MGT411
Short Notes
For Final Term exam
Prepared by Amna
Give brief explanation of the following.
What Discount rate is?
Answer
Interest rate charged by the central bank on loans to commercial banks
How is it controlled?
Answer
Set as a premium over the target federal funds rate
What is its impact on economy?
Answer
Provides short-term liquidity to bank in times of crisis and aids in controlling the federal funds rate
Question No: 50 ( Marks: 3 )
Why the aggregate demand curve slopes down?
ANSWER
There are two reasons why the aggregate demand curve slopes down:
1. First, because higher inflation reduces real money balances (thus reducing purchases),
2. Second, because higher inflation induces policymakers to raise the real interest rate, depressing
various components of aggregate demand.
Question No: 51 (Marks: 5)
“Central bank can stabilize the economy”. Discuss.
Answer
Central bank can play a very important role in the economic development of any country because
1. It is responsible for conducting monetary policy.
2. Monetary policy controls money supply and also determines price level.
3. This inflation control can impact employment and hence it impacts the economic growth in the
country.
4. Economic development of Pakistan is also possible because Central bank also maintains the
stability of the national currency and improves trade balance by impacting positively on exports.
5. The central bank has been described as "the lender of last resort", which means that it is
responsible for providing its economy with funds , in this way the central bank prevents the
country's banking system from failing.
6. Central bank is also the sole provider and printer of notes and coins in circulation.
Question No: 53 ( Marks: 5 )
Aggregate Govt.’s Net Demand = Consumption + Investment + Purchases + Exports
Which of the components of aggregate demand are sensitive and are not-sensitive to the aggregate
demand?
Answer
Investment
1. Investment is the most important of the components of aggregate demand that are sensitive to
changes in the real interest rate.
2. An investment can be profitable only if its internal rate of return exceeds the cost of borrowing.
Consumption
1. Consumption also responds to the real interest rate as sensitive.
2. Consumption decisions often rely on borrowing, and the alternative to consumption is saving
(higher rates mean more saving).
Net Exports
As for net exports, when the real interest rate in a country rises, her financial assets become attractive
to foreigners, causing local currency to appreciate, which in turn means more imports and fewer
exports (lower net exports)
So considering consumption, investment, and net exports, an increase in the real interest rate reduces
aggregate demand (the effect on government spending, is small enough to be ignored).
Question No: 53 ( Marks: 5 )
Aggregate Govt.’s Net Demand = Consumption + Investment + Purchases + Exports
Which of the components of aggregate demand are sensitive and are not-sensitive to the aggregate
demand?
Answer
Investment
1. Investment is the most important of the components of aggregate demand that are sensitive to
changes in the real interest rate.
2. An investment can be profitable only if its internal rate of return exceeds the cost of borrowing.
Consumption
1. Consumption also responds to the real interest rate as sensitive.
2. Consumption decisions often rely on borrowing, and the alternative to consumption is saving
(higher rates mean more saving).
Net Exports
As for net exports, when the real interest rate in a country rises, her financial assets become attractive
to foreigners, causing local currency to appreciate, which in turn means more imports and fewer
exports (lower net exports)
So considering consumption, investment, and net exports, an increase in the real interest rate reduces
aggregate demand (the effect on government spending, is small enough to be ignored).
Question No: 43 ( Marks: 3 )
What is the source of Trading risk, Credit risk and Liquidity risk?
Answer
Liquidity risk
Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side If a bank cannot meet customers’ requests for immediate funds it runs the risk of failure; even with a positive net worth, illiquidity can drive it out of business
Trading risk
Banks today hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital in the hope of making additional profits However, trading such instruments is risky (the price may go down instead of up); this is called trading risk or market risk
Managing trading risk is a major concern for today’s banks, and bank risk managers place limits on the amount of risk any individual trader is allowed to assume Banks also need to hold more capital if there is more risk in their portfolio
Credit risk
This is the risk that loans will not be repaid and it can be managed through diversification and Credit-risk analysis Credit-risk analysis produces information that is very similar to the bond-rating systems and is done using a combination of statistical models and information specific to the loan applicant
Question No: 50 (Marks: 3)
Give an account of different components of aggregate demand?
Answer
Aggregate demand is divided into four components:
1. Consumption,
2. Investment,
3. Government purchases,
4. Net exports
Investment is the most important of the components of aggregate demand that are sensitive to changes in the real interest rate. Consumption and net exports also respond to the real interest rate;
Aggregate Govt.’s Net Demand = Consumption + Investment + Purchases + Exports
Question No: 57 ( Marks: 5 )
Discuss different types of insurance companies in detail.
Answer
Insurance companies
Accept premiums, which they invest in securities and real estate in return for Promise to compensate the policy holder incase of any events occurs like fire, Accident, death etc
There are two type of in Insurance companies
1. Life insurance
2. Property and casualty insurance
Which makes a payment to the insured’s beneficiaries upon the death of the policy holder. Company can get group insurance for their employees.
Whole life insurance
It is combination of life insurance and fix saving account. We pay fix amount for a fixed period of time and in case of death of Policy holder his/her beneficiary gets the money. If the policyholder decides to discontinue the policy
Property and casualty Insurance
The policyholder pays fixed amount in exchange for protection to its property or Assets. For example Insuring the building against the fire. Insurance of house for theft. auto insurance.
Question No: 52 (Marks: 5)
A well-designed policy framework helps policymakers establish credibility. Discuss the principles of
central bank design.
Answer
A well-designed policy framework also helps policymakers establish credibility.
The Principles of Central Bank Design
Ø Independence
To keep inflation low, monetary decisions must be made free of political influence
Ø Decision making by committee:
Pooling the knowledge of a number of people yields better decisions than decision making by an individual
Ø Accountability and transparency
Policy makers must be held accountable to the public they serve and clearly communicate their objectives,
decisions and methods
Ø Policy framework:
Politicians must clearly state their policy goals and the tradeoffs among them
Question No: 51 ( Marks: 5 )
Give brief explanation of the following.
a)What is Target funds rate?
ANSWER
The target federal funds rate is the central bank’s primary policy instrument. It is Interest rate charged on overnight loans between banks
b) How it is controlled?
ANSWER
The central bank chooses to control the federal funds rate by manipulating the quantity of reserves through open market operations: the central bank buys or sells securities to add or drain reserves as required.
c)What will be the impact of target federal rate on economy?
ANSWER
Changes interest rates throughout the economy When central bank targets the quantity of reserves, a shift in reserve demand causes the market federal funds rate to move.
An increase in reserve demand forces the interest rate up, while a fall in reserve demand forces the interest rate down
Question No: 46 ( Marks: 5 )
Differentiate between the Foreign exchange risk and the Sovereign risk.
Answer
Foreign exchange risk
(The risk from unfavorable moves in the exchange rate) Banks manage their foreign exchange risk by attracting deposits denominated in the same currency as the loans and by using foreign exchange futures and swaps to hedge the risk
Sovereign risk
(The risk from a government prohibiting the repayment of loans) Banks manage sovereign risk by diversification, by refusing to do business in a particular country or set of countries, and by using derivatives to hedge the risk
Question No: 44 ( Marks: 3 )
"Monetary policy can be used to stabilize economy" Discuss
Answer
Monetary policy Control over the money supply and interest rates by a central bank or monetary authority to stabilize business cycles, reduce unemployment and inflation, and promote economic growth. Stability exists when fluctuations in prices, production, and employment have been eliminated. While stability for all aspects of the economy are important, monetary policy tends to be most concerned with price stability, that is, keeping the price level in check and eliminating inflation. Inflation erodes the purchasing power of financial wealth
Question No: 43 ( Marks: 3 )
Give a single line definition of the following.
Answer:
1) Credit risk:
This is a risk which arises when loans are not repaid. It is avoided by diversification and checking
credit worthiness.
2) Interest-rate risk:
The assets and liabilities of a bank are sensitive to interest rate but liabilities are of short term and
assets of long term so by an increase in interest rate banks have the risk that value of assets fall
more than that of liabilities affecting the net worth or capital of bank.
3) Liquidity risk:
It is a risk associated with a sudden increase in demand of funds. If bank can not meet the
withdrawal requirement of all its customers, bank is considered illiquid and it may fail.
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