be impossible following temporary or permanent
supply shocks. [5 MARKS]

Solution

When the country faces a recession due to a negative aggregate demand shock, the country can
pursue objectives for both economic growth and price stability simultaneously.

This is because, during a negative aggregate demand shock, there is a decline in the aggregate demand
in the economy which causes a decline in the equilibrium price level thereby lowering the inflation rate
in the economy.

A decline in the equilibrium price level i.e. a decline in the prices of goods and services reduces
producers' profit margin. This demotivates the producers of goods and services thus causing a decline in
the production of goods and services. The real GDP decreases and becomes less than the potential GDP,
resulting in a recessionary output gap in the economy. 

The above situation of recession due to aggregate demand shock can be corrected by implementing
expansionary monetary policy and/or expansionary fiscal policy. Both expansionary monetary policy and
expansionary fiscal policy aim at increasing the aggregate demand in the economy.

An increase in the aggregate demand causes a rise in the equilibrium price level thereby increasing the
inflation rate in the economy. The aim of price stability is achieved.

An increase in the equilibrium price level i.e. an increase in the prices of goods and services increases
producers' profit margin. This motivates the producers of goods and services thus causing an increase in
the production of goods and services i.e. a rise in the price level causes an expansion of aggregate
supply. The real GDP increases and the aim of economic growth is also achieved.

 
 But when the country faces a recession due to a negative aggregate supply shock, it becomes
impossible for the country to pursue objectives for both economic growth and price stability
simultaneously.

A negative aggregate supply shock causes an increase in the equilibrium price level in the economy
thereby increasing the inflation rate at the same time it causes a decline in the real GDP. 

If expansionary monetary policy and/or expansionary fiscal policy are implemented in order to achieve
economic growth, it would increase the aggregate demand thereby increasing the real GDP. An increase
in the aggregate demand would cause a further increase in the equilibrium price level thereby further
increasing the inflation rate in the economy. Economic growth is achieved but at a cost of a higher
inflation rate. 

If contractionary monetary policy and/or contractionary fiscal policy are implemented in order to
achieve price stability, it would decrease the aggregate demand thereby decreasing the price level (thus
decreasing the inflation rate). A decline in the aggregate demand would cause a further decrease in the
real GDP thereby further causing negative economic growth. Price stability is achieved but at a cost of
negative economic growth. 

b. An investor wishing to invest in Bonds is unsure on whether to invest in bonds of the same tenor
or not. They are also unsure if they should invest locally in Zambia’s currency assets or South
African currency assets. Using your knowledge of Money and Banking how would you advise
the investor?[10 MARKS]

Solution

One of the most important factors to consider when investing in bonds is the tenor. This refers to
how long your purchase will last, and it can be helpful to understand this information if you want
to make an informed decision about which bond investments are best for you. Ultimately, it is
important to do your research before making any investment decisions. South African currency
bonds might be a good option for investors who are looking for short-term stability and modest
growth, while Zambian currency bonds may be better suited for those who want longer-term
safety and high returns. Bond prices fluctuate constantly, so always check current values before
committing money.
c. Zambia recently concluded an Extended Credit Facility Arrangement with the International
Monetary Fund aimed at providing Balance of payment support. Using your knowledge of the
operations of the international monetary system as well as the operations of foreign exchange
markets, provide an assessment of how the Extended Credit Facility Arrangement would affect
the foreign exchange markets and support the Balance of payments of the country. [5 MARKS]

Solution

Given that, the nominal exchange rate is 0.91 kwacha/rand.

A good's cost is in South Africa 800 ZAR and in the Zambia 500 ZMW.

The real exchange rate is the rate at which one country can purchase a good from other country for
which the exchange rate is given. The formula to be used to calculate 

Real exchange rate = Nominal exchange rate*(Domestic price/Foreign price)

where nominal exchange rate is in foreign currency/domestic currency.

Here the domestic country is Zambia, so the nominal exchange rate is 1/0.91 rand/kwacha (kwacha is
domestic currency and rand is foreign currency).

Thus, Real exchange rate = (1/0.91)*(500/800) = 0.68 ZAR/ZMW

The real exchange rate 0.68 means to purchase a good in South Africa a Zambian citizen have to sacrifice
an amount that could purchase 0.68 good in Zambia. In other words, the Zambian citizen have to pay
less in South Africa for same units of goods they pay in Zambia.

Hence, the real exchange rate is 0.68 ZAR/ZMW, and it interprets, to purchase a unit of good in South
Africa one has to pay the amount which can purchase only 0.68 unit good in Zambia.

Question Three

a) What are some of the implications of the new currencies or forms of money (e.g. mobile
money, cryptocurrencies, credit cards) on the conduct of monetary policy

Solution

There are a number of implications that new currencies or forms of money have on the conduct of
monetary policy. Most notably, Currency markets will become more volatile as people try to predict
which currency will be most stable in the future. This could lead to irrational buying and selling
behaviour, heightened interest rates, and volatility in stock prices. Additionally, since cryptocurrencies
are not backed by any government or institution, they may pose a threat to traditional banks and
payment systems. In this sense, central banks may find it difficult to prevent outbreaks of financial
instability caused by cryptocurrency bubbles.

b) “Inflation is always and everywhere a monetary phenomenon”. What are the implications for
Central Banks of this famous adage? [5 MARKS]

Solution

The renowned assertion that "inflation is always and everywhere a monetary phenomenon" is
widely attributed to Milton Friedman. In other words, inflation is created by an increase in the
quantity of money that expands at a faster rate than the growth in output, and this is the only way
inflation can occur. It is general known that the key factor that determines the amount of money
that is available to the government is the spending priorities of the government, and in recent
years, the government has participated in a substantial amount of expenditure.

c) A basket of goods costs ZMW500 in Zambia while the same basket of goods costs ZAR800
in South Africa. A check at ABSA bank shows that for ZAR1 you need ZMW0.91. Using this
information compute the real exchange rate between the rand and the kwacha. Ensure to
interpret the meaning of the real exchange rate computed. ? [5 MARKS]

Solution

Real exchange rate = Nominal exchange rate x Domestic price/Foreign price

=(1ZAR/ZMW0.91) x (ZMW500 per Zambian basket/ZAR800 per South African basket)

=(1 ZARx ZMW500 per Zambian basket)/(ZMW0.91 x ZAR800 per South African basket)

=(500/Zambian basket) / (728/South african basket)

= 0.69 South African baskets/Zambian Basket