Economics Questions: The Barter System

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ANSWER SCHEME
ECO551/553
APRIL 2010

QUESTION 1

a) A barter trade system is a system whereby people exchange goods for other goods.

( with example)

b) There are many problems facing the barter trade. Three of these problems are:

i) Double coincidence of wants
ii) Rate of exchange
iii) Divisibility
( with explanation)

(b) The four functions of money are as follows:

i) Medium of exchange
ii) Unit of account
iii) Store of value
iv) Standard for deferred payment
( with explanation)

QUESTION 2

a) Functions of a financial system

(i) Mobilisation of funds

(ii) Flexibility in investment

(iii) Implementation of monetary policy

(iv) An efficient savings process

( with explanation)

(b) Participants in the financial system
The financial system consists of individuals, companies, markets and government that are in some way involved in assisting the process of exchange of financial assets. The individuals,companies and government, which need to borrow, may be called the “deficit” units. However, if they have surplus funds to lend, they would be called the “surplus” units.

The participants and the roles played by them can be categorized as follows:
(i) Borrowers and lenders

(ii) Capital raisers and investors

(iii) Financial intermediaries

(iv) Service providers

( with explanation)

QUESTION 3

a) Loanable Fund Theory

•determines the interest rate using the demand and supply analysis in the bond market.
•determinants of demand and supply of assets :wealth, expected returns risk, liquidity, price.

Price of bonds, PBs

Bs2

P(i)

Bd2

Bd

Q 0 Q1Quantity of bonds,B

b) i)

Price of bonds, PBs1

Bs2

P(i)

Bd1

Q1Q2Quantity of bonds,B

Increase in government borrowing, increase the supply of bonds at each bond price.

(with explanation)

ii)

Price of bonds, PBs1

P(i)

P(i)*

Bd2Bd1

Quantity of bonds,B

Increase in the expected returns on other assets raises the quantity demand of the assets, thus decrease the demand for bonds.

QUESTION 4
a) Keynes felt the demand for money depended on income and interest rates.

Money was held to facilitate normal transactions and as a precaution for unexpected transactions. For both of these motives, money demand depended on income. People also held money as an asset, for speculative purposes. The speculative motive depends on income and interest rate. People hold more money for speculative purposes when they expect bond prices to fall, generating a negative return on bonds.

( with explanation + diagram)

Since money demand varies with interest rates, velocity changes when interest rates change. Also, since money demand depends upon expectations about future interest rates, unstable expectations can make money demand, and thus velocity, unstable.

In Friedman’s theory, increases in permanent income increase money demand. Increases in the returns on bonds relative to money and the returns on equities relative to money decrease money demand. Increases in the returns on goods relative to the return on money, which is the expected rate of inflation relative to the return on money, decrease money demand.

(equation and elaboration)

Md/p= Demand for real money

ƒ= function of/depends on

Yp = Friedman’s measure of wealth, known as permanent income (technically, the present discount value of all expected average long-run income)

rm= Expected return on money

rb= Expected return on bonds

re= Expected return on equity (common stocks)

πe= Expected inflation rate

Velocity is determined by the ratio of actual to permanent income....
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