Money and Banking Final
If GDP is $20 trillion and the money supply is $4 trillion, what is the velocity of money?
$20 trillion/$4 trillion = 5
Joshua says that he would need 3% interest in order to lend you money which you will pay back in two years. This implies that for Joshua the present value of $100 to be received two years from today is what amount?
$94.26
How can the Fed impact money supply?
1. Changing the reserve requirements 2. Open market operations 3. The discount window
Moral Hazard in Financial Markets - Insurance, Lending and Debt markets - How do can we combat this?
1. Government disclosures 2. Deductibles/premiums 3. Indemnification 4. Corporate governances
What happens if we don't have enough banks?
1. Lack of liquidity 2. Money supply does not increase 3. Economic activity lessens 4. Transaction costs 5. Diversification of lending
Your good friend Megan is starting a new business and you decide to invest with $20,000. If you get back $2,000, what is your rate of return?
10%.
Joe has a $1,000 debt with no interest. He is a plumber and earns $50 per hour. The real burden of Joe's debt is
20 hours of work.
Sarah is considering the purchase of a 10-year, $10,000 bond being issued by Disreputable, Inc. The bond offers an interest rate of 5.5%. The rate on a similar US Treasury bond is 2.5%. All else equal, what will Sarah's default premium be if she purchases the Disreputable, Inc. bond?
3%
Consider a bank that has a customer who deposits $10,000 into a 12-month CD that pays 2.5% interest and at the end of the 12 months the customer rolls the funds over into another 12-month CD and continues the rolling every 12 months. Further, suppose the bank uses these funds to make an auto loan for which the bank charges 4% interest. In this situation, the interest rate spread is
4% − 2.5% = 1.5%.
If the before-tax rate of return on a corporate bond is 7%, an individual in the 25% marginal tax bracket would earn a _____ rate of return on the bond.
5.25%
Carlos is considering buying either a corporate bond or a municipal bond that are exactly the same except for their yield. Carlos is in the 33% marginal tax bracket, and the municipal bond he is considering pays a 4% interest rate. To make Carlos indifferent between the two bonds, the corporate bond must offer an interest rate of how much?
5.97%
What is meant by a flight to quality? What is its impact on the bond market?
A flight to quality occurs when investors move financial resources from financial instruments with a high default risk to those with a lower risk of default. The impact of this is that it will tend to increase the default risk premium that higher risk borrowers will have to pay.
Asymmetric information - What is it and how does it lead to market inefficiencies
Asymmetric information: Information that is not equal or even. Asymmetric Information in markets can lead to inefficient outcomes The scarce resources of society can be wasted or misallocated
Through which of these methods can the Fed impact the money supply?
Bank reserves, open market operations, and interest rates
Which of these statements is most true of the function of banks?
Banks play a key role in creating money, and they help with the problem of adverse selection.
Why is it easier for the Fed to manage the level of bank reserves using the term auction facility (TAF) as opposed to using discount window lending?
Banks receive TAF proceeds on a 3-day delay, rather than on the day they are requested.
Edward would be equally happy with receiving $95 today or $100 one year from today. Edward's friend Bella would be just as happy receiving $90 today or $100 one year from today. Based on this information, which of the following best describes the difference between Edward and Bella?
Bella has a higher rate of time preference than Edward.
Name the 5 Cs of credit risk, and explain what they are used for.
Character - This is used to determine if the person or company is trust worthy and figure out what their character is like. Capacity - This is used to figure out if they have sufficient funds and incomes to afford payments. Capital - This deals with how much money they are asking for. Another thing to consider is how much of their own money (like a down payment) they are putting into the project/house/etc. Collateral - This is used to determine what means of secondary payment can be taken if they default on payments. It is important to accurately evaluate how much each piece of collateral is truly worth. Conditions - This deals with the terms of the agreement as well as the conditions of the economy.
ABC Bank has made several big loans to a mining equipment manufacturer that sells its equipment to the copper mining industry in Chile. Political unrest in Chile is a source of what kind of risk for ABC Bank?
Country risk
Illustrate why deflation can be a serious economic problem.
Deflation can be a serious problem because in increases the real burden of debt. This is because the amount of and the interest on the debt does not change meaning that someone will have to work more to pay off the pay amount since they are getting paid less. More of their checks will have to be used to pay off debt since that amount has not changed yet their income has decreased.
Which of these is not a likely result if banks hold onto excess reserves?
Demand for loans will increase, and business activity will increase.
Which of these statements was an argument for the elimination of trade barriers between various European nations after WWII?
Economic sanctions after WWI had contributed to economic and political instability; European nations wanted to avoid that instability after WWII.
A 4%, $10,000, 30-year bond will produce for the owner a series of 30 annual payments of $400 from the issuer of the bond and a one-time payment of $9,600. True/false
False
For an asset to function as commodity money, it must be easily divisible, easily standardized, easy to carry around, physically attractive, and broadly demanded. True/false
False
Very risky investments in the 1980s were largely limited to the so-called "junk bonds" sold at that time. True/false
False (because not just junk bonds, also savings and loans industry)
Which entities, by definition, issue the legal contracts known as bonds?
Governments, corporations, and government agencies
Which of the following statements most accurately describes the measurements of the money supply known as M1 and M2?
M1 was a measure of the money supply that worked well until the mid-1970s; then M2 became a more accurate measure until the 1990s.
Which of these open market operations in the European Central Bank is most central to overall monetary policy and carried out weekly?
Main refinancing
Describe money's role in society and the economy
Money has three main functions in the economy: - medium of exchange - unit of account - store of value
Define "money"
Money is any item or medium of exchange that is accepted by people for the payment of goods and services, as well as the repayment of loans
If the required reserve ratio is 3%, an initial demand deposit made in a bank of $100,000 can result in an expansion in the money supply of
Money supply = initial deposit x (1/RRR) = 100,000 x (1/0.03) = 3,333,000
Which of these is the most often used and the most flexible monetary tool used by the Federal Reserve?
Open market operations
What is meant by the phrase "double coincidence of wants" in a barter economy?
Person A must want what person B is offering in exchange, and person B must want what person A is offering in exchange
Which of these is most often used in practice to maintain a relatively stable price level?
Price level targeting
When a central bank wants to pursue an expansionary monetary policy, it can do which of these things?
Pump excess reserves into the banking system
Midtown Bank has net income of $50 million, total assets of $1 billion, and equity capital of $500 million. Midtown's ROA is
ROA (return on assets) = Net income/Total assets = $50 million/$1 billion = 5.0%.
Initially, the US Federal Reserve was created by Congress for what primary function?
Serve as a lender of last resort
In the early twentieth century, which of the following US industries were dominated by trusts?
Steel, railroads, and banking
What would be expected in a market for used cars, assuming asymmetric information and buyers who have little way to determine good used cars from poor used cars?
The average price for used cars would go down and drive the better used cars out of the market
Which of these statements is true of the board of governors of the Fed?
The board of governors consists of six members plus the chair; the term length for members is fourteen years.
The position of chair of the Federal Reserve is filled in what way?
The chair of the Fed is appointed by the president of the United States and confirmed by the US Senate.
What problem may occur if an economy has too few banks or none at all?
The economy will be underdeveloped, with a possible increase in unemployment and business failures.
What determines the market price of a bond?
The market price of a bond is simply the present value of the cash flows the owner of the bond can expect to receive over the life of the bond.
The sum of Federal Reserve notes in circulation, plus US coins, plus bank reserves is collectively referred to by which of these designations?
The monetary base
Which of these was a lesson that economists learned from the battle with stagflation in the late 1970s and early 1980s?
The money supply matters and has a very real impact on economic activity.
What is the difference between the pure expectations, term premium, and segmented market theories of the term structure of interest rates?
The pure expectations theory says that long-term interest rates are a reflection of the market's expectations of future interest rates. Higher expected future rates produce an upward-sloping yield curve, constant expected future rates produce a flat yield curve, and lower expected future rates produce a downward-sloping curve. The term premium theory suggests that short-term investments are preferred to long-term investments, so long-term bonds must offer higher interest rates to attract buyers. Essentially, this theory suggests that the yield curve slopes upward. The segmented market theory does not believe that a yield curve has any real value because the markets for short-, medium-, and long-term bonds are actually completely separate markets.
What is the role and mission of the United States Federal Reserve?
The role of the Federal Reserve is to maintain price stability and low unemployment (these are their two main goals). The Fed does this through monetary policy. Their main tools are open market operations and discount lending (lender of last resort). The goal of monetary policy is to promote stability in financial markets and in the economy, achieve price stability, maintain low unemployment, and keep the economy growing as it should through stable interest rates. The Fed aims to use its tools to achieve these things and keep the economy as healthy as possible.
Travis buys a 20-year, $10,000 US Treasury bond with a coupon rate of 5%. After three years, he has some unexpected expenses and decides to sell the bond. In which market will Travis sell his bond?
The secondary bond market
Explain the simple deposit multiplier process.
The simple deposit multiplier process begins with a bank deposit that creates excess reserves. For example, consider a cash deposit of $10,000 made in Bank A. The deposit creates both an asset and a liability for the bank—the $10,000 deposit is a liability to the bank, but the $10,000 cash is added to the bank's stock of reserves. The required reserve ratio, let's say 10%, tells the bank the portion of its deposits that it must hold as reserves and the portion that it can lend out. In this case, the $10,000 deposit means reserves must increase by $1,000; however, the bank's reserves have increased by $10,000, meaning that $9,000 can be loaned out. When a $9,000 loan is made, the money supply expands by $9,000. The person receiving the loan will deposit it in his or her bank, creating more excess reserves that get loaned out, and the process goes on and on.
What are the three types of bank reserves and what do they include?
The three types of banks reserves are required reserves, excess reserves, and actual reserves. Required reserves include the amount of money that the bank has to maintain by law at all times. Excess reserves is the amount of money that is in addition to the required reserves. Finally, actual reserves includes both the required reserves and the excess reserves.
According to Nobel Prize-winning economist Joseph Stiglitz, US monetary policy was largely understood before the Great Recession to be based on several generally accepted ideas, including the idea that there is no such thing as an asset bubble. Which of these did history show according to Stiglitz?
There was a stock market bubble in the United States in the 1920s, there was a Japanese asset bubble in the 1980s, and most recently, there was the dot-com asset bubble in the United States in the late 1990s.
How was the Federal Reserve supposed to operate as outlined by the Burgess-Riefler doctrine?
Under the Burgess-Riefler doctrine, commercial banks could borrow from the Federal Reserve only in times of need and not to earn a profit by relending the funds. Also, under the doctrine, the Federal Reserve could compel banks to borrow and repay loans by other means. Most importantly, according to the doctrine, the level of bank borrowing in Chicago and New York and the level of short-term nominal interest rates would be used to indicate whether there was a shortage or abundance of liquidity in the market.
Explain how the market for loanable funds will adjust to the situation where the market interest rate is below the equilibrium rate.
When the market interest rate is below the equilibrium rate, there will be a shortage of loanable funds.Borrowers who are trying to borrow at the market rate will have trouble borrowing funds, and lenders willing to lend at the market rate will find that they do not have sufficient funds for all the borrowers interested in borrowing at the market rate. As a result, lenders will recognize an opportunity to raise the interest rate, and the interest rate will rise until it reaches the equilibrium rate.
In Vance's homeowner's insurance policy, it states that he is required to pay out-of-pocket the first $5,000 for any homeowner's insurance claim that he submits before the insurance company will reimburse for any loss. This is an example of using
a deductible to try to mitigate the problem of moral hazard.
The Chairman of the Federal Reserve, Paul Volcker, decided that dealing with stagflation would require
a shift in focus by the Federal Reserve from targeting interest rates to targeting the rate of growth of the money supply.
Discount window
a. Primary Credit - healthy banks allowed to borrow from the Fed for short periods of time b. Secondary Credit - banks suffering to stay open c. Seasonal - limited # of banks can borrow for short periods of time based on seasonality
The bond rating system, in which companies like Moody's and Standard & Poor's provide ratings for a company's default risk, is one way to deal with a. adverse selection b. adverse hazard c. symmetric information d. moral selection
adverse selection
A one-time deposit in a bank will result in
an expansion in the money supply that is larger than the size of the one-time deposit.
When the parties to a transaction have different levels of knowledge about each other and/or the nature and implications of the transaction, it is said that there exists __________ information.
asymmetric
Initially, quantitative easing was not much help in creating economic growth because
banks did not lend out the excess reserves that were created by quantitative easing.
Inflation is a benefit in the short run to
borrowers
Today, in the United States, several assets function as money. Which of the following would NOT be considered money? a. currency b. demand deposits c. checkable deposits d. credit cards
credit cards
Monetary policy has the best chance of influencing the level of __________ unemployment.
cyclical
If a bank has a positive interest rate gap and interest rates decline, then the bank will experience a(n)
decline in revenue
When the Federal Reserve increases the required reserve ratio, the impact will be to
decrease the size of the money multiplier.
Irving Fisher's equation of exchange led to the conclusion that the __________ is a function of the level of __________ income in the economy.
demand for money; nominal
Which of the following bank assets is most liquid? a. treasury bills b. mortgage bills c. deposits at the federal reserve d. treasury bonds
deposits at the federal reserve
What is the term for removal of funds from a financial intermediary (e.g., a bank) to invest them directly, as through a mutual fund?
disintermediation
A corporate bond offering an interest rate of 5% is as good a deal as a municipal bond offering the same interest rate. True/false
false
In the early 1980s, Paul Volcker used an easy monetary policy to bring inflation under control. True/false
false
When interest rates on loans and mortgages are low, the huge rush of easy borrowing is sometimes referred to as a credit crunch.
false (its when private borrowers find borrowing from banks to be difficult)
When the economy is caught in a liquidity trap, expansionary monetary policy will
have little impact on the economy.
Stagflation is the term used for an economy experiencing a combination of
high unemployment and rising rates of inflation.
During World War II, US policymakers feared inflation would result from the dramatic increase in wartime spending. In order to prevent that inflation, US policymakers
implemented wage and price controls, issued war bonds, and rationed many commodities.
If the goal of monetary policy is to keep interest rates stable, the Federal Reserve's response to increases in the demand for money will be to
increase the supply of money.
Imagine you live in a country with huge public debt and an uncertain future. Monetization of this public debt is most likely to lead to which of these outcomes?
inflation
One of the biggest challenges the Federal Reserve faces in conducting monetary policy is the existence of __________ lags.
information and impact
The coupon rate of a bond refers to the
interest rate to be paid to the holder of the bond.
Bond prices and interest rates are
inversely related
An inverted yield occurs when
long term interest rates are lower than short term interest rates
When the Federal Reserve buys US Treasury securities on the open market, it is attempting to
lower interest rates.
Purpose of money
medium of exchange, unit of account, store of value
Consider the following data about the economy: currency outstanding (C) = $1 trillion, total deposits (D) = $750 billion, total reserves (R) = $76 billion, and the required reserve ratio (RR ratio) = 10%. What is the money multiplier for this economy?
money multiplier = (1 + 1.33)/(1.33 + 0.1 + 0.00133) = 2.33/1.43133 = 1.63
Petra has an automobile accident and finds that as a result her auto insurance premium will increase by 25%. This is an example of an adjustable premium that insurance companies often use as a mechanism to combat a. shortsightedness b. adverse selection c. free-riders d. moral hazard
moral hazard
Of the policy tools available to the European Central Bank, the most frequently used are the
open market operations (OMOs).
In the Taylor Rule formulation for setting a federal funds target rate, a negative output gap means that the
output in the economy is below the economy's potential output.
A potential problem of a more politically controlled central bank is that
politicians may want to pursue monetary policies that are good in the short run but bad in the long run.
A financially healthy bank borrowing overnight from the Federal Reserve is known as
primary credit
You are having a conversation with your friend Yvonne about the upward-sloping yield curve that currently exists in the bond market. She explains this to you by saying that the upward slope to the yield curve is because the market expects future short-term interest rates to be higher than current interest rates. Her observation means that she is a proponent of the __________ theory of interest rates.
pure expectations
Imagine that Roland goes to his bank and deposits $10,000 in cash into his savings account. The bank, wanting to use those funds to generate revenue for itself, will look to make a loan with this cash. An important determinant of how much of that $10,000 the bank can lend is the
required reserve ratio
Actual bank reserves are equal to
required reserves + excess reserves.
On payday you get paid in cash, so each week you put $10 into a shoebox in your closet so that you can buy a big-screen TV at the end of the year. In this situation, money is serving as a
store of value
The board of governors of the Federal Reserve has three primary responsibilities, which are
the operations of the Fed, commercial bank regulation, and monetary policy.
Cleo is hired as the CEO of Wolfstarter Company, a publicly owned corporation. After she is hired, she authorizes the purchase of a company limousine to chauffeur her around town, purchases a skybox at the stadium of the local NFL team, and provides herself with a company-paid membership at the local country club. This behavior could be an example of
the principal-agent problem.
According to the pure expectations theory, a flat yield curve means the market
thinks that future interest rates will be exactly the same as current interest rates.
We learned about the lessened regulation of shadow banks compared to traditional banking institutions. Assuming the funds that shadow banks lend to consumers are borrowed from other banks, where does the risk ultimately lie?
traditional banks
Deductibles are one way insurance companies protect themselves from careless drivers.
true
Times of financial uncertainty tend to cause an increase in the overall demand for money.
true
When a coffee shop lists a tall coffee on its menu at $2.95, the coffee shop is using money as a
unit of account
