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Can you help me understand this Economics question?

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Assignment Question(s):

Q. 1. How does Financial System Coordinate Saving and Investment? Explain in detail. [10 Marks]

Q. 2. Discuss role play by Bank in the monetary system? How do bank create money?

Q. 3. Analyze and create T-account balance sheets.

Answer:

Question 1 è Answer:

Savers are those who tend to spend less on consumption and save big portions of their incomes. They are willing to lend their money and get a satisfying return on their savings. That means a huge financial resources are available for investments. On the other hand, the borrowers are willing to borrow and employ these savings in profitable investments and repay these funds later plus interest. However, savers and borrowers cannot deal with each other directly as they don’t know each other personally. In this case, saving, borrowing and investing activities would involve higher risks. Therefore, the financial system evolved to solve that problem.

The Financial System is a group of institutions which works as a bridge between savers and borrowers. These institutions can be classified into financial markets and financial intermediaries.

Financial markets are institutions, such as stock markets and bond markets, through which savers can directly provide funds to borrowers by purchasing stocks or bonds.

Financial intermediaries are institutions, such as banks and mutual funds, which indirectly help channel the savers’ funds to borrowers who are eager to make profitable investments. On one hand, the banks accept deposits from the savers and promise to pay them a specific interest rate for their savings with the possibility to withdraw their savings at any time. On the other hand, these banks charge the borrowers higher interest rates in order to cover the bankers’ profits and provide satisfying returns for the savers.

Question 2 è Answer:

Banks can be classified into two types: Central Banks and Commercial Banks.

Central banks create money simply by printing fiat currency such as dollars or euros or any other currency, and inject that money into the market by buying treasury bonds. In addition, central banks have the authority to oversee the banking system. Moreover, they can increase the interest rate and regulate the money supply in the market by issuing bonds and selling them, just in case they wanted to decrease the money supply circulated in the market. Or they can increase the money supply by buying treasury bonds and lowering the interest rate.

Commercial banks, on the other hand, create money through lending borrowers and going through a process called Money Multiplier Effect. The central bank sets a reserve ratio, which restricts the commercial banks and forces them to keep a specific portion of the savers’ deposits as reserves and loan out the rest. In other words, whenever a commercial bank accepts a deposit from a saver, the bank keeps a portion of that deposit in its vaults and lend the rest of it. As a result, that amount, which was deposited, will continue to multiply according to the reserve ratio set by the central bank.

Question 3è Answer:

The T-account balance sheet mentioned above shows the resources ( assets ) and the obligations ( liabilities ) which belong to the International Commercial Bank (CIB).

CIB collected $10.000 deposits from savers, which is an obligation over the bank.

CIB kept 10% of these deposits as reserves ($1000) in order to cover customers’ requests of withdrawals.

CIB lent $9000 to investors, and the bank is expecting to collect these loans plus interest later on specific dates.