Macro chapter 9 Final
What does a balance sheet show?
A balance sheet shows assets, liabilities, and net worth.
What are the assets of a bank? What are its liabilities?
A bank's assets consist of things of value that it owns such as its reserves, loans it has made, bonds it holds, and even the value of its building. A bank's liabilities consist of money it owes others. A bank's main liability is usually the money it owes its depositors. It may also owe money to others from whom it has borrowed money, such as the Federal Reserve.
In many casinos, a person buys chips to use for gambling. Within the walls of the casino, these chips can often be used to buy food and drink or even a hotel room. Do chips in a gambling casino serve all three functions of money?
As long as you remain within the walls of the casino, chips fit the definition of money; that is, they serve as a medium of exchange, a unit of account, and a store of value. Chips do not work very well as money once you leave the casino, but many kinds of money do not work well in other areas. For example, it is hard to spend money from Turkey or Brazil at your local supermarket or at the movie theater.
Explain why you think the Federal Reserve Bank tracks M1 and M2.
As we will discuss in the next chapter, one main task of the Federal Reserve is to control the size of the money supply. As you already know, a too-rapid increase in the money supply will cause inflation. As you will learn in the next chapter, changes in the money supply will also affect aggregate demand. The Fed must measure the money supply to see if it is too big or too small.
A bank has deposits of $400. It holds reserves of $50. It has purchased government bonds worth $70. It has made loans of $500. Set up a T-account balance sheet for the bank, with assets and liabilities, and calculate the bank's net worth.
Assets Liabilities and Net Worth Reserves = $50 Deposits = $400 Bonds = $70 Loans = $500 Net Worth = $220
Why is a bank called a financial intermediary?
Banks are an intermediary between savers and borrowers. Savers earn interest without having to find people to borrow their money.
How do banks create money?
Banks create money by accepting deposits and then loaning out their excess reserves. When the excess reserves loaned out are deposited in another bank, new deposits are created. New deposits imply a bigger money supply.
Explain why the money listed under assets on a bank balance sheet may not actually be in the bank?
Cash in a bank's vault is in the bank, but most of their assets are not. These include reserves that the bank holds at the Federal Reserve Bank, loans made to customers, and bonds.
What would the money multiplier be if banks were not required to keep reserves?
If banks were not required to keep reserves, the reserve requirement would be zero. That means the money multiplier would be 1/0, which is undefined. As the reserve requirement approaches zero, the money multiplier approaches infinity. Note, however, that even if the legal reserve requirement were zero, prudent banks would still hold some reserves, so the effective money multiplier would not be infinite.
What is the risk if a bank does not diversify its loans?
If the bank has made mostly one type of loan, say loans to home builders, then its assets will be wiped out if that industry collapses. That is one aspect of the most recent financial crisis. Home builders suffered large losses and were unable to repay their bank loans. Banks that "specialized" in loans to home builders were devastated.
Explain what will happen to the money multiplier process if there is an increase in the reserve requirement.
If the reserve requirement increases, then the money multiplier will be smaller. That means that any given increase in excess reserves will have a smaller effect on the money supply. In the previous question, the money supply increased by $10 billion. If the reserve requirement had been larger, say 10%, then the money multiplier would have been 1/0.1 = 10. The money supply would have only increased by 10 x $500 million = $5 billion.
If the reserve requirement is 5% and the banking system acquires $500 million in new excess reserves, by how much can the money supply increase?
If the reserve requirement is 5%, then the money multiplier is 1/0.05 = 20. The money supply can increase by 20 x $500 million = $10 billion.
The Bring it Home Feature discusses the use of cowrie shells as money. Although cowrie shells are no longer used as money, do you think other forms of commodity monies are possible? What role might technology play in our definition of money?
In the past, many different commodities have served as money. For example, salt, tobacco, cattle, and large stones have been used as money. New technologies have already affected what we consider to be money; think about Bitcoin and other "crypto-currencies."
What components of money are counted as part of M1?
M1 consists of currency, traveler's checks, and all checkable accounts owned by the non-bank public.
What components of money are counted in M2?
M2 consists of M1 plus savings accounts, money market funds, certificates of deposit, and other time deposits.
Can you name some item that is a store of value, but does not serve the other functions of money?
Many physical items that a person buys at one time but may sell at another time can serve as an answer to this question. Examples include a house, land, art, rare coins or stamps, and so on
How does the existence of money simplify the process of buying and selling?
Money eliminates the need for barter. Money eliminates the requirement for a double-coincidence of wants that must exist in a barter system. Barter makes a sophisticated economy almost impossible.
If you are out shopping for clothes and books, what is easier to spend, money in your checking account or money in a certificate of deposit?
Money in a checking account, which is part of M1, is easier to spend than money in a certificate of deposit. Money in a certificate of deposit is part of M2, but not M1.
What are the three functions of money?
Money serves as a medium of exchange, a unit of account, and as a store of value.
What is the asset-liability time mismatch that most banks face?
Most of a bank's liabilities are deposits, and these can usually be withdrawn quickly. Most of a bank's assets are in the form of loans and bonds that may take years to be repaid. This creates a problem: If interest rates rise, it will have to pay higher interest rates to its depositors, but it will only receive the old, lower interest rate on its existing loans; the bank may therefore lose money.
The total amount of U.S. currency in circulation divided by the U.S. population comes out to about $3,500 per person. That is more than most of us carry. Where is all the cash?
Most of the cash is in one of three places: 1. Cash is used in the underground economy (such as the drug trade) because it does not leave a trail. 2. In countries with high inflation rates, many people hold dollars as a store of value rather than their domestic currency. 3. There are a few countries around the world (such as Ecuador) that use the U.S. dollar as their currency.
If you take $100 out of your piggy bank and deposit it in your checking account, how did M1 change? Did M2 change?
Neither M1 nor M2 changed. All that happened was that the form of M1 changed; you have less currency but a larger checking account.
What is the double-coincidence of wants?
The double-coincidence of wants is required for barter. Each person must find someone who wants what they have AND has what they want before they can trade. That means that trade can consume most of one's time.
What is the formula for the money multiplier?
The money multiplier equals 1 divided by the reserve requirement. If, for example, the reserve requirement is 20%, then the money multiplier equals 1/0.2 = 5.
How do you calculate the net worth of a bank?
The net worth of a bank is equal to the value of its assets minus the value of its liabilities. If a bank has $10 billion in assets and $9 billion in liabilities, its net worth is $1 billion.
How can a bank end up with negative net worth?
The typical way a bank ends up with negative net worth is when the loans or bonds it owns go bad. This happens when people "default," that is, do not pay what they owe the bank. Think of a bank with $20 million in reserves, $75 million in loans, and deposits of $90 million. Its assets would be $20 million + $75 million = $95 million. Its net worth would be positive, equal to $95 million - $90 million = $5 million. Now suppose a customer who had borrowed $7 million defaults. The bank's loans fall in value to $68 million and therefore its assets fall to $88 million. Its net worth is then negative, equal to $88 million - $90 million = -$2 million.
Explain the difference between how you would characterize bank deposits and loans as assets and liabilities on your own personal balance sheet and how a bank would characterize deposits and loans as assets and liabilities on its balance sheet.
To me, my bank deposits are assets and my bank loans are liabilities. To the bank, my deposits are liabilities and my loans are assets.
Imagine that you are a barber in a world without money. Explain why it would be tricky to obtain groceries, clothing, and a place to live.
You would have to find people who have these things who also want a haircut. Plus, it is unlikely that the person who has the place to live would need enough haircuts for you to pay the rent. This is an illustration of why the double-coincidence of wants required for barter can be a major problem.
Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payments on loans made by banks) for a bank or other financial services company. Explain why you would be willing to pay more or less for a given loan if: a. The borrower has been late on a number of loan payments b. Interest rates in the economy as a whole have risen since the loan was made c. The borrower is a firm that has just declared a high level of profits d. Interest rates in the economy as a whole have fallen since the loan was made
a. A borrower who has been late on a number of loan payments looks perhaps less likely to repay the loan, or to repay it on time, and so you would want to pay less for that loan. b. If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it. c. If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan. d. If interest rates in the economy have fallen, then the loan is worth more.
For the following list of items, indicate if they are in M1, M2, or neither: a. Your $5,000 line of credit on your Bank of America card b. $50 dollars' worth of traveler's checks you have not used yet c. $1 in quarters in your pocket d. $1200 in your checking account e. $2000 you have in a money market account
a. Neither in M1 or M2 b. It is part of M1, and because M2 includes M1, it is also part of M2 c. Currency out in the public hands is part of M1 and M2 d. Checking deposits are in M1 and M2 e. Money market accounts are in M2 but not M1
Someone finds a stash of currency worth $20 million and deposits it all into Humongous Bank. a. By how much has the money supply changed as a result of the initial deposit? b. Suppose Humongous Bank is required to hold 5% of its deposits as reserves, and to loan out the rest. By how much will the money supply increase after this first round of loans? c. The banking system in this economy has several banks. By how much could the money supply increase with the original loan from Humongous Bank?
a. The money supply would not change; it would just change forms from currency to deposits. b. The bank loans out 95% of the $20 million, or $19 million. When the check it issues is deposited, the money supply will rise by $19 million. c. The money supply can increase by the money multiplier times the new excess reserves. In this case the money multiplier is 1/0.05 = 20. The new excess reserves are $19 million. So the money supply could increase by 20 x $19 million = $380 million.