UNIT 2.

TUTORIAL QUESTIONS

1. What are financial intermediaries? What economic functions do they perform?

A financial intermediary links those with surplus funds (e.g. lenders) to those with
deficit in funds (e.g. potential borrowers) thus providing aggregation and economies
of scale, risk pooling, and maturity transformation.

Functions FROM TEXTBOOK:

 They provide obvious and convenient ways in which a lender can save money.
 They provide a ready source of funds for borrowers.
 They can aggregate or 'package' the amounts lent by savers and lend on to
borrowers in different amounts.
 They help reduce individual lenders’ risk by pooling, as any losses suffered are
effectively pooled and borne as costs by the intermediary.
 By pooling the funds of large numbers of people, some financial institutions are
able to give investors access to diversified portfolios covering a varied range of
different securities, such as unit trusts and investment trusts.
 They provide maturity transformation, i.e., they bridge the gap between the wish
of most lenders for liquidity and the desire of most borrowers for loans over
longer periods.

MISS EXPECTED ANSWER:

Financial intermediaries are institutions that bring together providers and users of
finance, either as a broker or as principal e.g., commercial banks, credit unions
building societies and life insurance companies. They link lenders with borrowers by
obtaining deposits from lenders and then re-lending them to borrowers.

Functions:
 Advising firms
 Underwriting securities issues
 Managing distribution
 Enhance credibility,
 Create new securities.
 2. What is Fiscal Policy? How is it used to influence the economy?

Fiscal policy is the action by the government to spend money, or to collect money in
taxes with the purpose of influencing the condition of the national economy.
Government can withdraw more/less from the economy or spend more (expansionary)/
less (contractionary).

This is done through implementing policies such as

a. Spending more money and financing this expenditure by borrowing

b. Collecting more in taxes without increasing public spending
c. Collecting more in taxes in order to increase public spending, thus diverting
income from one part of the economy to another, increasing govt spending
(injection).

Fiscal policy is the use of government spending and taxation to influence the
economy by promoting strong and sustainable growth and reduce poverty.

 Fiscal policy is the governmental decision to increase or decrease taxation and

spending.
 Fiscal policy and monetary policy are often used together to influence the
economy.
 Fiscal policy can affect a company’s growth, hiring ability and taxes.

How does fiscal policy influence the economy?

1. Business tax policies – Taxes that businesses pay to the government affects its
profits and investments spending. Lowering taxes increases both aggregate
demand and business investment opportunities.

2. Government Spending – Aggregate demand is increased by the government’s

own spending.

3. Individual tax policy – such as income tax – after their personal income and
how much they can spend, injecting more money back into the economy.

Therefore, spending is used as a tool for fiscal policy to drive government money to specific
sectors needing an economic boost.
 Two (2) Types of Fiscal policy

Expansionary: designed to stimulate the economy, is most often used during a

recession, times of high unemployment or low periods of the business cycle. It entails the
government spending more money, lowering taxes or both.

Contractionary: is used to slow economic growth, such as when inflation is growing too
rapidly. This policy raises taxes to cut spending. As consumers pay more taxes, they
have less money to spend, and economic stimulation and growth slow.

3. What is Monetary Policy? How is it used to influence the economy?

Monetary policy is the regulation of the economy through control of the monetary system
by operating on such variables as the money supply, the level of interest rates, and the
conditions for the availability of credit.

Monetary policy refers to the action of central banks to achieve macroeconomic

policy objectives such as price stability, full employment, and stable economic
growth.

It is used to influence the economy by increasing the money supply and lowering
interest rates causing an increase in investment which in turn increases aggregate
demand.

When interest rates decline financial institutions obtain funds at low-interest rates.

Lending rates on loans reduce the decline in interest rates at which firms borrow directly
from the market. Easier to procure working capital.

Households also find it easier to borrow. Economic activities improve such monetary
policy and stimulate the economy through monetary easing.

 When interest rates rise institutions obtain funds at higher rates and lending rates
also increase. Firms and households - difficult for them to borrow.

 Makes the economy sluggish overheating of the economy.

 Downward pressure on prices is called monetary tightening.

MISS EXPECTED ANSWER:

In general, the effects of monetary policy on economic activity, through a decline or a

rise in (real) interest rates, are as follows.

When interest rates decline, financial institutions can procure/obtain funds at low-
interest rates. This enables them to reduce their lending rates on loans to firms and
households. Given the linkage between various financial markets, there is a
decline/reduce in not only financial institutions’ lending rates but also interest rates
at which firms borrow directly from the market, such as in the form of corporate bond
issuance.

In this situation, firms it is easier to procure working capital, (funds needs for payment
of salaries and input costs) and fixed investment funds (funds needed for construction of
factories, stores, etc.), and households also find it easier to borrow funds, such as
purchasing housing.

As a result, firms’ and households’ economic activity picks up, and this stimulates the
economy. Upward pressure on prices is also generated in turn.

Such monetary policy measures aimed at stimulating the economy through/ are called
monetary easing.

On the other hand, when interest rates rise, financial institutions must procure/ obtain
funds at higher rates and raise their lending rates on loans to firms and households and
households. Firms and households find it difficult to borrow funds, which makes their
economy sluggish. This, in turn, causes overheating of the economy and exerts
downward pressure on prices.

Such monetary policy measures, aimed at containing an overheating of the economy, are
called monetary tightening.
4. What does it mean when a country is said to be running a trade deficit? What
impact will a trade deficit have on interest rates?

A trade deficit occurs when a country's imports exceed its exports during a given
time period.

This signifies that there is a strong domestic currency making the imports cheaper.
But this is not necessarily good for the country because they are consuming more than
they are producing (not having as much income being plunged back into the country).

So, this makes the domestically produced goods more expensive in other countries
and to attract foreign currencies then they would have to increase the interest rates on
these goods.

5. Differentiate between Capital and Money Market

Capital markets are markets for long-term capital. Money markets are markets for
short-term capital.

Capital markets are markets for trading in long-term finance, this involves a life of
more than twelve (12) months, in the form of long-term financial instruments such as
equities and corporate bonds.

Money markets are markets for: Trading short-term financial instruments and Short-
term lending and borrowing. These normally have a life of less than twelve (12)
months.

Money markets securities are less risky when compared to capital market securities
because they are issued for shorter periods and involve less volatility. Money
markets are highly liquid compared to capital markets. Also, money markets help in
meeting short term credit requirements of the companies, such as providing
working capital.

The money markets are operated by the banks and other financial institutions. Although
the money markets largely involve borrowing and lending by banks, some large
companies, as well as the government, are involved in money market operations.
COMPARISON POINTS MONEY MARKET CAPITAL MARKET

6. How does fiscal policy affect business?

By influencing aggregate demand for goods and services in the economy:

Business planning should take account of the likely effect of changes in AD on sales
growth. Business planning will be easier if government policy is relatively stable.

By tax changes: For example, labor costs will be affected by changes in employers’
national insurance contributions. If indirect taxes such as sales tax or excise duty rise,
either the additional cost will have to be absorbed or the rise will have to be passed on
to consumers at higher prices. Planning is easier if policy is stable.