Final Revision

Money & Banking

Question 1: Define the following terms:

1- Banks:Banks are financial institutions that accept deposits and make loans.

2- Financial Markets:Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.

3- Monetary theory:The theory that relates the change in the quantity of money to changes in aggregate economic activity & the price level.

4- Inflation:Is the continuous increase in the price level of goods & services in an economy.

5- Interest rate:Is the cost of borrowing (or the return from lending.

6- Current account:

A current account is an account in which money or checks can be taken out or payments can be made at any time.

7- Deposit accounts:

These earn an interest, since the customers are not expected to make frequent withdrawals, and should give notice in advance.

8- The balance sheet:

Is a statement of banks assets, liabilities , and net worth at a given point in time.

9- Reserves

Are either bank deposits held at the central bank, or currency that is physically held by banks

10- Required reserves : a certain fraction of deposits must be held as reserves by law

11- Excess reserves: used by a bank to meet obligations to depositors.

12- Adverse selection

Is the problem created by asymmetric information before the transaction occurs.

13- Moral hazard is a problem of asymmetric information occurring after a loan is made.

Example:

Suppose that John Brown has heard that the first National Bank provides excellent service, so he opens a checking account with 100 $

He now has a 100$ checkable deposit at the bank, which shows up as a 100$ liability on the bank’s balance sheet

The bank now puts his 100$ into its vault so that the bank’s assets rise by the 100$ increase in vault cash.

Assets liabilities

Reserves 100$ checkable deposits 100$

If john had opened his account with a 100$ check written on an account at another bank, say the second National Bank, we would get the same result. The initial effect on the T-account of the first National Bank as follows

Assets Liabilities

cash item in 100$ checkable deposits 100$

process of collection

The final balance sheet positions of two banks are as follows:

First National Bank

Assets Liabilities

Reserves 100$ checkable deposits 100$

second National Bank

Assets liabilities

Reserves - 100$ checkable deposits -100

The process can be summarized as follows: when a check written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount .

Example:

Suppose that the first National bank has the following balance sheet position, and the required reserve ratio on deposits is 20%

Assets Liabilities

Reserves 25 m Deposits 100 m

Loans 75 Bank capital 10

Securities 10

1) If the bank suffers a deposit outflow of 6 million, what will its balance sheet now look like?. Must the bank make any adjustment in its balance sheet? Why?

2) Suppose the bank now is hit by another 4 million deposits outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet? Why?

3) If the bank satisfies its reserve requirements by selling of securities, how much will it have to sell? Why?

4) After selling off the securities to meet its reserve requirement , what will its balance sheet look like?

5) If after selling off the securities the bank is now hit by another 10 million withdrawals of deposits, and it sells off all its securities to obtain reserves, what will its balance sheet look like?

6) If the bank is now unable to call in or sell any of its loans and no one is willing to lend funds to this bank, then what will happen to the bank and why?

Answer :

1) Assets Liabilities

Reserves 19 m deposits 94 m

loans 75 Bank capital 10

securities 10

The answer is no because the bank still satisfy its reserve requirement (94 * 20%)

2) Assets Liabilities

Reserves 15 m deposits 90 m

loans 75 Bank capital 10

securities 10

The answer is yes because the bank must make an adjustment to its balance sheet, because its required reserve are 18 million. It has a reserve deficiency of 3 million

3)That bank will have to sell 3 million . As the bank has a reserve shortfall of 3 million, which it can acquire by selling the 3 million of securities

4) Assets Liabilities

Reserves 18m deposits 90 m

loans 75 Bank capital 10

securities 7

5) Assets Liabilities

Reserves 15m deposits 80m

loans 75 Bank capital 10

securities 0

6- The bank could fail. The required reserves for the bank are 16 million (20% of 80 million) , but it has 15 million of reserve.

Example:

Suppose that you are the manager of a bank that has the following balance sheet; with a required reserve ratio of 10%.

Assets Liabilities

Reserves 20 m Deposits 100 m

Loans 80 Bank capital 10

Securities 10

1)If the bank suffers a deposit outflow of 10 m , what will its balance sheet? Why?

2) Let's assume that instead of initially holding 10m in excess reserves, the bank makes loans of 10m, so that it holds no excess reserves. What will its balance sheet position look like now?

3) Suppose the bank now is hit by another 10 m deposit outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet? Why?

Answer:

1) The required reserve = 10% * 100= 10m

The bank has excess reserves of 10m. when a deposit outflow of 10m occurs, the bank's balance sheet becomes.

Assets Liabilities

Reserves 10 m Deposits 90 m

Loans 80 Bank capital 10

Securities 10

The answer is no because the bank still satisfy its reserve requirement

2) The initial balance sheet would be:

Assets Liabilities

Reserves 10 m Deposits 100 m

Loans 90 Bank capital 10

Securities 10

3) When the bank suffers the 10 m deposits outflow, its balance sheet becomes:

Assets Liabilities

Reserves 0 m Deposits 90 m

Loans 90 Bank capital 10

Securities 10

To eliminate this shortfall, the bank has four basic options:

a)the first option is to sell some of its securities.

Assets Liabilities

Reserves 9 m Deposits 90 m

Loans 90 Bank capital 10

Securities 1

a) The second option is borrowing from other banks or borrowing from corporations

Assets Liabilities

Reserves 9 m Deposits 90 m

Loans 90 borrowing from

Securities 10 Other banks 9

Bank capital 10

c)the third option is borrowing from the central bank

Assets Liabilities

Reserves 9 m Deposits 90 m

Loans 90 discount loans

Securities 10 from the CB 9

Bank capital 10

d)Finally, reducing its loans by this amount

Assets Liabilities

Reserves 9 m Deposits 90 m

Loans 81 bank capital 10

Securities 10

When a deposit outflow occurs holding excess reserves allows the bank to escape the costs of:

1)borrowing from other banks or corporations

2)borrowing from the CB

3) selling securities

4)calling in or selling off loans.

Because excess reserves have a cost, banks also take other steps to protect themselves: for example, they might shift the holding of assets to more liquid securities (secondary Reserves)

Example:

Let ‘s consider two banks with identical balance sheets, except that the High Capital Bank has a ratio of capital to assets of 10%, while the Low Capital Bank has a ratio of 4%.

High capital Bank:

Assets Liabilities

Reserves 10m deposits 90 m

loans 90 Bank capital 10

Low capital Bank:

Assets Liabilities

Reserves 10m deposits 96m

loans 90 Bank capital 4

- The high capital bank has 100 million of assets, and 10 million of capital, which gives it an equity multiplier of 10 (100/10)

• The low capital bank has only 4 million of capital , so its equity multiplier is higher , equaling 25 (100/4)

• Suppose that these banks have been equally well run so that they both have the same return on assets 1%

• The return on equity for the high capital bank equals 1% * 10= 10% while

• The return on equity for the low capital bank equals 1%*25= 25%

We now see why owners of a bank may not want it to hold too much capital.

Question 3: Discuss

A- There are four players in the Money Supply Process. Explain.

Answer:

(1) The central Bank:

The government agency that oversees the banking system , and is responsible for the conduct of monetary policy.

(2) Banks (Depository Institutions):

The financial Intermediaries that accept deposits from individuals & institutions and make loans.

(3) Depositors:

Individuals and institutions that hold deposits in banks.

(4) Borrowers from banks:

Individuals and institutions that borrow from the depository Institutions , and institutions that issue bonds that are purchased by the Depository Institutions.

B-Examine the essential role of the central bank in an economy.

Answer:

(1) Lender of the last Resort:

the central bank is the provider of reserves to financial institutions. When no else would provide them in order to prevent a financial crisis.

(2) Government Banker:

- It is responsible for implementing government monetary policy , which aims at controlling the amount of money in circulation (to control the inflation rate)

- It has the important job of controlling foreign exchange

(3) A Banker’s Bank:

- The central bank holds deposits made by commercial banks, which appear in its balance sheet in the liability side( appear in the balance sheet of commercial banks in the asset side)

- Control of credit and cash available to the public

C- The central bank interferes in the market through specific tools. Elaborate

Answer:

Tools of Monetary Policy:

First: the three major tools of Monetary policy

(1) Open market operations

(2) Setting reserves requirements for commercial banks and other depository institutions

(3) Setting the level of the discount rate

(1) Open market operations:

• The central bank can directly affect the amount of bank reserves by buying or selling government securities ( stock, bonds) , in the open market where these securities are traded. Such transactions are called open market operations

• When the central bank conducts open market purchases, it buys government bonds and puts reserves into the banking system, causing an expansion of demand deposits and other checkable deposits, and hence an increase in the economy’s money supply

• When the central bank conducts open market sales , it sells government bonds and takes reserves out of the banking system, causing a contraction of demand deposits and other checkable deposits, and hence a decrease in the economy’s money supply

(2) Legal Reserves Requirements:

The central bank has the authority to set the required reserve ratios within limits.

(A) Increase in the legal Reserves Requirement

• Suppose that the central bank wants to tighten up the economy’s money supply, this means that the central bank wants to force the banks in the banking system to reduce their lending activity or their holdings of other earnings.

(B) Decrease in the legal Reserves Requirement

• If the central bank wants to increase the money supply, it can reduce the reserves requirement.

• In general, we can say that an increase in the required reserve ratio will force a money supply reduction. A decrease in the required reserve ratio increase the amount of excess reserves, encouraging banks to increase lending and deposit expansion, thereby increasing the money supply.

(3) Setting the Discount Rate:

• The depository institutions make loans to the public, and the central banks make loans to depository institutions.

• Banks naturally find it attractive to borrow from the central bank, whenever the interest rates they can earn from making loans to business and consumers or by purchasing securities, are greater than the discount rate.

• On the other hand, when the discount rate is higher than these interest rates, banks are discourage from borrowing at the central bank.

• In general, we can say that if the central bank raises the discount rate, bank borrowing is reduced, and the amount of reserves in the banking system falls . this tends to deposit contraction, and a reduction in the size of the money supply

• If the central bank lowers the discount rate, bank borrowing rises, causing an increase in reserves and deposit expansion and hence an increase in the money supply.

D- Differentiate between stocks & Bonds

E-Explain briefly the functions of money.Answer:

1- Medium of Exchange.

Money in the form of currency or checks is a medium of exchange. It is used to pay for goods and services.

If there were no money, goods would have to be exchanged by barter.

• For a commodity to function effectively as money, it as to meet several criteria:

1- it must be widely accepted

2- it must be divisible

3- it must be easy to carry

4- it must not deteriorate quickly.

2- Measure of value

It is used to measure value in the economy. We measure the value of goods and services in terms of money.

Using money as a unit of account reduces transaction costs in an economy by reducing the number of prices that need to be considered.

3- store of value

People usually save in the form of money. However, this function of money depends on its stability of value. If money loses its stability of value, people tend to save in the form of buying assets.

4- Unit of Account

In both households and businesses, it is necessary to look a head and calculate future income and expenditure. Money, acting as a unit of account, can serve these purposes.