Department
of Economics
Econ353:
Section 2
Money,
Banking and Financial Institutions
Spring
2003
PART ONE: Multiple-Choice Questions
1) If the First National Bank has a gap equal to a negative
$30 million, then a 5 percentage point increase in interest rates will cause
profits to
A) increase by $15 million.
B) increase by $1.5
million.
C) decline by $15 million.
D)
decline by $1.5 million.
2) Because larger loans create greater incentives for
borrowers to engage in undesirable activities that make it less likely they
will repay the loans, banks
A) ration credit, granting borrowers smaller loans than
they have requested.
B) ration credit, charging higher interest rates to borrowers
who want large loans than to those who want small loans.
C) ration credit, charging higher fees as a percentage
of the loan to borrowers who want large loans than to those who want small
loans.
D) do none of the above.
3) For a given return on assets,
A) the lower is bank capital, the higher is the return
for the owners of the bank.
B) the lower is bank capital, the higher is the credit
risk for the owners of the bank.
C) the higher is bank capital, the higher is the return
for the owners of the bank.
D) both (a) and (b) of the above.
4) The most significant change
in the economic environment that changed the demand for financial products
since 1970 has been
A) the aging of the baby-boomer generation.
B) the dramatic increase in the volatility of interest
rates.
C) the dramatic increase in competition from foreign banks.
D) the deregulation of financial institutions.
5) The most important source
of the changes in supply conditions that stimulate financial innovation has
been the
A) aging of the baby-boomer generation.
B) dramatic increase in the volatility of interest rates.
C) improvement in computer and telecommunications technology.
D) dramatic increase in competition from foreign banks.
E) the deregulation of financial institutions.
6) Loophole mining refers to
A) financial innovation designed to hide transactions
from the IRS.
B) financial innovation designed to conceal transactions
from the SEC.
C) financial innovation designed to get around regulations.
D) none of the above.
7) The _____ Fed bank, with over 30 percent of the system's
assets, is the most important of the Federal Reserve Banks.
A)
B)
C) Miami
D)
E)
8) Which of the following are entities of the Federal Reserve
System?
A) Federal Reserve
Banks
B) The FOMC
C) The Board of
Governors
D) All of the above
are Federal Reserve entities
E) Only (a) and
(b) of the above are Federal Reserve entities
9) Banks subject to reserve requirements set by the Federal
Reserve System include
A) only state chartered banks.
B) only nationally chartered banks.
C) only banks with assets less than $100 million.
D) only banks with assets less than $500 million .
E) all banks whether or not they are members of the Federal
Reserve System.
10) The designers of the Federal Reserve Act meant to create
a central bank characterized by its
A) system of checks and balances and decentralization
of power.
B) strong concentration of power in the hands of a few
men.
C) inability to function as a lender-of-last-resort.
D) responsiveness to the electorate.
11) The theory of bureaucratic behavior suggests that the objective
of a bureaucracy is to maximize
A) the public's welfare.
B) profits.
C) its own welfare.
D) conflict with the executive and legislative branches
of government.
12) Although it enjoys a high degree of autonomy, the Fed is
still subject to the influence of the President because
A) the President can veto legislation that would limit
Fed appropriations.
B) the President can veto legislation that would restrict
Fed independence.
C) the President can remove members of the Board of Governors
on a whim.
D) of only (a) and (b) of the above.
13) The sum of vault cash and bank deposits at Federal Reserve
banks is called
A) the monetary base.
B) the money supply.
C) reserves.
D) discount loans.
14) The Federal Reserve entity that determines monetary policy
strategy is the
A)
Board of Governors.
B)
chairman of the Board of
Governors.
C)
Federal Open Market
Committee.
D)
Shadow Open Market
Committee.
15) The strongest argument for an independent Federal Reserve
rests on the view that subjecting the Fed to more political pressures would
impart
A) an inflationary bias to monetary policy.
B) a deflationary bias to monetary policy.
C) a disinflationary bias
to monetary policy.
D) a countercyclical bias to monetary policy.
16) A bank cannot increase its loans by an amount greater than
A) the total reserves it has before it makes the loan.
B) 10 percent of
its net worth.
C) 5 percent of
its net worth.
D) the excess reserves it has before it makes the loan.
17) The sum of vault cash, deposits at Federal Reserve banks,
and currency in circulation is called
A) the money supply.
B) the
monetary base.
C) Federal Reserve
liabilities. D) near-cash.
18) When the Fed supplies the banking system with an extra
dollar of reserves, deposits ______ by _____ than one dollar--a process called
multiple deposit creation.
A) increase; less
B) increase; more C) decrease; less D) decrease; more
19) If the Federal Reserve wants to drain reserves from the
banking system, it will
A) purchase government securities.
B) lower the discount
rate.
C) sell government securities. D) raise reserve requirements.
20) The Fed conducts most of its open market operations in
Treasury securities because the market for these securities
A) is the most liquid.
B) has the largest trading volume.
C) is monopolized by the Fed.
D) involves all of the above.
E) only (a) and (b) of the above.
21) If the Fed wants to temporarily inject reserves into the
banking system, it will engage in
A) a repurchase agreement. B) a matched sale-purchase transaction.
C) reverse repurchase agreement.
D) none of the above.
22) If either Treasury deposits or foreign deposits at the
Fed are predicted to temporarily fall, then a _____ open market _____ would
be needed to offset the expected increase in reserves and the monetary base.
A)
defensive; sale
B)
defensive; purchase
C)
dynamic; sale
D)
dynamic; purchase
23) The Fed's ability to discourage banks from making too many
trips to the discount window is frequently referred to as
A)
"arm twisting."
B)
the "red dog" rule.
C)
"discount blitzing!"
D)
"moral suasion."
24) Discount policy affects the money supply by affecting the
volume of _____ and the _____.
A) excess reserves; monetary base
B) discount loans; monetary
base
C) excess reserves; money multiplier
D) discount loans; money multiplier
25) The Fed's discount loans are of three types: _____ is the
most common category; _____ is given to a limited number of banks in vacation
and agricultural areas; _____ is given to banks that have experienced severe
liquidity problems.
A) seasonal credit; extended credit; adjustment credit
B) extended credit;
seasonal credit; adjustment credit
C) adjustment credit; seasonal credit; extended credit
D) seasonal credit; adjustment credit; extended credit
26) There are two types of open market operations: _____ open
market operations are intended to change the level of reserves and the monetary
base, and _____ open market operations are intended to offset movements in
other factors that affect the monetary base.
A) defensive; dynamic
B) defensive; static
C) dynamic; defensive D) dynamic;
static
27) A bank faces three costs when it borrows from the discount
window
A) the interest cost; the cost of complying with Fed investigations
of the soundness of the bank; the cost of being turned down for a discount
loan in the future.
B) the interest cost; the administrative cost to the bank;
the cost of being turned down for a discount loan in the future.
C) the interest cost; the origination fee charged by the
Fed; the administrative cost to the bank.
D) only (a) and (b) of the above.
28) Disadvantages of discount policy include
A) the confusion concerning the Fed's intentions about
future monetary policy because of the uncertainty about what a change in
the discount rate is intended to signal.
B) large fluctuations in the money multiplier from even
small changes in the discount rate.
C) its powerful effect, when compared to open market operations,
on reserves and the monetary base.
D) only (a) and (b) of the above.
29) The main advantage of using reserve requirements to control
the money supply and interest rates is
A) that they affect all banks equally and have a powerful
effect on the money supply.
B) that they eliminate the need for the Fed to use dynamic
open market operations.
C) that raising them can reduce liquidity problems for
banks with low excess reserves.
D) none of the above.
30) If the banking system has a large amount of reserves,
many banks will have excess reserves to lend and the federal funds rate will
probably _____; if the level of reserves is low, few banks will have excess
reserves to lend and the federal funds rate will probably _____.
A) fall; fall B) fall;
rise C) rise; fall D) rise;
rise
Question 1:
Suppose you are the manager of a bank
whose $100 billion of assets have an average duration of four years and whose
$90 billion of liabilities have an average duration of six years. If the
interest rate rises by 2 percentage points, conduct a duration analysis for
the bank and show:
(a)
what will happen to the
market value of assets
The market value of assets will fall by $8 billion.
% change
in market value of the assets ≈ – % change in interest rate x duration in
years
% change
in market value of the assets ≈ – 2% x 4 years = – 8%
The change
in the market value of assets = $100 billion x (– 8%) = – $8 billion
(b)
what will happen to the
market value of liabilities
The market
value of liabilities will fall by $10.8 billion.
% change
in market value of the liabilities ≈ – % change in interest rate x duration
in years
% change
in market value of the liabilities ≈ – 2% x 6 years = – 12%
The change
in the market value of liabilities = $90 billion x (– 12%) = –$10.8 billion
(c)
what will happen to the net worth of the bank.
Net worth
of the bank will rise by $2.8 billion
Net worth
= – $8 billion – (– $10.8 billion) = – $8 billion + $10.8 billion = + $2.8
billion
(d)
Describe one action
you could take to reduce the bank’s interest-rate risk.
Any one of the following:
a.
shortening the maturity
of liabilities to a duration of 4 years
b.
lengthening the maturity
of assets to a duration of 6 years
c.
engaging in interest rate swap ( swap interest rate earned on this bank’s
assets with interest on another bank’s assets that have a duration of 6 years).
Question 2:
Part (a): Using T-accounts for the nonbank public, the banking system (if applicable)
and the Fed show:
(i)
how a Federal Reserve sale
of $100 of government bonds to the nonbank public
will affect the monetary base and reserves if the
nonbank public pays for the bonds in checks
Nonbank Public
|
Assets |
Liabilities |
|
Securities + $100 |
|
|
Checkable Deposits - $100 |
|
Banking System
|
Assets |
Liabilities |
|
Reserves - $100 |
Checkable Deposits - $100 |
|
|
|
The Fed
|
Assets |
Liabilities |
|
Government Securities - $100 |
Reserves -$100 |
Change in the monetary base = -$100
Change in reserves = -$100
(ii)
how a Federal Reserve sale
of $100 of government bonds to the nonbank public
will affect the monetary base and reserves if the
nonbank public pays for the bonds in currency
Nonbank Public
|
Assets |
Liabilities |
|
Securities + $100 |
|
|
Currency - $100 |
|
The Fed
|
Assets |
Liabilities |
|
Government Securities - $100 |
Currency in circulation -$100 |
Change in the monetary base = -$100
Change in reserves = 0
(iii)
how does the answer in part (i) differ
from that in part (ii).
In both cases, the open market sale leads to a $100 decline in
the monetary base. In part (ii), however, reserves
do not change, while they decline by $100 in part (i).
Part (b): Assuming that the required
reserve ratio is 0.20
(i)
what is the change in reserves when the Fed sells $10 billion of government
bonds and extends discount loans of $5 billion to commercial banks?
The $10
billion sale of government bonds causes bank reserves to fall by $10billion. This is partially offset by the $5 billion in discount
loans that increase bank reserves by $5 billion. Thus on net, bank reserves
fall by $5 billion.
(ii)
Using the simple deposit
multiplier formula, calculate the resulting change in checkable deposits.
The simple deposit multiplier formula is change in D = (1/rD) x change in R.
The change in checkable deposits is calculated by multiplying the
$5 billion decline by 5 (= 1/0.20). Checkable deposits fall by $25 billion
in the simple model.
Question 3:
Part (a): In the market for reserves,
briefly explain:
(i)
why the demand curve is
downward sloping
If the federal
funds rate increases, the opportunity cost of holding excess reserves increases
and, holding everything else constant, the quantity of reserves demanded
decreases. This shows a negative relationship between
the federal funds rate and the quantity of reserves demanded.
(ii)
why the supply curve is
upward sloping
If the federal
funds rate increases, banks will borrow more from the Fed (as the discount
rate is now relatively lower), thus, holding everything else constant, discount
lending rises. This means that the quantity of reserves supplied rises. Thus, there is a positive relationship between the federal
funds rate and the quantity of reserves supplied.
Part (b): Using the supply and demand
in the market for reserves and starting from the point of equilibrium, show
what happens to the demand and/or the supply curves (i.e., shifts) and what happens to the federal funds
rate if:
(i)
the Fed purchases U.S.
Treasury securities
The supply curve shifts to the right and the federal funds interest
rate declines.
See Figure 2 on page 438 of your textbook for graph.
(ii)
the Fed lowers the discount
rate
The supply curve shifts to the right and the federal funds interest
rate declines.
See Figure 2 on page 438 of your textbook for graph.
(iii)
the Fed raises the reserve
requirement
The demand curve shifts to the right and the federal funds interest
rate rises.
See Figure 3 on page 439 of your textbook for graph.
Question 4:
a)
List the four advantages
of open market operations.
a.
Open market operations
occur at the initiative of the Fed (complete control over the volume by the
Fed).
b.
Open market operations
can be used to any degree (flexible and precise).
c.
Open market operations
can be easily reversed.
d.
Open market operations
can be implemented quickly.
b)
Why might it be important
to have a lender of last resort even with the existence of deposit insurance?
Many deposits
exceed the $100,000 limit that the FDIC promises to pay.
Thus the lender of last resort prevents bank failures due to large
depositor withdrawal. In addition, the FDIC contingency fund is limited and
a wave of bank failures could seriously jeopardize the solvency of the system
leading to a severe financial panic that only a lender of last resort might
prevent.
c)
List two reasons why changes
in reserve requirements are rarely used as a policy tool to conduct monetary
policy.
a.
Small changes in reserve
requirements are too costly to administer, so it is too blunt a tool to be
used effectively.
b.
Raising reserve requirements
can cause immediate liquidity problems for banks with small amounts of excess
reserves.
Extra Credit:
Assume that the required
reserve ratio is 20% and that the Fed purchases $1000 in government bonds
from the First State Bank of
|
Bank |
Change in Deposits |
Change in Loans |
Change in Reserves |
|
A |
+ $1000.00 |
+ $800.00 |
+ $200.00 |
|
B |
+ $800.00 |
+ $640.00 |
+ $160.00 |
|
C |
+ $640.00 |
+ $512.00 |
+ $128.00 |
|
D |
+ $512.00 |
+ $409.60 |
+ $102.40 |
|
. |
. |
. |
. |
|
. |
. |
. |
. |
|
. |
. |
. |
. |
|
Total All banks |
+ $5000.00 |
+ $4000.00 |
+ $1000.00 |