1) Outline three ways in which the behavior of the financial system could affect the level of aggregate demand in the economy.
The creation of liquid assets, the expansion of banking and money and the changes in people’s financial wealth are three ways by which the financial system could affect the level of aggregate demand in the economy. For a real economy to expand, liquidity of assets is a requirement and the availability of liquid assets increases the aggregate demand in the economy as consumers have easy access to cash when needed as liquid assets are assets that can be easily converted into cash. The expansion of banking and money also affects the level of aggregate demand in a positive way.
The availability of proper banking systems which include financial intermediation increases the aggregate demand in the economy as people would be encouraged to spend and invest. Depending on the economy’s situation, changes in people’s financial wealth can have either a positive or negative on aggregate demand. Suppose the economy was experiencing a boom, the level of income and expenditure would be high and people would tend to spend more as a result of an increase in the aggregate demand. However, if the economy was going through a recession, the opposite would occur leading to a decline in spending thus a decrease in aggregate demand.
2) Suppose that prices in the US stock market suffer a major collapse. What effect would you expect this to have upon the rest of the US economy and the economies of other developed countries?
As a reflection to what has happened in January 2001 when the FTSE-100 index of stock prices fell by 50%, the US economy, economies of other countries and people within the US were greatly affected by this fall in prices. Possible effects would include central bank’s around the world lowering interest rates, aggregate demand would decline, saving would increase since people would become very reluctant to invest in stocks, people committed to paying pensions would find that their investments would no longer support their payments.
3) Why does a company’s share price matter in a takeover battle? If you were the financial director of the predator firm, what would you want to happen to your firm’s share price? Might you be able to influence it in any way?
In general, the share price determines how much needs to be paid for a takeover to take place. The share price matters because it reflects a unit of ownership in a company which works as an advantage in the case of a takeover battle if it was low. As a financial director of the predator firm, I would want to increase the share price as much as possible to protect the firm and to stimulate competition. I would try to influence the price though marketing and through focusing on the potential market share.
4) Why might financial systems fail to allocate resources to their most desirable use?
Financial systems might fail to allocate resources to their most desirable use due to different reasons which include: lack of resources available in the economy, shortage of funds circulating in the financial system, the cost of investment might be high, the interest rates might be high and many different competitors working within the same sectors hinders the proper allocation of resources to their most desirable use.