Financial Economics Exam – Answer Guide

Section A – Answer Any Five Questions

1a. Define Money and Characteristics of Modern Money

Definition of Money: Money is anything that is generally accepted as a medium of exchange
and used in the settlement of debts.

Characteristics of Modern Money:

1. Durability – It should last long without deteriorating.

2. Portability – Easy to carry.
3. Divisibility – Can be divided into smaller units.
4. Uniformity – Each unit must be the same in value and appearance.
5. Acceptability – People must accept it in transactions.
6. Stability in Value – Its value should not fluctuate wildly.
7. Recognizability – Must be easily identified and distinguished from fake money.

1b. Five Functions of Money and Three Theories in the Monetary Sector
Functions of Money:
1. Medium of Exchange
2. Store of Value
3. Unit of Account
4. Standard of Deferred Payment
5. Means of Transferring Value

Theories of Money:
1. Quantity Theory of Money (Fisher’s Equation): MV = PT
2. Keynesian Liquidity Preference Theory
3. Cambridge Cash Balance Approach

2a. Preference of Monetary Policy in Nigeria

The Central Bank of Nigeria (CBN) aims for price stability and inflation control using tools
such as interest rate regulation, open market operations, reserve ratios, liquidity
management, and exchange rate stabilization.

2b. Five Approaches to Monetary Control

1. Open Market Operations (OMO)
2. Cash Reserve Ratio (CRR)
3. Liquidity Ratio
4. Discount Rate Policy
5. Moral Suasion
3a. Five Roles of Banks and Non-Banking Institutions
1. Mobilization of savings
2. Provision of credit
3. Facilitating trade and commerce
4. Promoting investments
5. Support to SMEs

3b. Deflation vs Inflation

Inflation: Rise in general price level.
Deflation: Fall in general price level.

3c. Difference Between Money Market and Capital Market

Money Market: Deals with short-term funds (e.g., Treasury bills).
Capital Market: Deals with long-term funds (e.g., stocks, bonds).

4a. Impacts of Fiscal Policy on Nigerian Economy

1. Economic stabilization
2. Employment generation
3. Inflation control
4. Infrastructure development
5. Redistribution of income

4b. Impacts of Taxation on Economic Activities

1. Reduction in disposable income
2. Control of inflation
3. Investment influence
4. Resource allocation
5. Production encouragement/discouragement

5a. Internal vs External Debt

Internal Debt: Owed within the country.
External Debt: Owed to foreign entities.

5b. Consequences of External Debt

1. Exchange rate pressure
2. Debt servicing burden
3. Crowding out effect
4. Reduced capital investment
5. Inflation

5c. Multilateral Institutions vs Money Deposit Banks

Multilateral Institutions: IMF, World Bank, focus on economic development.
Money Deposit Banks: Profit-driven financial institutions.
5d. Roles of Monetary Authority (CBN)
1. Currency issuance
2. Regulation of banks
3. Currency stabilization
4. Monetary policy implementation
5. Inflation control

6a. Rationale for Government Participation in Economy

1. Provision of public goods
2. Market failure correction
3. Income redistribution
4. Economic stability
5. Development promotion

6b. What is Anti-Money Laundering (AML)?

AML refers to laws and policies that prevent illegally obtained money from being
legitimized.

6c. AML vs KYC

AML: Prevents money laundering.
KYC: Customer identity verification.

7a. Define the Following Briefly

1. Inflation rate – General rise in prices.

2. Interest rate – Cost of borrowing.

3. Exchange rate – Value of one currency against another.

4. Foreign reserve – Government’s holdings of foreign currencies.

5. Cash reserve ratio – Percentage of deposits kept with CBN.

6. Market failure – When free market fails to allocate resources efficiently.

7. Subsidy – Government aid to reduce cost of goods/services.

8. Deregulation – Removal of government controls.

9. Capital Flight – Large outflow of domestic capital to foreign markets.

10. Recession – Economic decline for two consecutive quarters.

Section B – Question 1

1(i) The Money Supply is Determined Both Endogenously and Exogenously – Explain the
Determinants
Money supply refers to the total quantity of money available in the economy at a particular
point in time. It is influenced by both endogenous (internal) and exogenous (external)
factors.

Endogenous Determinants:

- Commercial Bank Lending: When banks extend credit, they create money through deposit
multiplication.
- Interest Rate: Lower interest rates encourage borrowing, increasing money supply.
- Demand for Credit: Higher credit demand leads to more money creation.
- Reserve Requirement: Lower reserve ratios allow banks to lend more.
- Liquidity Ratio and Cash Reserve Ratio: Determines how much money banks can circulate.

Exogenous Determinants:

- Central Bank Monetary Policy: Adjusting CRR, OMO, and discount rates.
- Government Fiscal Policy: Government spending and borrowing influence money in
circulation.
- Foreign Investment: Inflows from foreign investment increase money supply.
- Exchange Rate Policy: Influences the flow of foreign currencies.
- International Aid and Grants: Add to the monetary base externally.

1(ii) Derive the Formula and Determine the Relationship between Money Supply and Powered
Money
The money supply (Ms) is derived from the monetary base (MB or H) and the money
multiplier (m). The formula is:

Ms = m × MB

Where:
- Ms = Money Supply
- m = Money Multiplier
- MB = Monetary Base or High-Powered Money (Currency in circulation + bank reserves)

The money multiplier is calculated as:

m = 1 / (CR + RR)

Where:
- CR = Currency Ratio (public's preference for cash vs deposits)
- RR = Reserve Ratio (proportion of deposits that banks must keep as reserves)
Implication:
- An increase in MB or m leads to an increase in Ms.
- A higher reserve ratio or higher currency ratio reduces the multiplier, thus reducing the
money supply.

Example:
If MB = ₦100 billion and m = 4, then:
Ms = 4 × ₦100 billion = ₦400 billion

Section B – Question 2

2(i) Deeply explain the two main functions of money as it relates to the supply of money
The two main functions of money in relation to the supply of money are:
1. Medium of Exchange:
- Money facilitates the buying and selling of goods and services. It eliminates the
inefficiencies of barter trade.
- As a medium of exchange, the supply of money must be sufficient to enable smooth
economic transactions.
- If money supply is too low, trade is hindered; if too high, inflation may result.

2. Store of Value:
- Money allows individuals to save or store their wealth for future use.
- For money to serve this function effectively, it must maintain its purchasing power.
- Inflation erodes the value of money, reducing its effectiveness as a store of value.

2(ii) Differentiate between Bimetallic and Monometallic standard of money

Bimetallic Standard:
- This monetary system uses two metals, usually gold and silver, as the basis for the money
supply.
- Both metals are legal tender at a fixed ratio defined by the government.
- It allows flexibility in coinage and provides a hedge against fluctuations in the value of one
metal.
- However, it often leads to the problem of 'Gresham’s Law', where bad money drives out
good money.

Monometallic Standard:
- This system uses only one metal, usually gold (Gold Standard) or silver (Silver Standard),
as the basis for currency.
- Only one type of metal coin is considered the legal tender.
- It is simpler to manage but may lack flexibility if the supply of the single metal is unstable.
Section B – Question 3

3(i) Keynes in his General Theory used the term 'liquidity preference' for the demand for
money. Describe the three motives he used to explain the demand for money.
John Maynard Keynes explained the demand for money using the concept of 'liquidity
preference', which refers to the preference of individuals to hold their wealth in the form of
liquid cash instead of other assets. He proposed three motives:

1. Transaction Motive:
- This refers to the need to hold money for everyday transactions, such as buying goods and
services.
- It is influenced by the level of income and the frequency of receipts and payments.

2. Precautionary Motive:
- Money is held as a precaution against unforeseen events such as emergencies or
unexpected expenditures.
- The amount held depends on the individual's risk aversion and income stability.

3. Speculative Motive:
- This motive refers to holding money to take advantage of future changes in bond prices
and interest rates.
- When interest rates are low, people expect them to rise and bond prices to fall; hence they
hold money instead of bonds.

3(ii) Diagrammatically explain the Liquidity Trap and also using the formula discuss.
A Liquidity Trap occurs when interest rates are very low and savings rates are high, making
monetary policy ineffective. In this situation, people prefer holding cash rather than
investing in non-liquid assets because they expect interest rates to rise and bond prices to
fall.

In the liquidity trap, the demand for money becomes perfectly elastic (horizontal) at a very
low interest rate. This means increases in the money supply do not lower interest rates
further or stimulate investment.

Formula:
Md = L1(Y) + L2(i)
Where:
- Md = Demand for Money
- L1(Y) = Transaction and Precautionary Demand (depends on income, Y)
- L2(i) = Speculative Demand (depends on interest rate, i)

In the liquidity trap, L2(i) becomes infinitely large as interest rate (i) approaches zero,
making monetary expansion ineffective.
Diagram (to be drawn manually):
- Draw a graph with interest rate (i) on Y-axis and Quantity of Money (Md) on X-axis.
- Show downward sloping Md curve becoming flat at very low interest rates.

Section B – Question 4

4(i) Explain the methods of controlling credit by the CBN

The Central Bank of Nigeria (CBN) uses various credit control methods to regulate the
amount of credit supplied by commercial banks. These methods include:

1. Quantitative Methods (General Controls):

- Open Market Operations (OMO): Buying and selling of government securities to influence
money supply.
- Bank Rate Policy: Altering the interest rate at which the CBN lends to commercial banks.
- Cash Reserve Ratio (CRR): Changing the percentage of deposits banks must hold as
reserves.
- Liquidity Ratio: Adjustment of the ratio of liquid assets banks must maintain.

2. Qualitative Methods (Selective Controls):

- Credit Rationing: Limiting the amount of credit for specific sectors.
- Moral Suasion: Persuading banks to follow monetary guidelines.
- Direct Action: Imposing penalties on banks that do not comply with policies.

4(ii) Credit control is a means to control the lending policy of commercial banks by the CBN.
Explain the objectives of credit control.
The objectives of credit control include:
1. Regulating Inflation: To control excess money supply and stabilize prices.
2. Economic Stability: To prevent boom and bust cycles in the economy.
3. Ensuring Availability of Credit: To ensure credit flows to productive sectors.
4. Exchange Rate Stability: To manage foreign exchange reserves.
5. Financial Discipline: To ensure responsible lending and reduce bad loans.

Section B – Question 5

5(i) Discuss the various instruments of fiscal policy.

Fiscal policy instruments include:
1. Government Expenditure: Spending on infrastructure, education, defense, etc.
2. Taxation: Adjusting taxes to influence consumption and investment.
3. Transfer Payments: Social welfare payments like pensions and subsidies.
4. Public Borrowing: Issuing bonds to raise funds without increasing taxes.
5. Budget Deficits/Surpluses: Adjusting spending and revenue to manage economic activity.

5(ii) With the aid of a diagram explain the following:

a) Expansionary Monetary Policy:
- Used to stimulate economic growth by increasing money supply and reducing interest
rates.
- Leads to increased investment, output, and employment.

Diagram (to be drawn manually):

- IS-LM curve showing a rightward shift in LM curve.

b) Restrictive Monetary Policy:

- Used to reduce inflation by decreasing money supply and increasing interest rates.
- Leads to reduced investment and controlled inflation.

Diagram (to be drawn manually):

- IS-LM curve showing a leftward shift in LM curve.

Section B – Question 6

6(a) Is Balance of Payment always in equilibrium? Discuss.

The Balance of Payments (BOP) is theoretically always in equilibrium because it records all
international transactions. However, individual accounts within the BOP (current, capital,
financial) may experience deficits or surpluses.
- Disequilibrium arises due to trade imbalances, capital flows, debt servicing, and currency
fluctuations.
- Persistent deficits may lead to depletion of reserves and borrowing from international
institutions.

6(b) Use the balance of payment account schedule and balance of trade account to distinguish
between balance of payment and balance of trade.
Balance of Trade:
- Refers to the difference between the value of a country's exports and imports of goods.
- It is a part of the current account in the BOP.

Balance of Payments:
- A comprehensive record of all economic transactions between a country and the rest of
the world.
- It includes the current account (trade, services, income), capital account, and financial
account.

Schedule Example:
| Account Type | Credit (Inflow) | Debit (Outflow) |
|------------------|----------------|-----------------|
| Exports of Goods | $500 million | |
| Imports of Goods | | $400 million |
| Services | $100 million | $50 million |
| Capital Inflow | $300 million | |
| Capital Outflow | | $250 million |