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Banking Problem #4 Answers (
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Select the Banking module from the SimEcon® menu. Perform experiments with
this module to test your responses to the questions below. Suppose that the Federal
Reserve Bank of the United States policy is to tighten the money supply. What does
that mean the Fed wants to do to the money supply? Explain. Other things being
equal, what impact will this policy have on interest rates? Explain.
If the Federal Reserve wants to tighten the money supply, this means that it is pursuing
policies to reduce the money supply. Since commercial banks will have less available to
lend, borrowers will have to compete for the more limited amount of funds. Banks can
charge higher interest rates on their loans because the competition for these limited funds
is so keen. Market interest rates will rise in this situation.
What is the required reserve ratio? For a tight money policy would the Federal
Reserve choose to increase or decrease the required reserve ratio? Explain why.
The required reserve ratio is the percentage of deposits that a commercial bank must hold
in reserve. Funds held in reserve may not be loaned out or otherwise invested. If the
required reserve ratio is increased, banks won’t be able to lend out as much because they
will have to hold a larger portion of their deposits as reserve. Lending by banks creates
money so an increase in the required reserve ratio will cause the money supply to
contract. This is a tightening of the money supply.
As a result of this action, other things being equal, do all banks enjoy higher profits,
lower profits, or losses? What is the difference between a high-risk bank and a lowrisk bank? Explain. How does the impact on profits/losses differ between a highrisk bank and a low-risk bank as a result of the given change in the required reserve
ratio? Explain.
A high-risk bank is a bank that invests a major portion of its assets in long-term fixedinterest instruments. If interest rates go up, then the high-risk bank will be stuck with its
fixed-interest instruments that now earn a lower interest rate than can be earned in the
market. That is why these fixed interest instruments will have a lower market value.
Moreover, the bank will pay out high market interest rates to its depositors and will earn
a lower interest rate on its long term fixed-interest investments. (They are locked in at
the previously lower rate). The increase in costs relative to revenue plus the capital
losses on long term fixed rate assets means that a high-risk bank will suffer
comparatively large losses if market interest rates go up. On the other hand, a low-risk
bank keeps a relatively larger portion of its assets in short-term and variable interest
instruments. Both types of banks suffer capital losses when interest rates go up, but
compared to a high-risk bank a low-risk bank suffers smaller losses. A low-risk bank
invests in variable interest rate instruments. Interest rates on these assets automatically
adjust to changes in the market. A low-risk bank will have some long term fixed-interest
instruments, but since these are a smaller proportion of the total, the amount of gain or
loss that might result is comparatively small. This type of bank also has some short term
fixed investments, but these do not change much in market value even when interest rates
changed (because they will be paid off so soon).
What is the discount rate? For a tight money policy, would the Federal Reserve
choose to increase or decrease the discount rate? Explain.
There are occasions when a commercial bank will less in reserves than it is required to
have. In that case, the commercial bank can ask to borrow from the Federal Reserve in
order to increase its reserves to the required amount. When commercial banks borrow
from the Federal Reserve in this manner, they must pay interest on these loans. That
interest rate is called the discount rate. {The FED does not have to lend if it does not
want to, and a bank in this situation has the alternative of borrowing from other banks
instead.)
To tighten money policy, the Federal Reserve could increase the discount rate. When the
Federal Reserve increases the discount rate, borrowing from the Federal Reserve
becomes more expensive. Commercial banks are therefore more careful to maintain the
required reserves so that they don’t have to pay this rate. As a result, lending by these
commercial banks goes down, and the money supply contracts.
As a result of this action, other things being equal, do all banks enjoy higher profits,
lower profits, or losses? How does the impact on profits/losses differ between a
high-risk bank and a low-risk bank as a result of the given change in the discount
rate? Explain.
As stated before, high-risk banks suffer more when the market interest rate goes up,
because a much larger portion of their investments are locked in long-term, fixed-interest
instruments. Suppose that you have a ten-year bond with a fixed annual interest of 5%.
If the market interest rate then goes up to 10%, no one will want to buy your bond
because they know that they can get 10% interest elsewhere. Thus, in order to sell your
bond, you will have to offer a lower selling price for the bond. The same thing happens
to high-risk banks when the market interest rate goes up. A longer term of maturity of
this type of bond means a stiffer loss, because on longer-term bonds, you will have to
offer an even lower price to get someone to buy the bond.
Low-risk banks invest more in variable interest rate instruments, whose interest rates go
up and down with the market. Low-risk banks also have some short term fixed-interest
instruments, but the loss is comparatively smaller since they can be held till they mature
(are paid off). These banks hold some long term fixed assets, but a smaller proportion of
these and therefore they get smaller losses.
What are open market operations? To tighten money policy, would the Federal
Reserve buy or sell bonds on the open market? Explain.
Open market operations involve the Federal Reserve buying or selling bonds on the open
market. If the Federal Reserve wanted a tighter money policy, it would sell bonds on the
open market. When the Federal Reserve sells bonds on the open market, commercial
banks and other organizations must give the Federal Reserve money to pay for the bonds.
The Federal Reserve will take this money that is obtained from the sale of bonds
ultimately takes those funds out of bank reserves. Since commercial banks now have
smaller reserves, they can make fewer loans and borrowers have to compete for the
limited amount of funds. This is a reduced money supply, a tight money policy.
As a result of this action, other things being equal, do the banks enjoy higher
profits, lower profits, or losses? How does the impact on profits/losses differ
between a high-risk bank and a low-risk bank as a result of the open market
operations? Explain.
Any time interest rates rise, banks suffer capital losses. However, the losses for high-risk
banks will be much higher for reasons already discussed..
If you were the CEO of a private bank, and you strongly believed that the Federal
Reserve Bank was going to pursue a tight money policy in the future, which of the
following would be wiser: to operate as a high-risk bank or to operate as a low-risk
bank? Explain.
If I know that the Federal Reserve is going to pursue a tight money policy in the future,
then I know that, other things being equal, the money supply will contract and market
interest rates will rise. At the present time, I would want to hold variable-interest rates
because they automatically adjust with changes in the market. If I held a lot of long-term
fixed-interest investments, I would be stuck with the current lower market rats and would
have capital losses when interest rates rise in the future. Thus, my strategy would be to
hold variable-interest and very short-term fixed interest instruments. This is the strategy
of a low-risk bank.