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Banking Exercise #5 Answers
Student Name: ________________________
Section: ______________________________
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points)
Please limit your answers to the spaces provided. If necessary, write on the back of the page.
Do not attach printout or additional pages. All questions pertain to the Banking module in the
SimEcon® software package.
Make sure that you have read the “Banking Manual” and SimEcon® Operation Instructions”.
These materials may be found at the Class Web site prior to beginning the exercise. For many of
the exercise’s questions, it will be necessary to refer to those instructions. For many of the
exercise’s questions, it will be necessary to refer to your text.
Open the Banking module. You will arrive at the table entitled, “Banking System: Initial
Conditions. Print out this table for future reference. Look at this table. What is the difference
between the discount rate and the interest rate, as listed by the SimEcon® Banking module?
The interest rate represents the average interest rate paid by consumers and businesses on
credit cards, home mortgages, auto loans and other types of debt. The discount rate is the
interest rate charged by the Federal Reserve System for loans to commercial banks. What
is the required reserve ratio? The required reserve ratio represents the percentage of total
deposits that commercial banks must hold in reserve with the Federal Reserve System or in
the bank vault. What are open market operations? Open market operations involve the
process of the Federal Reserve in buying and selling bonds on the open market in order to
regulate the money supply.
What is the difference between demand deposits and the money supply? The number indicated
for demand deposits represents the total amount of money held in checking accounts. The
money supply includes the total amount of currency and coins in circulation plus the total
amount of demand deposits.
List below the three main tools that the Federal Reserve System uses to regulate the money
supply. List them in the order of the tool with the strongest impact on top and the tool with the
weakest impact on the bottom.
1) Changing the required reserve ratio.
2) Conducting open market operations.
3) Changing the discount rate.
Consider the following statement: “In order to regulate the money supply, the Federal Reserve
changes the required reserve ratio very frequently while it changes the discount rate very rarely.”
Is this statement true or false? This statement is false. Consider the following statement: “The
Federal Reserve System frequently uses open market operations to ‘fine tune’ the economy.” Is
this statement true or false? This statement is true.
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Banking Exercise #5 Answers
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Click “Continue”. You will see the table that asks you which tool you want to use. Assume that
the economy is currently in a severe recession. Select the button entitled “Required Reserve
Ratio and click “Continue”. Set the required reserve ratio equal to 10.5% and click “Continue”.
With a higher reserve ratio, will commercial banks have to keep more or less reserves?
Commercial banks will have to keep more reserves. Will commercial banks be able to loan
out more or less money? Commercial banks will be able to loan out less money. Thus, what
will happen to the money supply as a result of this change? The money supply will decrease.
If the economy is in a recession, does this seem like a wise policy? No (Yes, No). Please
explain. By increasing the required reserve ratio, we are decreasing the money supply
when we should be increasing it in order to stimulate aggregate demand. A higher level of
aggregate demand will reduce unemployment.
What has happened to interest rates as a result of this policy? Interest rates have increased.
What is a high-risk bank? A high-risk bank is a commercial bank that has a large portion of
its assets invested in fixed interest loans to consumers and businesses. If the interest rate
increases, how does that cause a problem for high-risk banks? In that case, a large portion of
the bank’s loans has a fixed interest rate that is less than the market rate of interest. Thus,
these investments will decline in value. This will cause the net worth of the bank to go
down, other things being equal.
Click “High Risk Bank” and the table that appears will show you the results of increasing the
reserve ratio for a high-risk bank. In this case, an error message also appears. What does that
error message say? The message says that the capitalization ratio has fallen below 8%. The
message says that the financial system is in trouble. What is the capitalization ratio? The
capitalization ratio is owner’s equity divided by total assets. Why is the capitalization ratio
important? The capitalization ratio shows how much the owners of the bank have at risk if
the managers make bad decisions. If they have too little at risk it gives the bank too much
incentive to make decisions that either give very high profits for the owners or inflict large
losses on depositors or insurers (FDIC. Click “OK”. What was owner’s equity before the
change? $890,000. What is owner’s equity after the change? $-16,250. Does this bank appear to
be doing well after the change? No (Yes, No). Why or why not? The owner’s equity of the
bank has been eliminated and legally this bank would have to close immediately.
Click “New Tool”. You will arrive at the table that asks you what tool you want to use. Select
“Discount Rate” and click “Continue”. Decrease the discount rate to 4.5% and click “Continue”.
With a lower discount rate, what will happen to the costs of commercial banks when they have to
borrow money from the Federal Reserve System? The costs of these banks will go down.
Thus, will commercial banks be more or less likely to loan money out to private consumers and
individuals? Commercial banks will be more likely to loan out money. Thus, what will
happen to the money supply? The money supply will increase. What will thus happen to the
interest rate? The interest rate will go down.
Click “See Graph” and draw the resulting graph below. Indicate the old money supply curve, the
new money supply curve, the money demand curve and the old and new interest rates.
Course
Banking Exercise #5 Answers
Interest
Rate
MS
Page 3
MS’
MS = Old Money Supply
MS’ = New Money Supply
MD = Money Demand
re = Old Interest Rate
re’ = New Interest Rate
re
re’
MD
Quantity of Money
Click “New Tool”. Then, select “Discount Rate” and click “Continue”. Keep the discount rate
at 4.5% and click “Continue”. This will take you back to exactly where you were before the
graph that you drew above. Then click “Low-Risk Bank”. What is a low-risk bank? This is a
bank that has a large portion of its assets invested in short term and variable interest rate
loans. What was owner’s equity before the change? $890,000. What is owner’s equity after the
change? $1,157,490. What is the increase or decrease in owner’s equity? There is an increase
of $267,490 in owner’s equity. Does this bank appear to be doing well after the change? Yes
(Yes, No).
Click the “Back” button once. Then, click “High-Risk Bank”. What was the owner’s equity
before the change in discount rate? $890,000. What is the new owner’s equity after the change
in the discount rate? $1,782,490. What is the increase or decrease in owner’s equity? There is
an increase of $892,490 in owner’s equity. Given a decrease in market interest rates, which
type of bank appears to have profited more from the change? The high-risk bank appears to
have profited more.
These last two paragraphs discussed what happens when the interest rate decreases. Why did the
high-risk bank enjoy a larger increase in profits? The high-risk bank invested in fixed interest
instruments. When the interest rates decreased, the high-risk bank got large capital gains
as the market values of fixed rate assets increased. They also got a small increase in
revenues from their variable rate assets. Why did the low-risk bank enjoy a smaller increase
in profits? The low-risk bank invested in short-term and variable interest instruments.
When the interest rate decreased, they did not get as much in capital gains because they did
not have much in fixed rate assets and variable rate assets do not give them capital gains.
They do get a bigger rise in revenues from their variable rate assets
Now, we discuss what happens when the market interest rate rises. Click “New Tool”. This
time, select “Open Market Operations” and click “Continue”. You will see the table entitled,
“Set Open Market Operations”. If the government wanted to decrease the money supply, should
the Federal Reserve System buy or sell bonds on the open market? The Federal Reserve
System should sell bonds. Select the button entitled, “Sell”. The program will automatically
respond. Enter “20” for $20 billion worth of bonds and click “Continue”. What has happened to
the money supply as a result of this change? The money supply has decreased. What has
happened to the interest rate as a result of this change? The interest rate has increased.
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Banking Exercise #5 Answers
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Now, click “High-Risk Bank”. In this case, an error message also appears. What does that error
message say? The message says that the capitalization ratio has fallen below 8%. The
message says that the financial system is in trouble. Click “OK”. What is the owner’s equity
before the change? $890,000. What is the owner’s equity after the change? $414,290. What is
the resulting change in owner’s equity? There is a decrease of $475,710. Click the “Back”
button once, then click “Low-Risk Bank”. The same error message will appear. Click “OK”.
For the low-risk bank, what is the owner’s equity before the change? $890,000. For the low-risk
bank, what is the owner’s equity after the change? $742,860. What is the resulting change in
owner’s equity? There is a decrease in owner’s equity of $147,140.
When the interest rates increased, which type of bank experienced a smaller decrease in owner’s
equity? The low-risk bank experienced a smaller decrease in owner’s equity. What was the
disadvantage of a high-risk bank in this situation? The high-risk bank invested a lot of its
assets in fixed interest, long-term instruments. When the market interest rate rose, the
high-risk bank experience large capital losses on its fixed interest investments. What was
the advantage of the low-risk bank in this situation? When the interest rates increased, the
short term and variable interest investments of the low risk bank automatically adjusted,
so that the bank could enjoy the higher rates and it had smaller losses on its fixed rate
assets since it had fewer such assets.
Suppose that you were a bank manager. If you expected interest rates to fall, would you invest
your assets in fixed or variable interest rate instruments? I would invest in fixed interest rate
instruments. On the other hand, if you expected interest rates to rise, would you invest in fixed
or variable interest rate instruments? I would invest in variable interest rate instruments.
You should still be at the table that provides the balance sheet for the low risk bank. This table
showed the results of an increase in interest rates. Click the “Back” button once. Click “See
Graph” and draw the resulting graph below. Indicate the old money supply curve, the new
money supply curve, the money demand curve and the old and new interest rates.
Interest
Rate
MS’
MS
MS = Old Money Supply
MS’ = New Money Supply
MD = Money Demand
re = Old Interest Rate
re’ = New Interest Rate
re’
re
MD
Quantity of Money
Earlier in this exercise, you were instructed to assume that the economy was in a severe
recession. If that was the case, would it make sense to sell bonds on the open market? No (Yes,
No).
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Banking Exercise #5 Answers
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Why or why not? Selling bonds on the open market would not make sense in a severe
recession because such an action would decrease the money supply and raise interest rates.
This would stifle private investment and consumption spending (through reduced use of
credit cards) and this would in turn reduce aggregate demand. What are the three monetary
policy actions that the Federal Reserve could take to increase the money supply in a severe
recession? The Federal Reserve could lower the required reserve ratio, lower the discount
rate, or buy bonds on the open market.