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ECON 310 009 Money & Banking J. Scott Sperling Spring 2002 [email protected]
Problem Set 5 Answers
Due: 2 May, 2002
1. In your own words, explain each of the following terms and give an example of each. (20 points) You should have comfortably been able to define each of these, I’ll list some examples. - adverse selection lending (the decision whether or not to make a loan), buying a used car (the market for lemons) - moral hazard lending (what is the borrower doing with the money after a loan has been made?), insurance (does your health insurer know you are skydiving?) - principal-agent problem a plant manager and employees, a bank and its customers, government and regulators - free-rider problem financial analysis, public radio/TV 2. There are three factors which contribute to financial innovation. aIdentify each factor, briefly describe how each factor affects financial institutions’ incentives to innovate, and give an example of an innovation which has occured due to each factor. (15 points)
The three factors are: changes in demand conditions, changes in supply conditions, and avoidance of regu- lation (loophole mining). Any reasonable example of each is acceptable.
3. True, False, or Uncertain: The Fed can accurately control the money supply through open market operations and discount lending. Defend your answer in five or fewer sentences (more weight will be put on your explanation). (5 points)
False. The Fed can accurately control the monetary base , but not the money supply. The Fed has less control of the money supply because it cannot control how much currency consumers hold (relative to deposits) or the amount of excess reserves banks hold. Furthermore, the Fed cannot force banks to borrow from the discount window.
4. True, False, or Uncertain: Deposit insurance decreases assymetric information and moral hazard prob- lems. Defend your answer in five or fewer sentences (more weight will be put on your explanation). ( points)
False. Deposit insurance increases assymetric information problems (both moral hazard and adverse selec- tion).
5. Suppose the Fed buys $100 million of deutsche marks with Federal Reserve Notes and, at the same time, sells $100 million of U.S. government securities for cash in a domestic open market operation. What is the net effect on the monetary base? How has the Fed’s balance sheet been affected? (5 points)
There is no effect on the monetary base. Currency in circulation ↑ $100 million, international reserves ↑ $ million, securities ↓ $100 million dollars, currency in circulation (or deposits at the Fed, i.e. reserves) ↓ $ million.
6. If the required reserve ratio is 25%, banks hold no excess reserves, and the public holds currency equal to 25% of deposits, what is the value of the money multiplier? (5 points)
m =
1 + CD
rD + ERD + CD
=
7. Suppose that the statistics for the economy as whole (in billions of dollars) are as follows: currency held by the public is 100, reserves held by banks is 200, checkable deposits held at banks is 800, and excess reserves held by banks is 40. If the required reserve ratio on checkable deposits is 20%, what is the value of the money multiplier? (5 points)
Answers in $ billions:
C = 100 D = 800 ER = 40 rD =. 2
m =
1 + CD
rD + ERD + CD
=
9. Extra Credit Go the the Federal Reserve Board of Governers web site and retrieve the releases of the “Aggregate Reserves of Depository Institutions and the Monetary Base” (H.3) and “Assets and Lia- bilities of Commercial Banks in the United States” (H.8) and “Money Stock and Debt Measures” (H.6) (http://www.federalreserve.gov/releases/). Using the seasonally adjusted data for the week ending on some date (choose a date from the tables that makes sense) of H.8, the seasonally adjusted, adjusted for changes in reserve requirements data for the two weeks ending some date, and the seasonally adjusted money stock figures for some month, find the following: currency holding (C), checkable deposits (D), re- quired reserves (RR), excess reserves (ER), the monetary base (MB) and the M1 money supply. From these data, calculate the ratios C/D, ER/D and the reserve requirement (rD ). Calculate the money multiplier using the multiplier formula. Now calculate the money multiplier using the equation M 1 = m × M B. Compare the two multipliers. How do they compare to the simple deposit multiplier (1/rD )? Why is the simple deposit multiplier so much larger? (20 points)
As long as you used reasonable numbers from the tables, you are alright. There are two things which you needed to know/do to get acceptable answers: convert all figures to a common unit (e.g. $ 1 billion = $ 1000 million) and MB = C + R. Here is an example (in $ millions):
RR = 42194 ER = 1526 M B = 628972 C = M B − (RR + ER) = 585252 D = 643500 M 1 = 1157000 C D
ER
D
rD =
RR
D
m =
1 + CD
rD + ERD + CD
m =
M 1
M B
The two numbers we calculated for m are relatively close. The difference can be accounted for in rounding and the fact that the required reserve ratio is a little more complicated than the simple calculation used above. The simple deposit multiplier is:
m =
rD
This large difference is the fact that the simple deposit multiplier does not take into account that people want to hold currency and banks want to hold excess reserves.
