Ch. 3 Question and Answer

Who owns a credit union? Explain.

Credit unions are owned by their members. When credit union members put money in their credit union, they are not technically "depositing" the money. Instead, they are purchasing shares of the credit union. In general, credit unions exist to pay interest on shares bought by, and collect interest on loans made to, the members.

Compare and contrast a defined benefit and a defined contribution pension plan.

In a defined benefit plan, retirement benefits are determined by a formula that usually considers the worker's age, salary, and years of service. The employee and/or the firm contribute the amounts necessary to reach the goal. In a defined contribution plan, the contributions to be made by the employee and/or employer are spelled out, but retirement benefits depend on the total accumulation in the individual's account at the retirement date.

What can a financial institution often do for a deficit economic unit (DEU)that it would have difficulty doing for itself if the DEU were to deal directly with an SEU?

SEUs typically want to supply a small amount of funds, while DEUs typically want to obtain a large amount of funds. Thus it is often difficult for surplus and deficit economic units to come together on their own to arrange a mutually beneficial exchange of funds for securities. A financial institution can step in and save the day. A bank, savings and loan, or insurance company can take in small amounts of funds from many individuals, form a large pool of funds, and then use that large pool to purchase securities from individual businesses and governments. (This is just one example of the beneficial things financial institutions do for DEUs)

Compare and contrast mutual and stockholder-owned savings and loan associations.

Some savings and loan associations are owned by stockholders, just as commercial banks and other corporations are owned by their stockholders. Other S&Ls, called mutuals, are owned by their depositors. When a person deposits money in an account at a mutual S&L, that person becomes a part owner of the firm. The mutual S&L's profits (if any) are put into a special reserve account from which dividends are paid from time to time to the owner/depositors.

What tools are used in online banking to ensure the security of transactions?

Special security software is used such that customers who enter their identification and password information can keep sensitive information out of the hands of hackers.

What can a financial institution often do for a surplus economic unit that it would have difficulty doing for itself if the surplus economic unit (SEU) were to deal directly with a deficit economic unit (DEU)?

Surplus economic units do not usually have the expertise to determine whether deficit economic units can and will make good on their obligations, so it is difficult for them to predict when a would-be deficit economic unit will fail to pay what it owes. Such a failure is likely to be devastating to a surplus economic unit that has lent a proportionately large amount of money. In contrast, a financial institution is in a better position to predict who will pay and who won't. It is also in a better position, having greater financial resources, to occasionally absorb a loss when someone fails to pay. (This is just one example of the beneficial things financial institutions do for SEUs)

Define intermediation.

The financial system makes it possible for surplus and deficit economic units to come together, exchanging funds for securities, to their mutual benefit. When funds flow from surplus economic units to a financial institution to a deficit economic unit, the process is known as intermediation. The financial institution acts as an intermediary between the two economic units.

Which type of insurance company generally takes on the greater risks: a life insurance company or a property and casualty insurance company.

The risks protected against by property and casualty companies are much less predictable than are the risks insured by life insurance companies. Hurricanes, fires, floods, and trial judgments are all much more difficult to predict than the number of sixty-year-old females who will die this year among a large number in this risk class. This means that property and casualty insurance companies must keep more liquid assets than do life insurance companies.

What are a bank's primary reserves? When the Fed sets reserve requirements, what is its primary goal?

Vault cash and deposits in the bank's account at the Fed are used to satisfy these reserve requirements; they are called primary reserves. These primary reserves are non-interest-earning assets held by financial institutions. The Federal Reserve requires all commercial banks to keep a minimum amount of reserves on hand to meet the withdrawal demands of its depositors and to pay other obligations as they come due. Many would argue, however, that the reserve requirement is set more with monetary policy in mind than to ensure that banks meet their depositors' withdrawal requests.

Goodfellows National Bank has decided to compete with savings and loan asso-ciations (S&Ls) by offering 30-year fixed-rate mortgage loans at 8 percent annual interest. It plans to obtain the money for the loans by selling one-year 6 percent CDs to its depositors. During the first year of operation, Goodfellows sells its depositors $1,000,000 worth of 7 percent one-year CDs, and homebuyers take out $1,000,000 worth of 8 percent 30-year fixed-rate mortgages. a.Considering only the information above, what is Goodfellows' gross profit for the first year of operation? In Goodfellows' second year of operation, Goodfellows must sell $1,000,000 worth of new CDs to replace the ones that mature. However, interest rates have gone up during the year, and now the rate the bank must pay to get people to buy new CDs is 9 percent. b.Assuming that Goodfellows does sell $1,000,000 worth of new CDs at 9 percent interest in the second year, and assuming the $1,000,000 worth of 8 percent mortgage loans are still outstanding, what is Goodfellows' gross profit during the second year? (Note: For the purposes of this problem, assume that the mortgage holders make only interest payments each year.)

a) ($1,000,000 x .08) - ($1,000,000 x .07) = $10,000 a profit of $10,000 b) ($1,000,000 x .08) - ($1,000,000 x .09) = -$10,000 a loss of $10,000

a.Assume that the Goodfellows National Bank pays 5 percent interest on depositors' accounts and charges 10 percent interest on loans it makes to businesses. What is Goodfellows' interest rate spread? b.Perhaps that was too simple. To make it a little more challenging, assume that Goodfellows pays 5 percent interest on depositors' passbook savings accounts, which make up 50 percent of all funds on hand, and 7 percent interest on de-positors' Certificates of Deposit, which make up the other 50 percent of funds received. Next, assume that Goodfellows charges 10 percent interest on short-term loans, which make up 50 percent of all loans outstanding, and 12 percent interest on long-term loans, which make up the other 50 percent of all loans outstanding. Now what is Goodfellows' interest rate spread?

a) .10 rate on loans made - .05 rate paid to depositors = .05 = 5% interest rate spread b) (.5 x .10) + (.5 x .12) = .11 = 11% weighted average loan rate (.5 x .05) + (.5 x .07) = .06 = 6% weighted average deposit rate 11% - 6% = 5% interest rate spread

Assume that society is made up of 100 surplus economic units (SEUs) that have $10 each and three deficit economic units (DEUs) that need $100 each. With that in mind, describe (a) how the society would have to operate if there were no finan-cial institutions present to perform financial intermediation, and (b) how financial institutions help overcome the problems you described.

a) If there were no financial institutions the SEUs and the DEUs would find that the amount of money needed by a given DEU did not match the amount of money available by a given SEU. The money available would not be put to work and the economic activity that would have otherwise taken place would not. b) If financial institutions were available in this society they could position themselves between the SEUs and DEUs. The financial institution could pool the $1,000 available (100 SEUs times $10 each) and pass that money along in $100 increments to the DEUs. This could be done via either a debt or equity claim that the financial institution would accept from the DEU in return for the money.

A. Assume that you are attending a meeting of the Federal Reserve's Open Market Committee (FOMC). There is great concern among the members present that the economy is in a recessionary trend. a.What would you recommend that the FOMC do to stimulate the economy? b.Explain the chain of events that occurs when the FOMC takes the action that you recommended in part a?

a) The FOMC should buy government securities in the open market. This would increase the reserves of the banking system and would put downward pressure on the federal funds rate. b) The Fed's trader at the New York Federal Reserve Bank would contact various government securities dealers and would buy the Treasury securities from them. Payment would be made by crediting the accounts at the Fed of these dealers. This would make more funds available and would tend to put downward pressure on the cost of these funds, the federal funds rate.