Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Fear of floating wikipedia , lookup
Pensions crisis wikipedia , lookup
Exchange rate wikipedia , lookup
Monetary policy wikipedia , lookup
Early 1980s recession wikipedia , lookup
Helicopter money wikipedia , lookup
Real bills doctrine wikipedia , lookup
Modern Monetary Theory wikipedia , lookup
Fractional-reserve banking wikipedia , lookup
Quantitative easing wikipedia , lookup
Course Course Number University or College Professor’s Name Banking Exercise #5 Answers Student Name: ________________________ Section: ______________________________ ( 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. Course Banking Exercise #5 Answers Page 2 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. Course Banking Exercise #5 Answers Page 4 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). Course Banking Exercise #5 Answers Page 5 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.