FINANCIAL ECONOMICS Overall Performance The table below shows the distribution if candidates by scores: Grade Marks % of Candidates F 3 0-34 32% F 2 35-44 35% F 1 45-48 4% P 50-74 28% D 75 and above 1% Total 100 As indicated in the table, the overall pass rate was 29%, including one candidate passing in distinction. The overall performance in the paper was rather unimpressive, especially when compared with previous diets. The candidates did not show good grasp of the subject matter of Financial Economics. Many of them lacked understanding of the requirement of most of the questions, hence the poor performance. Section A Question 1 Indicate which of the following statements are True or and comment briefly to substantiate the choices made. (iv) (v) The IS-LM model is a theoretical construct that determines a general equilibrium position for the economy as a whole. If exchange rates float freely, the exchange rate for any currency is determined by the official reserves that backs it. Financial innovation makes way for increased availability of credit in the economy. The Nigeria Deposit Insurance Corporation (NDIC) is the apex regulatory authority of the Nigerian Financial System. Special Drawing Right (SDR) is a stand-by agreement of the International Monetary Fund (IMF) that entitles member countries to borrow from the fund. 1
(vi) The loanable funds theory explains the determination of interest in terms of the demand for and the supply of money. (vii) An implication of the quantity theory of money is that the higher the money stock in the economy, the greater will be the number of transactions. (viii) A withdrawal of money from the current account will leave narrow money supply unchanged. (ix) The demand for bonds and bond process are directly related. The higher the price. (x) Euro dollars refers to the medium of exchange in the European Union member countries. This is the true /false type question, designed to test candidates understanding of the various aspects of the syllabus. Specifically, the question tests candidates knowledge of principles, concept and policy issues in the area of Financial Economics. (FECO) Being a compulsory question, all the candidates attempted it, and the pass rate was only 36%, indicating not particularly impressive performance. Most of the candidates lost marks because of the inability to explain their choice. This is an indication of lack of familiarity with the basic concepts and principles in FECO. Candidates are therefore advised to prepare adequately well for a paper like this and be more exposed to standard texts in Economics. Suggested Solution True The IS-LM integrates the real, I-S (investment = savings), and the monetary, L-M (demand for, and supply of money), sides of the economy simultaneously to present a determine general equilibrium position for the economy as a whole. The exchange rate for any currency under a flexible or floating exchange rate system is determined by the demand for, and the supply of currency. True Financial innovation involves development of new financial products which in most cases are near money assets that could serve to extend the liquidity base of the economy. Hence, these new financial products help to increase the availability of credit. 2
(iv) The Nigeria Deposit Insurance Corporation (NDIC) is not the apex regulatory authority of the country s financial system. It is the Central Bank of Nigeria (CBN) that serves in that capacity. NDIC, however, complements the regulatory and supervisory role of the CBN. (v) SDR is not a stand-by arrangement of the IMF for borrowing. SDR is a monetary asset held by member countries of the IMF as part of international reserves. The stand-by arrangement of the IMF is an arrangement that entitles a member country to borrow up to an agreed amount of foreign currency from the fund to cover a possible deficit on its balance of payments. (vi) The loanable funds theory explains interest rate in terms of the supply of and the demand for fund (i.e. credit) available for lending and borrowing and not just money. (vii) (viii) True It depends on the velocity of money in circulation. It is possible for a small money stock used more intensively generate the same number of transactions as a large stock of money with lower velocity of circulation. Since narrow money is defined as M l = C+D i.e., currency plus demand deposit, withdrawal of cash is transforming demand deposit to currency. The total remains as before. (ix) There is an inverse relationship between bond prices and demand for bonds. This derives from the inverse relationship between bond prices and interest rates. When therefore the price of bonds falls (the interest rate rises) people will demand for more bonds to take advantage of the higher interest rate. 3
(x) Section B Question 2 Eurodollars are US dollars deposited in foreign banks outside the United States or in foreign branches of US banks. 25marks (a) (b) Make a clear distinction between liquidity and liquidity preference. Use the IS-LM framework to analyse the effects of an increase in liquidity preference on the economy. Examiner s Report on the Questions The question requires candidates to distinguish between liquidity and liquidity preference. The second part requires candidates to use the liquidity preference framework to analyse the effects of an increase in liquidity preference on the economy. The question was not popular. Only 36% of the candidates attempted it. Only one candidate had a clean pass in it. Most candidates correctly distinguished between liquidity and liquidity preference, though some saw liquidity only as the quantity of liquid assets a bank has while some failed to include motives for liquidity preference. Virtually all the candidates could not correctly analyse the effects of an increase in liquidity preference on the economy. Suggested Solution A. Liquidity and Liquidity Preference Liquidity is the extent to which an asset can be quickly and completely converted into currency (notes and coins) in order to be used as a means of payment. (3 ½ marks) Liquidity preference, on the other hand, refers to a preference for holding money instead of investing it. Keynes identifies three motives for holding money, namely transactions demand, precautionary demand, and 4
speculative demand. The amount held for those purposes depends on two main factors. The interest rate and the level of national income. (3½ marks) B. Liquidity preference and IS-IM framework An increase in liquidity preference is when the society prefers to hold more cash for whatever reason(s) (3marks) Such increased liquidity preference will shift the LM curve to the left; as indicated below (3marks) Interest rate LM 1 LM r 1 r ys ys IS National income (iv) (v) (vi) Assuming IS does not shift position, the shift of LM to LM 1 will raise interest rate from r to r 1 (3marks) With the rise in interest rate, aggregate demand, especially investment and consumption, will be curtailed. (3marks) The reduction in aggregate demand will ultimately result in the decline in national income from y s to y s1 (3marks) The extent of the changes in interest rate (r) and national income (y s ) will depend on the slope of the LM. The steeper the LM curve, the more pronounced the changes in r and y s. (3marks) 5
Question 3 Discuss any FIVE factors used by the Central Bank of Nigeria (CBN) in assessing the performance of financial institutions. The question requires a discussion of the factors used by the CBN to assess the performance of the economy. The question was fairly popular. 61% of the candidates attempted it. However, only 24% of them had a clear pass in it. Most candidates rather discussed in general, the function of the Central Bank or such issues as bank rate, open market operation, moral suasion etc. instead of such factors as capital adequacy, provision for bad and doubtful loans, reserve requirement etc. Suggested solution 3 The performance of financial institutions is assessed based on the following (iv) (v) (vi) Capital requirement: The CBN will check whether each financial institution is able to meet the minimum paid-up capital requirement, which is N25billion for Commercial banks with the 2005 bank consolidation. The apex bank checks whether the institution meets the capital ratio a capital measure which weighs the banks capital base against the portfolio of risk assets carried. Reserve requirement: Whether the bank meets the ratio of banks cash deposits with the CBN to total deposit liabilities. This is the reserve requirement Liquidity ratio: CBN conducts checks on each bank stock of liquidity and analyses the liquid assets which include eligible development stocks, certificate of deposits, treasury bills and certificates and commercial papers. This ensures that the financial system does not carry excess liquidity which may lead to inflation. Loan Concentration: The apex Bank checks whether its guideline on diversification of lending activities is followed that lending operations are not concentrated on a single individual or a single sector of the economy. The banks and other financial institution (BOFI) Act requires banks to report large borrowings to the CBN Provisioning: The CBN wants to be satisfied by commercial banks that their provision for bad and doubtful debts is adequate. The apex bank considers the method used for the provisions and the system put in place for loan recovery. Management: The apex bank wants to be sure that persons that occupy or propose to occupy the position of Directors or Managers of a bank are suitable for the position. Suitability is determined by such factors as competence, experience, 6
integrity, etc. The CBN is also interest in whether such officials adhere to the code of conduct laid down for them. Award 5 marks for each of any 5 points mentioned and explained. Total - 25marks Question 4 (a) (b) Make a clear distinction between deflation and devaluation in economics. Examine factors that can affect the efficacy of devaluation in the restoration of country s balance of payments deficit. The first part of the question expected candidates to distinguish between deflation and devaluation. The second part requires an examination of the factors that can affect the efficacy of devaluation in restoring balance of payments equilibrium. About 50% of the candidates attempted it but only 25% of the candidates had a clean pass in it. Most candidates saw deflation only in terms of a fall in the general price level neglecting other issues like fall in aggregate demand, output and employment most candidates correctly explained devaluation. Most candidates could not correctly discuss the factors that aid devaluation such as imports and exports and their elasticity conditions. Suggested solution 4 A. Deflation and Devaluation Deflation is a reduction in the level of national income and output, usually accompanied by a fall in the general price level on a sustainable basis. A deflation is often deliberately brought about by the authorities in order to reduce inflation and to improve the balance of payments by reducing import demand. Instruments of deflationary policy include tax increases and high interest rates. (6marks) Devaluation is an administered reduction in the exchange rate of a currency against other currencies under a fixed exchange rate system. Devaluations are resorted to by governments to assist in the removal of balance of payments deficit. The effect of a devaluation is to make import (in the local currency) more expensive, thereby reducing import demand, and exports (in the local currency) cheaper, thereby acting as a stimulus to export demand (6marks) B. Efficacy of Devaluation 7
Whether or not a devaluation works in achieving balance of payments equilibrium depends on a number of factors. Export supply size: If the devaluing country s total export in relation to the total world supply is small, devaluation will not help a great deal Export supply elasticity: If export supply elasticity is low, it will be very difficult to produce enough products to satisfy the increase foreign demand caused by devaluation. In this circumstance, devaluation may lead to inflation via an increase in aggregate demand which cannot be satisfied. (iv) Import Demand Elasticity If the demand for a particular import is inelastic, an increase in its price will not substantially reduce the volume demanded and the amount of foreign exchange spent on imports will not be substantially reduced. If, however the demand is relatively elastic, a price increase will reduce the volume imported thereby conserving foreign exchange. Export Demand Elasticity If the demand for export is elastic in both price and income, a decrease in price will invariably increase the volume of sales (assuming there is no supply constraint). If, however, price is inelastic, increased sales would not be possible. 3 marks each for 4 points = 12marks +1 mark for good presentation Marks allocation A: 12 marks B: 12 marks 25marks Question 5 (a) (b) What is meant by Financial Intermediation? Discuss the role of the Central Bank of Nigeria (CBN) and the Nigeria Deposit Insurance Corporation (NDIC) in the process of financial intermediation. The question expected the candidates to explain the concept of financial intermediation and discuss the roles of the Central Bank of Nigeria and the NDIC in its process. Most (90%) of the candidates attempted it, but only 47% of them had a clear pass in it. Most candidates correctly explained financial intermediation albeit; some did not include financial intermediaries in their explanation. The candidates were more comfortable with the roles of the NDIC in financial intermediation than those of the CBN. Again, most of them just discussed the functions of the CBN in general like Bankers bank, banker to 8
the government lender of last resort etc instead of the facilitation and supervisory roles of the CBN. Suggested solution 5 A. Financial Intermediation It is the process in financial markets that link lenders and borrowers, or savers and investors. The institutions that engage in bringing together ultimate users (borrowers / investors) are referred to as financial intermediaries such institutions include commercial banks, insurance companies, pension funds, savings bank e.t.c. (4marks) B. Role of the CBN and NDIC (iv) (v) (vi) (vii) The CBN and NDIC are not really financial intermediaries, but they play facilitating and regulatory role in the process of financial intermediation The CBN, in particular, aligns the activities of these financial intermediaries with the overall policy goals of the country. CBN regulates and supervises the country s banking system and licensing of financial companies in the country. The CBN makes available relevant information and data needed for transparency in the entire process, which builds the public confidence in the process. The CBN, in conjunction with the NDIC, ensures healthy development of the country s financial system within which the process of intermediation takes place. The NDIC is primarily set up to provide deposit insurance and related services of banks in order to promote confidence in the banking industry. NDIC serves as undertakes for the ailing or distressed banks; a function which helps to sanitize the country s financial system as well as the process of financial intermediation. Question 6 Carefully differentiate between the following pairs: Expansionary and contractionary fiscal policy Built-in stabilizers and Balanced budget multiplier. 9
The question requires distinction between expansionary and contractionary fiscal policy and built-in stabilizers and balanced budget multiplier. The question was the least popular. Only 16% of the candidates attempted it but only 6% of them had a clean pass in it. Candidates were more comfortable explaining expansionary and contractionary fiscal policy than built-in stabilizers and balanced budget multiplier. Indeed it was only one candidate that got the latter right. Suggested solution A. Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy refers to an increase in government expenditures for goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. Price level P P 2 AS P 1 AD 2 AD 1 y 2 y 1 Real GDP Price level The effect of expansionary fiscal policy measures is to shift aggregate demand from AD l to AD 2, leading to an increase in real GDP from y 1 to y 2 (5marks) Contractionary fiscal policy: this refers to a decrease in government expenditures for goods and services, an increase in net taxes, or some combination of the two, for the purpose of decreasing aggregate demand and thus controlling inflation. P AS P 1 P 2 AD 1 y 2 y 1 AD 2 10
The contractionary fiscal policy measures will lead to a fall in price level from P 1 and P 2 and a reduction in real GDP from y 1 to y 2. B. Built-in Stabilizers and Balanced Budget Multiplier Built-in stabilizer, otherwise known as automatic stabilizer, refers to elements in fiscal policy that serve to automatically reduce the impact of fluctuations in economic activity. A fall in national income and output reduces government taxation receipts and increases its unemployment. Lower taxation receipts and higher payments increase the governments budget deficit and restore some of the lost income. (5 ½ marks) Balanced budget multiplier: This is a change in aggregate demand brought about by a change in government expenditure, which is exactly matched by a change in revenues received from taxation and other sources. The change in government expenditure has an immediate effect on aggregate demand and generates income and an equivalent size. By contrast, the change in taxation does not change aggregate demand by an equivalent amount because some of the increased / reduced disposable income will be offset by changes in savings consequently; an increase in government expenditure and taxation of equal amount will have a net expansionary effect in aggregate demand and incomes. (5 ½ marks) Question 7 Write short explanatory notes on the following international financial institutions: (a) (b) (c) The African Development Bank (ADB) The International Monetary Fund (IMF) The International Finance Corporation (IFC) Candidates were expected to write short notes on the ADB, IMF and IFC. About 47% of the candidates attempted it and just 49% had a clear pass in it. Candidates were relatively comfortable with the ADB and IMF, though many still mistook the role of the World Bank for the IMF s. But most candidates did not recognize that it is private enterprises that the IFC assists 11
Suggested solution 7 A. The African Development Bank (ADB) The Bank ( ADB) was established in 1964, but started operations in 1966 It is owned by 53 African countries and 24 countries in Europe, the Americas and Asia The ADB is a regional multilateral development bank whose mandate is to prioritise economic development in regional member countries in Africa. (iv) ADB makes loans and equity investments available for the economic and social advancement of the member countries in Africa. (v) It promotes investment of public and private capital for development purposes. (vi) It provides technical assistance for the preparation and execution of development projects. (vii) ADB responds to requests for assistance in coordinating development policies and plans in regional member countries. 2marks each for any 4 points= 8marks B. The International Monetary Fund (IMF) The fund (IMF) was set up in 1945 with 29 member-countries and as at 2004 it had a membership of 184 countries It helps to promote international monetary cooperation It promotes exchange rate stability. (iv) IMF works towards eliminating exchange rate constraints to international trade. (v) It provides short-and long term balance of trade and / or payment problems. 2marks each for any 4 points = 8 marks C. The International Finance Corporation (IFC) IFC was established in 1956 and now has 127 members. The IFC is an affiliate of the World Bank with the specific objective of promoting private sector development in the developing member countries. IFC helps in financing private sector projects in these countries. It offers advisory services and mobilizes resources for investment. 2marks each for any 4 point = 8marks 12