Check Your Understanding

1. Question

   Rank the following assets from the lowest level to the highest level of (i) transaction costs, (ii) risk, and (iii) liquidity. Ties are acceptable for items that have indistinguishable rankings.

   1. a bank deposit with a guaranteed interest rate

   2. a share of a highly diversified mutual fund, which can be quickly sold

   3. a share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

      The transaction costs for (a) a bank deposit and (b) a share of a mutual fund are approximately equivalent because each can typically be accomplished by making a phone call, going online, or visiting a branch office. Transaction costs are highest for (c) a share of a family business since finding a buyer for the share consumes time and resources. The level of risk is lowest for (a) a bank deposit since these deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000; somewhat higher for (b) a share of a mutual fund since despite diversification, there is still risk associated with holding stocks; and highest for (c) a share of a family business since this investment is not diversified. The level of liquidity is the lowest for (c) a share of a family business since it can be sold only with the unanimous agreement of other members and it will take some time to find a buyer; higher for (b) a share of a mutual fund since it will take only a few days between selling your shares and the payment being processed; and highest for (a) a bank deposit since withdrawals can usually be made immediately.

2. Question

   What relationship would you expect to find between the level of development of a country’s financial system and the country’s level of economic development? Explain in terms of the country’s levels of savings and investment spending.

   Economic development and growth are the result of, among other factors, investment spending on physical capital. Since investment spending is equal to savings, the greater the amount saved, the higher investment spending will be, and so the higher growth and economic development will be. Thus, the existence of institutions that facilitate savings will help a country’s growth and economic development. As a result, a country with a financial system that provides low transaction costs, opportunities for diversification of risk, and high liquidity to its savers will experience faster growth and economic development than a country that doesn't.