in the credit allocation process?
Money supply transmission: Depository institutions affect the level of money supply growth in the
economy. The money supply is increased when the Fed increases money available to banks, but
the extent of money supply growth is affected by banks' decisions to lend the increased supply of
funds. If the banks do not lend the increased money, the given increase in funds by the Fed will
result in only a small change in the total money supply in the economy.
Credit Allocation: FIs price risk and allocate capital to users who they believe can generate a high
enough rate of return to compensate the lender for the risk the lender bears in loaning the money.
FIs also monitor the borrower's condition after the loan is made. A well-functioning economy must
have sound mechanisms for allocating capital. In capitalist countries, FIs and markets allocate
capital to its highest valued uses, thereby maximizing economic growth. The role of government is
to ensure disclosure of risks and fair practices of all involved. In communist and some socialist
countries, governments allocate capital according to a current political agenda and strong, lasting
economic growth is rarely, if ever, seen in these countries. As the text indicates, the government can
also channel credit to socially deserving areas such as housing, farms, and small business
development.
Intergenerational wealth transfers and risk shifting: Pension funds and insurance firms allow
investors to transfer wealth through time, while avoiding taxation, and/or allow investors the ability
to choose which risks in their life they will bear and which they will insure.
Payment services: The ability to store and quickly move large sums of money (or many small sums)
at low cost with little risk encourages greater investment by market participants and, thus, lowers
the overall cost of funds in our economy.
References
Short Answer Difficulty: 3 Hard
49.
Award: 10.00 points
50.
Award: 10.00 points
What determines the price of financial instruments? Which are riskier, capital market instruments or
money market instruments? Why?
The price of any financial instrument is the present value of future cash flows discounted at an
appropriate rate. A small change in interest rates causes a large change in present value of distant
cash flows. Hence, the prices of long-term capital market instruments are more sensitive to changes
in interest rates than prices of short-term instruments. In addition, distant cash flows for stocks are
not known with certainty. Changing economic prospects can cause very large changes in current
stock values. Money market instruments have predictable cash flows and mature in one year or
less, so they are much less risky.
References
Short Answer Difficulty: 3 Hard
Explain how the credit crunch originating in the mortgage markets hurt financial intermediaries'
attempts to use diversification and monitoring to limit the riskiness of their loans and investments
while offering more liquid claims to savers.
Financial intermediaries' (FIs) attempts to diversify away from specific risk failed when large portions
of the debt markets "seized up" and stopped functioning. At that point, many security prices
declined all at once, regardless of historical correlations among security prices. This is a failure of
diversification to reduce risk. FIs exploit diversification principles and economies of scale to allow
the FI to invest large amounts of money. They also must closely monitor the riskiness of their loans
and securities, and many FIs are also regulated by the government to ensure they manage the
riskiness of their assets. Some would argue that FIs failed to monitor the riskiness of many of their
mortgage investments as well, leading to large numbers of poor investments.
References
Short Answer Difficulty: 3 Hard