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Macroeconomics (Acemoglu/Laibson/List) Chapter 10 Credit Markets 10.1 What Is the Credit Market? 1) Economic agents who borrow funds are known as: A) creditors. B) debtors. C) receivers. D) investors. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 2) Credit is: A) the loan that a debtor receives. B) the income that an employee earns. C) any good that is available for free. D) any good that cannot be consumed but is used for the production of other goods. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 3) Which of the following statements is true? A) Money that is lent out is considered to be a liability. B) People who lend money are known as debtors. C) People who borrow money are known as creditors. D) Non-bank institutions are also a part of the credit market. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 4) The additional payment a borrower has to make on a loan is referred to as: A) credit. B) stock. C) interest. D) principal. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 1 Copyright © 2015 Pearson Education, Inc. 5) The total interest that a borrower has to pay on a loan is equal to the: A) principal plus the rate of interest. B) principal minus the rate of interest. C) principal times the rate of interest. D) principal divided by the rate of interest. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 6) The annual price of a one dollar loan is referred to as the: A) principal. B) service tax. C) rate of interest. D) discount value. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 7) Which of the following statements is true? A) Banks are the only financial institutions that lend money and do not accept deposits. B) Banks are the only financial institutions that do not lend money but accept deposits. C) Out of two loans, the interest accumulated after the end of a year will be more on the one that is a smaller principal. D) Out of two loans, the interest accumulated after the end of a year will be more on the one that is a larger principal. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 8) If an individual borrows $100 at an annual rate of interest of 5%, how much interest will he have to pay at the end of a year? A) $5 B) $10 C) $20 D) $50 Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans 2 Copyright © 2015 Pearson Education, Inc. 9) If an individual borrows $200 at an annual rate of interest of 10%, what is the total amount that he will have to repay after one year? A) $20 B) $200 C) $210 D) $220 Answer: D Difficulty: Medium AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans 10) If an individual borrows $100, and pays back $100 after a year to settle his loan, it implies that the rate of interest is: A) 0 %. B) 1%. C) 10%. D) 100%. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans 11) A debtor's quantity of credit demanded and the rate of interest are likely to be: A) unrelated. B) positively correlated. C) negatively correlated. D) positively related if the rate of interest is below 10% and negatively related if it is above 10%. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Borrowers and the Demand for Loans 12) An individual may borrow a certain sum of money from any of the three banks in his town. Bank 1 offers him loans at an annual rate of 5%, Bank 2 offers him loans at an annual rate of 3% per year, and Bank 3 offers him a loan at an annual rate of interest of 10%. A rational individual will: A) borrow from Bank 1. B) borrow from Bank 2. C) borrow from Bank 3. D) be indifferent about borrowing from any of the three banks. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans 3 Copyright © 2015 Pearson Education, Inc. 13) Assuming all else equal, a rise in the rate of interest: A) results in a fall in the cost of borrowing. B) results in a fall in the quantity of credit demanded. C) results in an increase in the number of potential debtors. D) results in a fall in the amount of interest accumulated on a loan. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 14) The real interest rate is given by: A) the nominal interest rate adjusted for tax rates. B) the nominal interest rate adjusted for inflation. C) the nominal interest rate adjusted for income changes. D) the nominal interest rate adjusted for changes in exchange rate. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 15) Which of the following equations is correct? A) Real interest rate = Nominal interest rate + Inflation rate B) Real interest rate = Nominal interest rate - Inflation rate C) Real interest rate = Nominal interest rate × Inflation rate D) Real interest rate = Nominal interest rate / Inflation rate Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 16) If the nominal interest rate in an economy is 6%, and the rate of inflation in the economy is 4%, the real interest rate in the economy is: A) 2%. B) 24%. C) 1.5%. D) 10%. Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: Real and Nominal Interest Rates 4 Copyright © 2015 Pearson Education, Inc. 17) If the nominal interest rate in an economy is 4% and the real interest rate in the economy is 2%, the rate of inflation in the economy must be: A) 2%. B) 4%. C) -2%. D) 0.5%. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: Real and Nominal Interest Rates 18) Consider two economies: A and B. The nominal interest rate is the same in both economies, but the rate of inflation is higher in economy B. Which of the following statements will then be true? A) The real interest rate will be higher in economy A. B) The real interest rate will be higher in economy B. C) The real interest rate will be the same in both economies. D) Whether the real interest rate is higher in economy A or B will depend on the number of borrowers in both economies. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: Real and Nominal Interest Rates 19) If the nominal interest rate is greater than the real interest rate in an economy: A) inflation must be positive in the economy. B) inflation must be negative in the economy. C) inflation must be zero in the economy. D) the real interest rate must be negative. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 20) If the real interest rate is greater than the nominal interest rate in an economy: A) inflation must be positive in the economy. B) inflation must be negative in the economy. C) inflation must be zero in the economy. D) the nominal interest rate must be equal to zero. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 5 Copyright © 2015 Pearson Education, Inc. 21) If the real interest rate is equal to the nominal interest rate in an economy: A) inflation must be zero in the economy. B) inflation must be positive in the economy. C) inflation must be negative in the economy. D) the nominal interest rate must be zero. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 22) If the nominal interest rate increases without any change in the rate of inflation: A) the real interest rate decreases. B) the real interest rate increases. C) the real interest rate remains the same. D) the ratio of real interest rate to nominal interest rate increases. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 23) An optimizing economic agent will use the ________ rate while calculating the economic cost of a loan. A) tax B) exchange C) real interest D) nominal interest Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 24) If the annual inflation rate in an economy is "i", then $1 borrowed at the beginning of a year will have the same purchasing power as ________ dollars at the end of the year. A) i B) (1/i) C) (1 - i) D) (1 + i) Answer: D Difficulty: Hard AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 6 Copyright © 2015 Pearson Education, Inc. 25) If the annual inflation rate in an economy is positive, the purchasing power of a dollar kept in a bank: A) will increase over time. B) will decrease over time. C) will remain the same over time. D) can increase or decrease depending on the economic growth rate. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 26) If the annual inflation rate in an economy is negative, the purchasing power of a dollar: A) will increase over time. B) will decrease over time. C) will remain the same over time. D) can increase or decrease depending on the nominal interest rate. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: Real and Nominal Interest Rates 27) The credit demand curve is the schedule that reports the relationship between the quantity of credit demanded and ________ in an economy, assuming all else equal. A) the average tax rate B) the annual inflation rate C) the real rate of interest D) the nominal rate of interest Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 28) The credit demand curve is: A) vertical. B) horizontal. C) upward sloping. D) downward sloping. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 7 Copyright © 2015 Pearson Education, Inc. 29) The slope of the credit demand curve from the text book implies that the: A) higher the rate of taxation, the lower the quantity of credit demanded. B) higher the rate of taxation, the higher the quantity of credit demanded. C) higher the real rate of interest, the higher the quantity of credit demanded. D) higher the real rate of interest, the lower the quantity of credit demanded. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 30) When the credit demand curve is relatively steep: A) the quantity of credit demanded is relatively sensitive to changes in the tax rates. B) the quantity of credit demanded is relatively sensitive to changes in the real interest rate. C) the quantity of credit demanded is not very sensitive to changes in the tax rates. D) the quantity of credit demanded is not very sensitive to changes in the real interest rate. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 31) When the credit demand curve is relatively flat: A) the quantity of credit demanded is relatively sensitive to changes in the taxation rates. B) the quantity of credit demanded is relatively sensitive to changes in the real interest rates. C) the quantity of credit demanded is not responsive to changes in the taxation rates. D) the quantity of credit demanded is not responsive to changes in the real interest rate. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 32) Assuming all else equal, if there is an increase in the real interest rate: A) the credit demand curve shifts to the left. B) the credit demand curve shifts to the right. C) there will be an upward movement along the credit demand curve. D) there will be a downward movement along the credit demand curve. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 8 Copyright © 2015 Pearson Education, Inc. 33) Assuming all else equal, a decrease in the real interest rate will cause: A) the credit demand curve to shift to the right. B) the credit demand curve to shift to the left. C) a downward movement along the credit demand curve. D) an upward movement along the credit demand curve. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 34) Assuming all else equal, if the real interest rate increases, it will lead to: A) a decrease in the quantity of credit demanded by a firm. B) an increase in the quantity of credit demanded by a firm. C) a rightward shift of the credit demand curve of a firm. D) a leftward shift of the credit demand curve of a firm. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve 35) Assuming all else equal, if the real interest rate decreases, it will lead to: A) an increase in the quantity of credit demanded by a firm. B) a decrease in the quantity of credit demanded by a firm. C) the credit demand curve of a firm to shift to the right. D) the credit demand curve of a firm shifts to the left. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Demand Curve 36) Factors that cause an increase in the demand for credit at a given real interest rate cause: A) a downward movement along the credit demand curve. B) an upward movement along the credit demand curve. C) the credit demand curve to shift to the right. D) the credit demand curve to shift to the left. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 9 Copyright © 2015 Pearson Education, Inc. 37) Factors that cause a decrease in the demand for credit at a given real interest rate cause: A) a downward movement along the credit demand curve. B) an upward movement along the credit demand curve. C) the credit demand curve to shift to the right. D) the credit demand curve to shift to the left. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 38) Which of the following is likely to shift the credit demand curve of an automobile manufacturer to the right, assuming all else equal? A) A decrease in the real interest rate B) An increase in the real interest rate C) A plan to increase production and expand to newer markets D) A plan to decrease production and exit from existing markets Answer: C Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve 39) Which of the following is likely to shift the credit demand curve of a computer manufacturer to the left, assuming all else equal? A) An increase in the real interest rate B) A decrease in the real interest rate C) A decrease in the scale of production D) An increase in the scale of production Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 40) Assuming all else equal, if an airline company decides to purchase new planes, it is likely to cause: A) a downward movement along its credit demand curve. B) an upward movement along its credit demand curve. C) its credit demand curve to shift to the right. D) its credit demand curve to shift to the left. Answer: C Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve 10 Copyright © 2015 Pearson Education, Inc. 41) Assuming all else equal, if households are optimistic about their future income, it is likely to cause a(n): A) downward movement along their credit demand curve. B) upward movement along their credit demand curve. C) rightward shift of their credit demand curve. D) leftward shift of their credit demand curve. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Demand Curve 42) Assuming all else equal, if households are pessimistic about their future income, it is likely to cause a(n): A) downward movement along their credit demand curve. B) upward movement along their credit demand curve. C) rightward shift of their credit demand curve. D) leftward shift of their credit demand curve. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Demand Curve 43) John is expecting to get a hike in his monthly salary after three months. Assuming all else equal, this is likely to cause a(n) ________ his current credit demand curve. A) downward movement along B) upward movement along C) leftward shift in D) rightward shift in Answer: D Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve 44) All else equal, an increase in government borrowing is likely to cause a(n): A) leftward shift of the credit demand curve. B) rightward shift of the credit demand curve. C) upward movement along the credit demand curve. D) downward movement along the credit demand curve. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 11 Copyright © 2015 Pearson Education, Inc. 45) All else equal, a decrease in government borrowing is likely to cause a(n): A) leftward shift of the credit demand curve. B) rightward shift of the credit demand curve. C) upward movement along the credit demand curve. D) downward movement along the credit demand curve. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 46) Savers are willing to lend out money because: A) of altruism. B) the rate of inflation in an economy is normally positive. C) the rate of inflation in an economy is normally negative. D) they prefer to spend money in the future rather than today. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Saving Decisions 47) Money or goods that parents leave to their children in their wills are referred to as: A) charity. B) bequests. C) interest. D) social responsibility. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Why Do People Save? 48) The opportunity cost of current consumption is: A) the inflation rate. B) real wage rate. C) the real interest rate. D) nominal wage rate. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 12 Copyright © 2015 Pearson Education, Inc. 49) Which of the following statements is true? A) If the real interest rate increases, the opportunity cost of current consumption increases. B) If the nominal wage rate increases, the opportunity cost of current consumption decreases. C) If the real wage rate increases, the opportunity cost of current consumption decreases. D) If the unemployment rate increases, the opportunity cost of current consumption decreases. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 50) Which of the following statements is true? A) If the opportunity cost of current consumption is high, people will save more. B) If the opportunity cost of current consumption is high, people will save less. C) If the opportunity cost of current consumption is high, the inflation rate will increase. D) If the opportunity cost of current consumption is high, the unemployment rate will decrease. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 51) Which of the following statements is true? A) An increase in the real interest rate might discourage savings. B) An increase in the real interest rate always encourages higher savings. C) In an economy which has a positive inflation rate, the real wage rate is always greater than the nominal wage rate. D) An increase in the nominal wage rate leads to a decrease in the real wage rate if the price level is stable. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 52) Assuming all else equal, the credit supply curve shows the relationship between the quantity of credit supplied and the: A) inflation rate. B) real wage rate. C) income tax rate. D) real interest rate. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 13 Copyright © 2015 Pearson Education, Inc. 53) The credit supply curve is: A) vertical. B) horizontal. C) upward sloping. D) downward sloping. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 54) Assuming all else equal, the slope of the credit supply curve implies that: A) as the inflation rate decreases, the quantity of credit supplied increases. B) as the inflation rate increases, the quantity of credit supplied increases. C) as the real interest rate increases, the quantity of credit supplied increases. D) as the real interest rate decreases, the quantity of credit supplied increases. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 55) Assuming all else equal, an increase in the real interest rate will cause: A) a leftward shift of the credit supply curve. B) a rightward shift of the credit supply curve. C) an upward movement along the credit supply curve. D) a downward movement along the credit supply curve. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 56) Assuming all else equal, a decrease in the real interest rate will cause: A) the credit supply curve to shift to the left. B) the credit supply curve to shift to the right. C) an upward movement along the credit supply curve. D) a downward movement along the credit supply curve. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 14 Copyright © 2015 Pearson Education, Inc. 57) John makes it a point to save a portion of his salary every month. Assuming all else equal, if the real interest rate increases, it is likely to cause: A) an upward movement along John's credit supply curve. B) a downward movement along John's credit supply curve. C) John's credit supply curve to shift to the left. D) John's credit supply curve to shift to the right. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Supply Curve 58) Assuming all else equal, any change that causes an increase in the credit supply at a given real interest rate will cause: A) the credit supply curve to shift to the left. B) the credit supply curve to shift to the right. C) an upward movement along the credit supply curve. D) a downward movement along the credit supply curve. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 59) Assuming all else equal, any change that causes a decrease in the credit supply at a given real interest rate will cause: A) the credit supply curve to shift to the left. B) the credit supply curve to shift to the right. C) an upward movement along the credit supply curve. D) a downward movement along the credit supply curve. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 60) Assuming all else equal, if a household is pessimistic about future income, it is likely to cause a(n): A) downward movement along the current credit supply curve of the household. B) upward movement along the current credit supply curve of the household. C) shift in the current credit supply curve of the household to the right. D) shift in the current credit supply curve of the household to the left. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Supply Curve 15 Copyright © 2015 Pearson Education, Inc. 61) Assuming all else equal, if a household is optimistic about future income, it is likely to cause: A) a downward movement along the current credit supply curve of the household. B) an upward movement along the current credit supply curve of the household. C) the current credit supply curve of the household to shift to the right. D) the current credit supply curve of the household to shift to the left. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Supply Curve 62) An automobile manufacturer decides to increase its retained earnings. Assuming all else equal, this will cause: A) the current credit supply curve of the firm to shift to the left. B) the current credit supply curve of the firm to shift to the right. C) an upward movement along the current credit supply curve of the firm. D) a downward movement along the current credit supply curve of the firm. Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Supply Curve 63) Assuming all else equal, if a firm decides to pay more dividends and lowers the amount of retained earnings it holds, it will cause: A) the current credit supply curve of the firm to shift to the left. B) the current credit supply curve of the firm to shift to the right. C) an upward movement along the current credit supply curve of the firm. D) a downward movement along the current credit supply curve of the firm. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Supply Curve 64) The market where borrowers obtain funds from savers is referred to as the: A) spot market. B) credit market. C) capital market. D) exchange market. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 16 Copyright © 2015 Pearson Education, Inc. 65) The loanable funds market is also referred to as the: A) spot market. B) credit market. C) capital market. D) exchange market. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 66) At the equilibrium rate of interest: A) the quantity of credit demanded is zero. B) the quantity of credit supplied is zero. C) the quantity of credit demanded equals the quantity of credit supplied. D) the quantity of credit demanded falls short of the quantity of credit supplied. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 67) If the real interest rate is greater than the equilibrium real interest rate: A) interest rates tend to rise further. B) the quantity of credit demanded equals the quantity of credit supplied. C) the quantity of credit demanded falls short of the quantity of credit supplied. D) the quantity of credit supplied falls short of the quantity of credit demanded. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 68) If the real interest rate is lower than the equilibrium real interest rate: A) interest rates tend to fall further. B) the quantity of credit demanded equals the quantity of credit supplied. C) the quantity of credit demanded falls short of the quantity of credit supplied. D) the quantity of credit supplied falls short of the quantity of credit demanded. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 17 Copyright © 2015 Pearson Education, Inc. 69) If the quantity of credit demanded in a market exceeds the quantity of credit supplied in the market: A) the real rate of interest tends to fall. B) the real rate of interest tends to rise. C) the rate of inflation tends to rise. D) the unemployment rate tends to fall. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 70) If the quantity of credit supplied in a market exceeds the quantity of credit demanded in the market: A) the real rate of interest tends to fall. B) the real rate of interest tends to rise. C) the unemployment rate tends to rise. D) the rate of inflation tends to fall. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 71) Which of the following statements is true? A) An excess supply of credit exerts an upward pressure on the real rate of interest. B) An excess demand for credit exerts an upward pressure on the real rate of interest. C) At rates of interest below the equilibrium rate, there is an excess supply of credit. D) At rates of interest above the equilibrium rate, there is an excess demand for credit. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 18 Copyright © 2015 Pearson Education, Inc. The following figure shows two credit demand curves, CD1 and CD2, and two credit supply curves, CS1 and CS2. 72) Refer to the figure above. What is the equilibrium rate of interest when the credit demand curve is CD1 and the credit supply curve is CS1? A) 2% B) 3% C) 4% D) 5% Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 73) Refer to the figure above. What is the equilibrium quantity of credit when the credit demand curve is CD1 and the credit supply curve is CS1? A) $20 B) $30 C) $40 D) $50 Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 19 Copyright © 2015 Pearson Education, Inc. 74) Refer to the figure above. What is the equilibrium rate of interest when the credit demand curve is CD2 and the credit supply curve is CS1? A) 2% B) 3% C) 4% D) 5% Answer: D Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 75) Refer to the figure above. What is the equilibrium quantity of credit when the credit demand curve is CD2 and the credit supply curve is CS1? A) $20 B) $30 C) $40 D) $50 Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 76) Refer to the figure above. Which of the following statements is true when the credit demand curve is CD1 and the credit supply curve is CS1? A) At all rates of interest above 1% there will be an excess supply of credit. B) At all rates of interest above 2% there will be an excess supply of credit. C) At all rates of interest above 3% there will be an excess supply of credit. D) At all rates of interest above 4% there will be an excess supply of credit. Answer: D Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 77) Refer to the figure above. Which of the following statements is true when the credit demand curve is CD1 and the credit supply curve is CS1? A) At all rates of interest above 1% there will be a tendency for real interest rates to fall. B) At all rates of interest above 2% there will be a tendency for real interest rates to fall. C) At all rates of interest above 3% there will be a tendency for real interest rates to fall. D) At all rates of interest above 4% there will be a tendency for real interest rates to fall. Answer: D Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 20 Copyright © 2015 Pearson Education, Inc. 78) Refer to the figure above. Which of the following statements is true when the credit demand curve is CD2 and the credit supply curve is CS1? A) At all rates of interest below 5% there will be an excess demand for credit. B) At all rates of interest below 6% there will be an excess demand for credit. C) At all rates of interest below 7% there will be an excess demand for credit. D) At all rates of interest below 8% there will be an excess demand for credit. Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 79) Refer to the figure above. Which of the following statements is true when the credit demand curve is CD2 and the credit supply curve is CS1? A) At all rates of interest below 5% there will be a tendency for the interest rate to rise. B) At all rates of interest below 6% there will be a tendency for the interest rate to rise. C) At all rates of interest below 7% there will be a tendency for the interest rate to rise. D) At all rates of interest below 8% there will be a tendency for the interest rate to rise. Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 80) Everything else remaining unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit demand curve shifts to the right? A) Both equilibrium rate of interest and quantity of credit will increase. B) Both equilibrium rate of interest and quantity of credit will decrease. C) The equilibrium rate of interest will increase and the quantity of credit will decrease. D) The equilibrium rate of interest will decrease and the quantity of credit will increase. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 81) Everything else remaining unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit demand curve shifts to the left? A) Both equilibrium rate of interest and quantity of credit will increase. B) Both equilibrium rate of interest and quantity of credit will decrease. C) The equilibrium rate of interest will increase and the quantity of credit will decrease. D) The equilibrium rate of interest will decrease and the quantity of credit will increase. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 21 Copyright © 2015 Pearson Education, Inc. 82) Everything else remaining unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit supply curve shifts to the left? A) Both equilibrium rate of interest and quantity of credit will increase. B) Both equilibrium rate of interest and quantity of credit will decrease. C) The equilibrium rate of interest will increase and the quantity of credit will decrease. D) The equilibrium rate of interest will decrease and the quantity of credit will increase. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 83) Everything else remaining unchanged, what is likely to happen to the equilibrium real interest rate and quantity of credit if the credit supply curve shifts to the right? A) Both equilibrium rate of interest and quantity of credit will increase. B) Both equilibrium rate of interest and quantity of credit will decrease. C) The equilibrium rate of interest will increase and the quantity of credit will decrease. D) The equilibrium rate of interest will decrease and the quantity of credit will increase. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 84) What is meant by the term "rate of interest"? If the nominal rate of interest in an economy is 6%, and the rate of inflation in the economy is 4%, what is the real rate of interest in the economy? Answer: The rate of interest is the additional payment a borrower has to make on a one-dollar loan typically at the end of a year. The real rate of interest = nominal rate of interest - inflation rate → the real rate of interest = 6% - 4% = 2%. Difficulty: Easy AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans; Real and Nominal Interest Rates 85) What does the slope of the credit demand curve imply? When do movements along a credit demand curve occur? Answer: The slope of the credit demand curve is negative and it implies an inverse relationship between the real rate of interest and the quantity of credit demanded. This means that as the real interest rate increases, the quantity of credit demanded decreases. Movements along a credit demand curve occur when, everything else remaining unchanged, there is a change in the real interest rate. Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Demand Curve 22 Copyright © 2015 Pearson Education, Inc. 86) Everything else remaining unchanged, what is likely to happen to the credit demand curve of a software producing firm if: a. there is an increase in the real interest rate? b. they plan to expand production in near future? Answer: a. If there is an increase in the real interest rate, there will be an upward movement along the credit demand curve of the software manufacturer. b. If they plan to expand production in near future, the credit demand curve of the software firm is likely to shift to the right. Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve 87) List four reasons why people save. Answer: a. First, and foremost, people save for consumption after retirement. b. People save to cope with possible emergencies or shortages of funds in the future. c. People save to buy durable goods. d. People save so that they can invest in a personal business. Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Why Do People Save? 88) What does the slope of the credit supply curve imply? When do movements along a credit supply curve occur? Answer: The credit supply curve has a positive slope that implies a positive relationship between the real interest rate and the quantity of credit supplied. This means that as the real interest rate increases, the quantity of credit supplied increases. Movements along a credit supply curve occur when there are changes in the real interest rate, everything else remaining unchanged. Difficulty: Easy AACSB: Analytical Thinking Topic: The Credit Supply Curve 89) Everything else remaining unchanged, what is likely to happen to the credit supply curve of households if: a. there is a decrease in the real interest rate? b. households expect a recession in near future? Answer: a. Everything else remaining unchanged, if there is a decrease in the real interest rate, there will be a downward movement along the credit supply curve of households. b. Everything else remaining unchanged, if households expect a recession in near future, they will tend to save more today. This will cause the credit supply curve of households to shift to the right. Difficulty: Medium AACSB: Analytical Thinking Topic: The Credit Supply Curve 23 Copyright © 2015 Pearson Education, Inc. 90) What is the loanable funds market? What happens if the real interest rate in the market is held above the equilibrium interest rate? Answer: The loanable funds market is the market where borrowers obtain funds from savers. In such a market, if the real interest rate is held above the equilibrium interest rate, the quantity of credit supplied will exceed the quantity of credit demanded. This will create a downward pressure on the real interest rate. Difficulty: Easy AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 91) Everything else remaining unchanged, what is likely to happen to the equilibrium quantity of credit and the real interest rate if: a. the credit demand curve shifts to the right? b. the credit supply curve shifts to the left? Answer: a. Everything else remaining unchanged, if the credit demand curve shifts to the right, there will be an increase in both the equilibrium quantity of credit and the real interest rate. b. Everything else remaining unchanged, if the credit supply curve shifts to the left, there will be an increase in the equilibrium real interest rate but a decrease in the equilibrium quantity of credit. Difficulty: Medium AACSB: Analytical Thinking Topic: Equilibrium in the Credit Market 92) An individual plans to borrow a sum of $10,000 for one year. The nominal interest charged on the borrowed sum is 6%. a. If he takes the loan, what will be the interest amount and the total amount that he would have to pay at the end of the year? b. If the rate of inflation in the economy is 10%, then is it a good idea for him to take the loan? Why or why not? Answer: a. If the individual takes the loan, he will have to pay a rate of interest of 6% for the year. Hence, interest amount = .06 × 10,000 = $600. Total amount that he would have to pay back = $10,000 + $600 = $10,600. b. A rational individual should make his borrowing decisions on the basis of the real interest rate and not the nominal interest rate. Annual real interest rate in this case = 6% - 10% = -4%. Hence, for every $100 that he borrows, after adjusting for inflation, he is actually paying back $96 after the end of the year. Hence, borrowing at an annual nominal interest rate of 6% when the annual rate of inflation is 10% is a good idea, and he should take the loan. Difficulty: Medium AACSB: Application of Knowledge Topic: Borrowers and the Demand for Loans; Real and Nominal Interest Rates 24 Copyright © 2015 Pearson Education, Inc. 93) a. Everything else remaining unchanged, what is likely to happen to the credit demand curve of an economy if: i. businesses in the economy see scope for growth and are planning to expand production in the future? ii. households are pessimistic about future incomes? iii. the government is planning to borrow money from financial institutions for investment in infrastructures? b. Everything else remaining unchanged, what is likely to happen to the credit supply curve of an economy if firms tend to hold on to retained earnings instead of paying dividends? Answer: a. i. If businesses in the economy see scope for growth and are planning to expand production in the future, the credit demand curve of the economy is likely to shift to the right. ii. If households are pessimistic about future incomes, they are unlikely to borrow more today as they may not be able to repay the loans in the future. This shifts the credit demand curve of the economy to the left. iii. If the government is planning to borrow money from financial institutions to invest in infrastructures, the credit demand curve of the economy is likely to shift to the right. b. If businesses hold on to retained earnings instead of paying dividends, they generate savings. This shifts the credit supply curve to the right. Difficulty: Medium AACSB: Application of Knowledge Topic: The Credit Demand Curve; The Credit Supply Curve 25 Copyright © 2015 Pearson Education, Inc. 94) Illustrate graphically how the equilibrium quantity of credit and real rate of interest will change from an initial equilibrium if: a. credit demand decreases at the initial equilibrium rate of interest. b. credit supply curve increases at the initial equilibrium rate of interest. Answer: The equilibrium in the credit market is determined by the intersection of the credit demand curve and the credit supply curve. This is illustrated in the figure below: In the figure, CD1 is the credit demand curve and CS1 is the credit supply curve. The intersection of these two curves determines the equilibrium real interest rate at I1 and the equilibrium quantity of credit at C1. a. If credit demand decreases, the credit demand curve shifts to the left. The equilibrium real interest rate and the equilibrium level of credit will decrease. This is illustrated in the figure below: 26 Copyright © 2015 Pearson Education, Inc. After the credit demand curve shifts to the left to CD2, its intersection with CS1 will determine the equilibrium real interest rate and the equilibrium quantity of credit. The new equilibrium real interest rate is I2 and equilibrium quantity of credit is C2. It can be inferred from the figure that I2 < I1 and C2 < C1. b. If credit supply increases, the credit supply curve shifts to the right. The equilibrium real interest rate will decrease and the equilibrium quantity of credit will increase. This is illustrated in the figure below: After the credit supply curve shifts to the right to CS2, its intersection with CD1 will determine the equilibrium real interest rate and the equilibrium quantity of credit. The new equilibrium real interest rate is I2 and equilibrium quantity of credit is C2. It can be inferred from the figure that I2 < I1 and C2 > C1. Difficulty: Hard AACSB: Application of Knowledge Topic: Equilibrium in the Credit Market 10.2 Banks and Financial Intermediation: Putting Supply and Demand Together 1) Institutions that channel funds from suppliers of financial capital to users of financial capital are referred to as: A) central banks. B) mutual funds. C) financial intermediaries. D) deposit insurance committees. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Banks and Financial Intermediation: Putting Supply and Demand Together 27 Copyright © 2015 Pearson Education, Inc. 2) Companies that enable investors to use their savings to buy financial securities are referred to as: A) banks. B) hedge fund companies. C) private equity funds. D) asset management companies. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Banks are Only One of Many Types of Financial Intermediaries 3) Investment pools gathered from a small number of very wealthy individuals or institutions are referred to as: A) hedge funds. B) fixed deposits. C) capital investment. D) institutional savings. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Banks are Only One of Many Types of Financial Intermediaries 4) Which of these financial intermediaries is most likely to invest in new companies that are just starting up and have no track record? A) Hedge funds B) Private equity funds C) Venture capital funds D) Asset management companies Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Banks are Only One of Many Types of Financial Intermediaries 5) Investments that a bank makes are known as: A) liabilities. B) assets. C) deposits. D) capital. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 28 Copyright © 2015 Pearson Education, Inc. 6) Claims that economic agents have against banks are known as: A) liabilities. B) assets. C) deposits. D) capital. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 7) Which of the following statements is true? A) If a firm deposits a sum of $500 in a bank, the sum is a part of the bank's assets. B) If a firm deposits a sum of $500 in a bank, the sum is a part of the bank's liability. C) If a bank lends a sum of $600 to a firm, the sum is a part of the bank's liability. D) If a bank lends a sum of $200 to a household, the sum is a part of the bank's liability. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Assets and Liabilities on the Balance Sheet of a Bank 8) The statement of assets and liabilities of an entity is referred to as: A) a balance sheet. B) the balance of payments. C) an asset-liability sheet. D) a profit and loss statement. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 9) In the United States, bank reserves include: A) vault cash and the currency held by the public. B) vault cash and the bank's holdings on deposit at the Federal Reserve Bank. C) currency held by the public and bank's holdings on deposit at the Federal Reserve Bank. D) vault cash, currency held by the public and bank's holdings on deposit at the Federal Reserve Bank. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 29 Copyright © 2015 Pearson Education, Inc. 10) Cash equivalents are: A) a part of a bank's liability. B) riskless, liquid assets that banks can immediately access. C) the amount of deposits held by the public in a particular bank. D) assets that do not attract interest, and hence generate no additional revenue. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 11) An asset is said to be riskless if: A) it offers a positive rate of interest. B) it can be easily converted into cash. C) its value does not change from day to day. D) its value is more likely to fall in future. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 12) An asset is liquid if: A) it offers a positive rate of interest. B) its value does not change from day to day. C) it can be easily converted into cash without loss of value. D) its value is more likely to increase in future. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 13) Suppose Bank A holds $50,000 in deposits with other banks. In the balance sheet, this amount will be accounted as Bank A's: A) reserves. B) cash equivalents. C) long-term investments. D) short-term borrowing. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 30 Copyright © 2015 Pearson Education, Inc. 14) The value of the real estate that a bank uses for its operations will be included in the bank's: A) reserves. B) cash equivalents. C) long-term investments. D) short-term borrowing. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 15) Which of the following is NOT an asset of a bank? A) Official bank reserves B) Stockholders' equity C) Cash equivalents of the bank D) Long-term investments made by the bank Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 16) Deposit made by the public into a savings account are referred to as: A) overdraft. B) demand deposits. C) current deposits. D) stockholders' equity. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 17) Demand deposits are termed so because: A) depositors can demand any rate of interest on such deposits. B) most consumers want to open such accounts as they are greatly in demand. C) depositors can withdraw money from such deposits at any point of time. D) there are no limitations on the amount of money that can be deposited into such accounts. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 31 Copyright © 2015 Pearson Education, Inc. 18) Borrowed funds that are to be repaid in a year or more are referred to as: A) annual debt. B) long-term debt. C) loanable funds. D) stockholders' equity. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 19) If a bank borrows funds for three years, the borrowing will be classified as: A) long-term debt. B) demand deposits. C) stockholders' equity. D) short-term borrowing. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 20) The difference between a bank's assets and liabilities is referred to as: A) net profits. B) gross profits. C) retained earnings. D) stockholders' equity. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 21) Which of the following equations is correct? A) Stockholders' equity + total liabilities = total assets. B) Stockholders' equity/total liabilities = total assets. C) Stockholders' equity × total liabilities = total assets. D) Stockholders' equity - total liabilities = total assets. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 32 Copyright © 2015 Pearson Education, Inc. 22) If the total assets of a bank equals $50,000 and the total liabilities of the bank equal $20,000, stockholders' equity will equal: A) $20,000. B) $30,000. C) $50,000. D) $70,000. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Banks and Financial Intermediation: Putting Supply and Demand Together 23) If the stockholders' equity of a bank is $30,000 and the total liabilities of the bank is $10,000, the total assets of the bank will equal: A) $10,000. B) $20,000. C) $30,000. D) $40,000. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 24) Which of the following will NOT be included in a bank's liability? A) Cash equivalents of the bank B) Long-term debt of the bank C) Short-term borrowing by the bank D) Demand deposits held with the bank Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 25) Differentiate between asset management companies and venture capital funds. Answer: Asset management companies enable investors to use their savings to buy financial securities like stocks and bonds. On the other hand, venture capital funds are a particular kind of private equity fund that invest in new companies that are just starting up and therefore have no track record. Difficulty: Easy AACSB: Analytical Thinking Topic: Banks and Financial Intermediation: Putting Supply and Demand Together 33 Copyright © 2015 Pearson Education, Inc. 26) List the various categories in which a bank's assets are divided? Answer: A bank's assets are divided into: a. bank reserves: These include vault cash and its holdings on deposit at the central bank of the country. b. cash-equivalents: These are riskless, liquid assets that the bank can immediately access, like deposits with other banks. c. long-term investments: These are mostly comprised of loans to households and firms, but also include things like the value of the real estate that the bank uses for its operations. Difficulty: Medium AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 27) List the various categories into which a bank's liabilities are divided? Answer: A bank's liabilities are divided into the following. a. Demand deposits: These are funds loaned to the bank by depositors. b. Short-term borrowing: This is comprised of short-term loans that a bank has obtained from other financial institutions c. Long-term debt: This is defined as debt that is to be repaid in a year or more. d. Stockholders' equity: This is defined as the difference between a bank's total assets and liabilities. Difficulty: Medium AACSB: Analytical Thinking Topic: Assets and Liabilities on the Balance Sheet of a Bank 34 Copyright © 2015 Pearson Education, Inc. 28) The following table shows different statistics related to the Bank of Barylia. From the information in the table, estimate: a. Total assets of the bank b. Total liabilities of the bank c. Stockholders' equity of the bank Answer: a. Total assets of the bank = Reserves + cash equivalents + long-term investments = $(400 + 450 + 1,000) million = $1,850 million b. Total liabilities of the bank = Demand deposits + long-term debt + short-term borrowing = $(800 + 300 + 375) million = $1,475 million c. Stockholders' equity = Total assets - Total liabilities = $(1,850 - 1,475) million = $375 million Difficulty: Hard AACSB: Application of Knowledge Topic: Assets and Liabilities on the Balance Sheet of a Bank 10.3 What Banks Do 1) ________ refers to the time until debt must be repaid. A) Principal B) Maturity C) Dividend D) Time value of money Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Maturity Transformation 35 Copyright © 2015 Pearson Education, Inc. 2) Demand deposits have a ________ maturity. A) 0-year B) 1-year C) 2-year D) 3-year Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Maturity Transformation 3) The transfer of short-term liabilities into long-term investments is called: A) risk transformation. B) maturity transformation. C) investment restructuring. D) intertemporal transformation. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Maturity Transformation 4) One of the risks of maturity transformation is that: A) it discourages savings. B) it can lead to bank runs. C) it can increase the rate of inflation. D) it reduces the profitability of banks. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Maturity Transformation 5) As long as a bank's stockholders' equity is greater than zero: A) bank runs are not possible. B) the bank bears all the risk involved. C) the customers of the bank bear all the risk involved. D) the stockholders in the bank bear all the risk involved. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Management of Risk 36 Copyright © 2015 Pearson Education, Inc. 6) Normally, the Federal Deposit Insurance Corporation would shut down a bank when: A) stockholders' equity is greater than zero. B) assets of the bank exceed the liabilities of the bank. C) liabilities of the bank exceed the assets of the bank. D) assets of the bank equal the liabilities of the bank. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Management of Risk 7) Which of the following is a role of the Federal Deposit Insurance Corporation in the United States? A) It monitors the money supply. B) It controls the real rate of interest. C) It regulates banks that are insolvent. D) It determines the monetary policy of the country. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Management of Risk 8) Which of the following is a role of the Federal Deposit Insurance Corporation in the United States? A) It monitors the money supply. B) It controls the real rate of interest. C) It safeguards deposits held with banks. D) It determines the monetary policy of the country. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Management of Risk 9) One of the impacts of maturity transformation is that: A) it increases the rate of inflation. B) it decreases the rate of inflation. C) relatively liquid assets become relatively illiquid. D) relatively illiquid assets become relatively liquid. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Runs 37 Copyright © 2015 Pearson Education, Inc. 10) A bank is insolvent when: A) its total assets exceed its total liabilities. B) its total liabilities exceed its total assets. C) its stockholders' equity exceeds its total assets. D) its stockholders' equity exceeds its total liabilities. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Runs 11) A bank is solvent when: A) the value of its total assets exceeds the value of its liabilities. B) the value of its liabilities exceeds the value of its assets. C) its stockholders' equity exceeds the value of its assets. D) the value of its liabilities exceeds its stockholders' equity. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Runs 12) Consider two banks: Bank A and Bank B. Suppose the value of liabilities of both the banks is equal. However, Bank A is solvent but Bank B is insolvent. This would imply that: A) the value of Bank A's assets exceeds the value of Bank B's assets. B) the value of Bank B's assets exceeds the value of Bank A's assets. C) the value of Bank A's liabilities exceeds the value of Bank A's assets. D) the value of Bank B's assets exceeds the value of Bank B's liabilities. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: Bank Runs 13) A bank run occurs when: A) a bank's assets exceeds its liabilities. B) a bank sells its assets to its own stockholders. C) the central monetary authority regulates the functioning of banks. D) a bank experiences an extraordinarily large volume of withdrawals. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Runs 38 Copyright © 2015 Pearson Education, Inc. 14) An institutional bank run is most likely to occur when: A) households deposit their money into a weak bank. B) households withdraw their money from a weak bank. C) firms and other banks withdraw money from a weak bank. D) firms and other banks deposit their money into a weak bank. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Regulation and Bank Solvency 15) A well-capitalized bank: A) owns far more than it owes. B) does not have stockholders' equity. C) is prone to bank runs. D) only accepts deposits but does not advance loans. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Regulation and Bank Solvency 16) Systemically important financial institutions are: A) all banks whose value of assets exceeds its value of liabilities. B) all banks whose value of liabilities exceeds its value of assets. C) large banks that have become a large market power. D) banks that are owned and run by the government. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Too Big to Fail 17) In the case of banks, "living wills" spell out: A) the amount of bank resources to be retained as stockholders' equity. B) the balance sheet of systemically important financial institutions. C) how a bank would sell its assets and pay of its creditors in the event of shutdown. D) the long term business development plans of systematically important financial institutions. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Too Big to Fail 39 Copyright © 2015 Pearson Education, Inc. 18) Which of the following statements is true of the U.S. economy? A) No bank runs have occurred after 1990 in the U.S. economy. B) No bank runs have occurred before 1990 in the U.S. economy. C) Almost one-fourth of the U.S. banks failed during the Great Depression. D) The number of bank runs decreased after the FDIC was established. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Evidence-Based Economics: How Often Do Banks Fail? 19) The biggest wave of bank failures in the U.S. occurred: A) before the Great Depression. B) during the Great Depression. C) in the early 1990s. D) during 2007 to 2009. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Evidence-Based Economics: How Often Do Banks Fail? 20) The most established theory of stock prices relates a company's asset prices to: A) the future value of inflation and interest rates. B) past earnings of companies and past values of interest rates. C) future earning prospects of companies and future values of interest rates. D) future earning prospects of companies and future values of inflation rates. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Asset Price Fluctuations and Bank Failures 21) The theory of efficient markets suggests that: A) interest rates and inflation rates are inversely related. B) systemically important financial institutions are more likely to fail. C) all movements in stock markets are based on rational appraisals of new information. D) long-term investments by banks are more profitable than short-term investments. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Asset Price Fluctuations and Bank Failures 40 Copyright © 2015 Pearson Education, Inc. 22) What are the three functions that banks perform as financial intermediaries? Answer: The three functions that banks perform as financial intermediaries are: a. Banks identify good investment options. b. Banks transform short-term liabilities like deposits, into long-term investments. c. Banks transfer risk from depositors to the bank's stockholders and, in some cases, to the government. Difficulty: Easy AACSB: Analytical Thinking Topic: What Banks Do 23) In banking terminology, what is meant by maturity? What is meant by maturity transformation? Answer: In banking terminology, maturity refers to the time until debt must be repaid. Maturity transformation is a process by which banks take short-maturity liabilities and invest in longmaturity assets. Difficulty: Easy AACSB: Analytical Thinking Topic: Maturity Transformation 24) Differentiate between a solvent bank and an insolvent bank. Which of the two is likely to have a greater stockholders' equity? Answer: A bank is solvent when the value of the bank's assets is greater than the value of its liabilities. A bank becomes insolvent when the value of the bank's assets is less than the value of its liabilities. Since stockholders' equity is defined as total assets of a bank less the total liabilities, a solvent bank is likely to have a greater stockholders' equity than an insolvent bank. Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Runs 41 Copyright © 2015 Pearson Education, Inc. 25) The Bank of Lithasia plans to increase its revenue by using demand deposits held with the bank for long-term investments. What is this process known as? Is there any risk associated with this process? If yes, how can the risk be reduced? Answer: The process that Bank of Lithasia is planning to apply is known as maturity transformation. Maturity refers to the time until debt must be repaid. Maturity transformation refers to the process by which banks take short-term liabilities and invest in long-term assets. This process allows society to undertake long-term investments. One of the implications of such maturity transformations is that it creates a mismatch between the short-term maturities of deposits held with the bank and the long-term maturities of the investment made by the banks. Hence, if a large number of depositors simultaneously want to withdraw money from the bank, it can create a problem for the bank, as they may not have enough funds to allow for the withdrawal. Moreover, it is not possible for banks to recover the money they have used for long-term investments in such a short notice to repay the depositors. Hence, maturity transformations can place banks in a risky position. One possible method for banks to minimize the risks associated with maturity transformations is to maintain some fraction of the deposit pool as reserves or some other form of cash-like security. A small reserve usually suffices because only a small fraction of depositors are likely to withdraw their deposits on the same day. Difficulty: Hard AACSB: Application of Knowledge Topic: What Banks Do 26) Consider two banks: Bank A and Bank B. Bank A has total assets worth $50,000 and total liabilities worth $24,000. Conversely, Bank B has total assets worth $100,000 and total liabilities worth $90,000. Given this information, which of the two banks is more prone to bank runs and why? Answer: A bank run occurs when a bank experiences extraordinarily large volumes of withdrawals driven by a concern that the bank will run out of liquid assets with which to pay its depositors. This implies that bank runs are more likely to occur when depositors do not have much confidence on the solvency of a bank. Hence, one of the key methods to prevent such bank runs is to have lots of stockholders' equity and be well-capitalized. A bank is said to be wellcapitalized if it owns far more than what it owes. From the given information, the stockholders' equity for both banks can be calculated. Bank A's stockholders' equity = $50,000 - $24,000 = $26,000. Bank B's stockholders' equity = $100,000 - $90,000 = $10,000. The stockholders' equity implies that bank A owns more than it owes, while bank B owes more than it owns. Hence, bank B is more prone to bank runs than bank A. Difficulty: Medium AACSB: Application of Knowledge Topic: Bank Regulation and Bank Solvency 42 Copyright © 2015 Pearson Education, Inc.