• 2020-21: this was another time of major uncertainty due to the pandemic. Again, because of the uncertainties householders preferred to hold a larger proportion of their financial wealth in cash, and the government again was making significant payments to households and          businesses to support the economy and alleviate financial stress.

2. During the first of the periods identified above, what was happening to the growth of M3? What factors might explain an increase in Currency growth and a slowing in M3 growth occurring at the same time?

The growth of M3 was decelerating sharply during that period (see graph).

While the growth rates of the different monetary aggregates can often differ by significant amounts, it is unusual for their growth rates to move sharply in opposite directions. When this happens, it is    likely to signify some event that is having a major impact on the relative attractiveness of bank           deposits compared to currency. (This didn’t happen, for example, in the 2020-21 episode.)

In the 2007-9 period, while currency growth was increasing, the annual growth rate of M3 slowed      down from nearly 25 per cent to less than 15 per cent by 2008, and continued to slow down over the following year. The fact that these two growth rates were moving in opposite directions for a period of time can be explained by the nature of the financial crisis that was occurring. The M3 aggregate is equal to Currency plus bank deposits. During this period, people were losing confidence in the safety of banks. Some were withdrawing funds from bank deposits in order to build up their cash holdings.  Others may have chosen to increase their bank deposits more slowly than previously in order to         increase cash holdings more quickly. So the two growth rates were moving in opposite directions. As confidence in the banks was restored over the following two years, the rates of growth of the two      aggregates again converged.

3. The phenomenon of ‘dollarisation’ in an economy is said to occur when a significant proportion of residents prefer to make their transactions in US dollars rather than in the official domestic currency. Why might this occur, and why would this phenomenon be more common in some countries than in others?

One of the functions of money is store of value. This requires money to have a stable and                     predictable purchasing power. In other words, it requires an economy with low and stable inflation   of prices expressed in that currency. Dollarisation typically occurs in economies that have either high inflation, or a high fear of inflation.

If money is unable to perform the store of value function efficiently, this will also undermine the        other functions of money, especially the medium of exchange function. One of the desirable                characteristics of a medium of exchange is that money must be widely accepted. But if it is not            expected to maintain a stable value, no one will want to hold it and so it won’t be widely accepted as a means of payment. These things reinforce each other.

This explains why dollarisation is more common in some economies than others. Dollarisation is  particularly likely to occur in countries with a history of high inflation. Historically, Latin American countries like Argentina and some African countries have experienced significant dollarisation.

4. Consider a simple economy consisting of the following three persons: Ito is a hairdresser who needs to get some building work done

Rav is a builder who needs someone to do car repairs

Esta is a motor mechanic who needs a haircut

Describe the difficulties that would be encountered in arranging mutually beneficial exchange among these three if there were no such thing as money.

There are three types of product in this example, with one producer and one consumer for each product. In principle, therefore, there can be a mutually beneficial outcome where each               producer engages in their specialist productive activity and each is able to obtain their desired   product from a service provider. But this can only be achieved if there is some coordination        mechanism amongst the three individuals, since there is no double coincidence of wants             anywhere in this economy. If, for example, Rav had wanted a haircut rather than car repairs,      then Rav and Ito could make a direct exchange: a haircut in exchange for some building work.     But in the absence of such a double coincidence of wants, any exchange that occurs would have to be based on some system of promises and trust.

An example of how that could work would be the following.

Example: Ito employs Rav to do the building work and pays Rav with a haircut voucher (a     promise to give the holder a haircut). Rav hires Esta to do the car repairs and pays with the  haircut voucher already received from Ito. Then Esta takes the voucher to Ito and receives a haircut.

Observations:

•    In the above example, three-way mutually beneficial exchange has occurred

•    but, this is a cumbersome way to do it

•    it only works if Rav’s original promise can be relied upon

•    to the extent that this is the case, Rav’s haircut voucher functions as a de facto form of money in this system, since it is be used by all three as a medium of exchange

5. Consider a different example of three-way trade involving goods rather than services:

Alfa produces firewood for fuel

Betta produces a wheat crop for food

Gammo produces wool for clothing

Each person has a demand for some mix of all three products: food, fuel and clothing. Why would barter exchange be more likely to succeed in this situation than in the previous question? Why would it still be beneficial to introduce money into this economy?

Non-monetary (or barter) exchange would be easier in this economy than in the previous example for two reasons:

•    First,  the  products  being  traded  are  goods  rather  than  services,  and  the  goods  are storable. This means there is no need for exchanges to be based on promises. Alfa might engage in a trade with Betta which results in Betta having more firewood than desired, but  Betta can store the surplus and use that in a further exchange with Gammo.  No promises or trust are required.

•    Second,  in this example each  producer  has a demand for some quantity of all three products. So there will be some instances of double coincidence of wants. For example, Alfa  produces firewood and  requires some wool from Gammo, while Gammo desires some amount of the opposite exchange. So there will be situations where two-way barter exchange is mutually beneficial. This was not the case in the previous example.

Further comments

In this example, non-monetary exchange is possible but it would still be cumbersome and inefficient. For example, storing surplus firewood for subsequent resale would be a costly way to engage in three- way trade compared with using a mutually accepted form of money as a medium of exchange.

There is also the time dimension to consider. One producer may have an overall surplus of income in a given time period while another has a deficit. In an efficient system there needs to be store of value so that the person with the surplus can save in order to spend later. Storing the physical commodities is a possible way of doing this, but it is inefficient because these commodities are not permanently durable (one of the requirements of money) and are costly to store and to transport (the portability requirement of money)

6. (answers to two decimal places where applicable)

(a) What is the yield to maturity on a discount bond that has a face value of $8000, is three years from maturity and is currently trading at $7450?

The yield to maturity is the interest rate that equates price (P) to present value (PV)

Here,

P = 7450

PV =

So,

=  7450

1 + i =  3/

i = 2.40%

(b) What is the present value of a three-year coupon bond which has a face value of $1000, a coupon rate of 1.5 per cent and a yield to maturity of 2 per cent?

The security pays a coupon of $15 each year and a final principal repayment of $1000. The interest rate for calculating present values is i = .02

So the three-year stream of payments is (15, 15, 1015).

We calculate the present value of this stream using the interest rate to discount future cash flows as follows:

PV = + +

Hence, PV = $985.58

7. (answers to two decimal places where applicable)

(a) What is the market price of a discount security which matures in 2 years’ time, has a face value of $5000 and a yield to maturity of 1.8 per cent?

The market price is equal to the present value (PV) of the security. The future cash flow (CF) is

$5000. The discount factor of (1 + i) is equal to 1.018

So, the price of the security is

PV =

which gives the result, PV = $4824.75

(b) What is the market price of a discount security which matures in 3 years’ time, has a face value of $8000 and a yield to maturity of minus 2.5 per cent?

Again, the market price is equal to the present value (PV) of the security.

CF = $8000.

Here the discount factor (1 + i) is equal to (1 – 0.025) = .975

So the price of the security is given by,

PV =

which gives the result, PV = $8631.30

Notice that when the yield to maturity is negative, the market price is higher than the face value.  Another way of putting it is that if you buy the security now, you are repaid less than you invested when the security matures.

8. (answers to two decimal places where applicable)

(a) Calculate the market price of a consol with a coupon of $200 per annum and a yield of 2.6 per cent.

The formula that relates price, yield and coupon for a consol is:

P =

Here C = $200 and i =  .026

So

P =

Which gives: P = $7692.31

(b) Suppose you had purchased this consol at the price calculated above. After your purchase, suppose the yield on these securities falls to 1.7 per cent. Calculate the new price of the consol and the gain or loss you have incurred.

The new price is given by

P#  =

So P’ = $11,764.71

You have made a gain of P’ – P = $4072.40

Note that yield and price always move in opposite directions, so when the yield falls, the holder makes a gain.

9. In general, if you have purchased a long-term government bond and the yield to maturity falls by 0.5 per cent after you purchased it, would you be better or worse off? In that situation, would you prefer this to be a 10-year bond or a 5-year bond? Explain the reasoning for your answer.

For the reason explained in the previous question, price and yield move in opposite directions. So    you are better off in this situation. Furthermore, when the yield moves by any given amount, the     effect on price will be larger the longer the term to maturity. So in this case, you would prefer to be holding the 10-year bond because the capital gain would be larger.

10. Suppose you are a first homebuyer considering taking out a mortgage. You are offered a 30-year mortgage at an interest rate of 4.5 per cent fixed for the life of the loan. How would your assessment regarding the desirability of taking the loan be influenced by your current income, your expectations about future inflation and your expectations about future movements in housing prices?