Exam Spring 2016, questions and answers PDF

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Economics 320 Money and Banking

Spring 2016 Dr. Guzman Problem Set #6

1.

a. Briefly state and explain the rationale behind the existence of financial institutions. b. Suppose you are given the following information (all numbers are per £100 of assets)

Non-Interest Sensitive Initial Interest Rate New Interest Rate

Assets 35 5.5% 4.5%

Liabilities 75 2% 1%

i. Calculate the gap ii. Suppose the bank has £100 million in assets. What will be the impact of the change in interest rate on profits? iii. Suppose instead that all interest rates had decreased by 1.5%, how would your answers to (1) and (2) change. 2.

a. Which of the following three expressions uses the economist’s definition of money? Explain your answer. i. How much money did you earn last week? ii. When I go to the bookstore, I always make sure I have enough money to buy my favorite economics books. iii. The love of money is the root of all evil. b. You manage a bank whose balance sheet looks like the following Assets (in millions) Reserves $75 Loans $525

Liabilities (in millions) Deposits $500 Bank Capital $100

If the bank suffers a deposit outflow of $50 million, what actions must you take to keep your bank from failing? Assume that the required reserve ratio is ten percent. c. The independence of the Fed has meant that it takes the long view and not the short view. Is this statement true, false, or uncertain? Explain your answer.

Economics 320 Money and Banking

Spring 2016 Dr. Guzman Solutions to Problem Set #6

1.

a. Financial institutions arose to overcome problems inherent in direct financing, including: Creating Liquidity via maturity transformation Minimizing costs (both ex ante and ex poste) including transactions costs, adverse selection, monitoring, and moral hazard Risk transformation and diversification – risk screening and pooling b. i. Gap = 65– 25 = 40 ii. Profits will fall by 40p per £100 of assets, thus 𝛥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 = 1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(40)(−1%) = −£400,000 iii. 𝛥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 = 1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(40)(−1.5%) = −£600,000

2.

a. Only (ii) uses the economists definition of money. Part (i) is really referring to income, whereas part (iii) is alluding to the concept of wealth. See the book for a broader discussion of the differences between money, income, and wealth. b. The $50 million deposit outflow means that reserves fall by $50 million to $25 million. Since required reserves are $45 million (10% of the $450 million deposits), your bank needs to acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off $20 million of loans, borrowing $20 million in discount loans from the Fed, borrowing $20 million from other banks, using $20 million of retained earnings (bank capital), or some combination of all of these. c. Uncertain. Although independence may help the Fed take the long view, because its personnel are not directly affected by the outcome of the next election, the Fed can still be influenced by political pressure. In addition, the lack of Fed accountability because of its independence may make the Fed more irresponsible. Thus it is not absolutely clear that the Fed is more far sighted as a result of its independence....