Answer to Question #165234 in Finance for Bishem

Question #165234


Explain the factors determine money demand in Fisher’s quantity theory and how each affect money demand? What determines velocity in Fisher’s theory? What effect do interest rates have on velocity?

Identify the following with a sentence or at most two and give an example in each one (I)Multiplier

(ii)Monetary aggregate

(iii)Money illusion




(a)Suppose that the price level in Zambia is measured at 14% and is expected to rise by 3% over the next six months.

(b)Explain the costs associated with this expected inflation.

(c)Explain the other costs that Zambia will face if the inflation unexpectedly turns out to be 30%.

(d)Explain of the role of the banking system in the effective implementation of monetary policy.

(e)Explain the difference between reserve requirements and capital requirements for banks, and what differing purposes do they reflect.


(a)Explain the five (5) main solutions to the challenges of the barter system.

(b)Briefly explain the difference between an asset and a liability on a bank’s balance sheet. How does net worth relate to each? Why must a balance sheet always balance?

(c)List and briefly explain the major assets and claims on a commercial bank’s balance sheet.


(a)In September 2020, The Bank of Zambia announced a slight reduction in the statutory reserve ratio assuming from 10% to 9%. Explain how this kind of reduction in the statutory reserve ratio would affect the:

Size of the money multiplier,

(b)Amount of excess reserves in the banking system, and

Extent to which the system could expand the money supply through the creation of checkable deposits via loans?

(c)Demonstrate your understanding of the terms below by way of a brief explanation of each;


(ii)Nominal Anchor for Monetary policy

(iii)Monetary policy rate

(ivCost push inflation

(v)Monetary system


The growth of the financial sector as triggered by the structural adjustment programs implemented in the early 1990s has opened up significant opportunities for the private sector. Through various liberalisation policies there has been a proliferation of financial institutions, both depository and non-depository.

The Zambian financial markets landscape has also registered numerous financial institutions aimed at enhancing their intermediary roles and innovations. These innovations have most undoubtedly been as a consequence of the desire by financial institutions to grow and increase their market share sustainably.

In 1993, the collaborative efforts of the International Finance Corporation (IFC) and the World Bank led to establishment of the Lusaka Securities Exchange Plc. (LuSE).

LuSE opened its doors for business on 21st February 1994. It was also motivated by the need to deepen awareness and understanding of financial and capital markets in support of the emerging private sector. And this had contributed significantly to the country’s economic activities hence a stable GDP growth (World Bank, 2013).

On the debt market front, the Zambian government is also mindful of the need to maintain debt sustainability to safeguard macroeconomic stability. Total debt as a percentage of GDP stood at 59% in 2018. There have been concerns as to the Government’s fiscal management on its high debt obligations with its debut US $750 million Eurobond falling due for repayment in 2022. This repayment comes amid heightened repayments risks, downgraded credit rating and the unmeasured effects of global health pandemic (COVID-19).


(a)Briefly explain the terms highlighted in bold from the passage above.

(b)Describe and explain the five (5) roles played by the Lusaka Securities Exchange (LuSE).

(c)What would be your recommendations to help manage Zambia’s debt and ensure she does not default come 2022?

Expert's answer

Q1. Factors determine money demand in Fisher’s quantity theory:

  • M — the amount of money in circulation;
  • V — the speed of money circulation;
  • P is the absolute price level;
  • Y — real production volume.
  1. the absolute level of prices. All other things being equal, the higher the price level, the higher the demand for money, and vice versa
  2. the level of real output. As its growth and rising real incomes of the population, which means people will have more money, since the presence of a higher real income means greater volume of transactions;
  3. the velocity of money, all the factors that affect the velocity of money will affect the demand for money.

 velocity in Fisher’s theory:

The higher the interest rates, the more unused cash is generated, and vice versa. Thus, we can expect that the rate of circulation will increase (the average cash accumulation will decrease) with an increase in interest rates and decrease with a decrease in interest rates.

(i) Multiplier is a proportionality coefficient that measures how much of an endogenous variable changes in response to a change in some exogenous variable: discount multiplier

(ii)Monetary aggregate-an indicator of the structure of the money supply( money supply), the types of money and cash that differ from each other in the degree of liquidity, that is, the ability to quickly turn into cash: M, M2

(iii)Money illusion this is a misconception about the nominal value of money as the real value of money

(iv)Dollarization - this is the displacement of the national currency from the monetary circulation and the country's economy with a more stable foreign currency

(v)Devaluation this is a decrease in the exchange rate of the national currency in relation to the exchange rate of other countries


(a), (b) This is creeping (moderate) inflation. In this case, this is a normal type of inflation: insignificant inflation can, under certain conditions, stimulate the development of production and the modernization of its structure. The growth of the money supply accelerates the payment turnover, reduces the cost of loans, promotes the activation of investment activities and the growth of production. The growth of production, in turn, leads to the restoration of the balance between the commodity and money supply at a higher price level

(c) This is galloping inflation. The participants of the monetary turnover will pay the inflation tax.

In the contracts concluded, enterprises set the cost of their goods, products, works and services, taking into account price increases. The population begins to actively invest their savings in material values. Such inflation is difficult to manage. Monetary reforms are often carried out in the country. These changes indicate the presence of an economic crisis.

(d)The central bank has at its disposal a number of tools for achieving intermediate goals, such as bank reserves, money supply and interest rate. These operations, through appropriate tools, allow us to achieve the final indicators of a healthy economy: low inflation, output growth, and low unemployment.

(e)The mandatory reserve rate is the statutory rate of a credit institution's obligations on attracted deposits, which must be deposited with the Central Bank. The capital requirement is a standardized requirement for banks and other depository institutions that specifies how much liquidity is required for a certain level of assets.


(a) - Lack of mutual coincidence of desires.

- The lack of a single unit of measurement generates a huge number of product ratings

- The stored product may become significantly devalued (or become more expensive);

- storage can be expensive; - The absence of an acceptable instrument for making future (so-called futures or term) payments.

(b)Assets are the assets, liabilities, is the capital. The invested capital is represented as property, so there is always equality in the balance of assets and liabilities.

(c)The bank's liabilities can be divided into two groups:

  • equity capital (and related items) obtained from the initial issue of securities of a commercial bank and deductions from profits used to form or increase funds;
  • borrowed and borrowed funds received from the bank's deposit operations and loans from other legal entities.

The bank's assets are divided into four groups: cash; investments in securities; credit; and other assets.


(a)The rate of mandatory reserves affects the value of the money multiplier, which shows how many times the banking system can expand the money supply by issuing loans. The larger the norm, the fewer possibilities and the smaller the multiplier value.

(b)A fractional reserve banking system requires that a portion/fraction of checkable deposits are backed up by reserves of currency in bank vaults or deposits at the central bank


(I)Seigniorage is income received from the issue of money and appropriated by the issuer on the right of ownership

(ii)Nominal Anchor for Monetary policy is a publicly declared nominal variable is understood to play the role of the central bank's medium-term policy objective for which it is responsible.

(iii)Monetary policy rate this is the percentage at which the central bank issues loans to commercial banks and accepts money from them for deposits

(iv)Cost push inflation this is a partial loss of the real value of the national currency in the future

(v)Monetary system this is a form of organization of monetary circulation in the country, which has developed historically and is fixed by national legislation.



Structural adjustment programs is loans (structural adjustment loans ; SAL) provided by the International Monetary Fund (IMF) and the World Bank (WB) to countries that have experienced an economic crisis.

Deposit institutions are financial intermediaries that create debt instruments called deposits. Non-deposit accounts do not create deposits: these are insurance companies, pension funds, financial companies, etc.

The financial market is an economic relationship related to the borrowing, issuance, purchase, and sale of securities, precious metals, currencies, and other investment instruments.

The intermediary function is a logical complement to the savings function. Since the accumulation of saved funds implies the need to pay for them, financial institutions are forced to use these funds as efficiently as possible to generate income in an amount that allows not only to pay depositors the interest due to them, but also to receive income.

GDP growth is the increase in the total amount of goods and services produced in the state, ready for any use, whether it is consumption, export or accumulation.

An acceptable level of debt is the optimal level of debt load.

Macroeconomic stability is the constant development of the economy, ensuring the achievement of sustainable economic growth with a stable price level and a low level of unemployment.

Eurobonds are debt securities that are traded on the international stock market.

Redeemable securities, subject to payment under the terms of the agreement on the issue.

A downgrade is a reduced measure of an individual's creditworthiness (credit scoring).

(b)Intermediary; Indicative; Regulatory; Control, Redistributive

The control function is to ensure the reliability of the securities exchange rate and ensure the reliability of trading on the exchange. The regulatory function of a stock exchange is to organize and regulate securities trading. The indicative function is to determine the value of securities and their attractiveness to investors. The intermediary function is to create comprehensive conditions for issuers, investors and intermediaries to organize and conduct trading operations with securities. Redistribution allocates capital among the participants.

(c)all state revenue should be used to pay off the state debt and reduce state spending, and state spending should be used for construction and investment

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