Question

Explain the concept of asymmetric information in general. Discuss the implications of asymmetric information for the market of deposits, the credit market and the inter-bank market.

[50 marks]

Answer 1

asymmetric information refers to a situation in which one party has different information to another. this situation occurs when the seller of a good or service has greater knowledge than the buyer of the good. it is also known as "information failure". generally, one party has more knowledge about the good that the other party, this is done with the intention of getting a better deal than is due.

Implications

1. asymmetric information may result in cheating, such as adverse selection, in which an insurance company encounters the probability of extreme loss due to a risk that was not disclosed at the time of a policy's sale.

2. It may also lead to a situation in which a borrower may not specifically explain what are they borrowing money for and may use it for illegal purposes. there is a high chance that the lender may end up with loan amount not paid back on time or not paid back at all. if the loss of lender is great. it may force him to charge higher interest rates to other borrowers.

3. inter-bank market provide smooth liquidity across banks, and in this way they avoid liquidation of investment projects.they work in an efficient way. the banks' liquidity position depends upon monetary policy.

thank you. hope this helps.