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ECO 350 Money and Banking Problem Set

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Problem Set 3---Answer Key
Question 1: Answer the following questions.
a) (2 pts.) Using the T-accounts of the First National Bank and the Second National Bank,
describe what happens when Jane Brown writes a $50 check on her account at the First
National Bank to pay her friend Joe Green, who in turn deposits the check in his account
at the Second National Bank.
[Answer] When the check clears, the T-accounts of the banks look like:
First National Bank
Assets ($millions) Liabilities ($millions)
Reserves -$50 Deposits -$50

Second National Bank
Assets ($millions) Liabilities ($millions)
Reserves +$50 Deposits +$50
b) (2 pts.) Why has the development of overnight loan markets made it more likely that
banks will hold fewer excess reserves?
[Answer] As a device for meeting withdrawals and satisfying reserve requirements,
overnight loans are an alternative to holding excess reserves. As overnight loans
become cheaper and easier to use, banks will find them less expensive than holding
excess reserves, and thus reduce their holdings of excessive reserves.
Question 2: Consider a bank that initially has the following balance sheet:
Assets ($millions) Liabilities ($millions)
Reserves 120 Deposits 1000
Loans 1000 Borrowings 300
Securities 280 Bank Capital 100
a) (3 pts.) Suppose that Donald Trump withdraws $30 million of deposits from this bank. If
the bank faces a required reserve ratio of 10%, what actions can the bank take to bring it
back into compliance with its reserve requirements?
[Answer] Without taking any action, after the $30 million withdrawal the bank would
have $90 million of reserves, but $970 million of deposits and thus $97 million of
required reserves. The bank could raise the additional $7 million of reserves by: (1)
calling in loans; (2) bundling together loans and selling them; (3) borrowing from other
banks in the fed funds market; (4) borrowing from other institutions through such
devices as corporate paper or repurchase agreements; (5) taking out discount loans
ECO 350 Money and Banking Problem Set
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from the Federal Reserve; or (6) selling other assets, such as securities (if the bank has
any to sell).
b) (3 pts.) Suppose that the banks regulators required the bank to raise its bank
capital/assets ratio. How can the bank accomplish this?
[Answer] The bank could increase its bank capital/assets ratio by: (1) reducing dividends;
(2) issuing new shares of stock; (3) selling some of its securities or loans, and using the
funds thus generated to retire its debt (borrowings); (4) selling some of its securities or
loans, and using the funds thus generated (rather than new deposits) to meet deposit
withdrawals. Note that the first two strategies involve increasing bank capital (and
assets), while the latter two involve decreasing assets while keeping capital constant.
Question 3: Consider a bank with the following balance sheet:
Assets ($millions) Liabilities ($millions)
Reserves $35 Zero-interest checking $50
Variable-rate loans $170 3-month CDs $100
Fixed-rate loans $75 10-year CDs $175
3-month Treasury $50 Bank Capital $____
10-year Treasury bonds $25
a) (2 pts.) What is the bank capital?
[Answer] Since total liabilities and net worth must equal the asset total of $355, bank
capital must be $30.
b) (4 pts.) Find the banks (basic) gap.
[Answer] The variable-rate (V-R) assets are the V-R loans and the 3-month T-bonds. The
V-R liabilities are the 3-month CDs. This generates a gap of $170 + $50 - $100 = $120. It
is a positive gap.
c) (3 pts.) Suppose spot interest rates fell by 2 percentage points. What would happen to the
banks profits? (Assume that interest rates on variable-rate assets and liabilities change
instantly.)
[Answer] You would earn $220 2% = $4.40 less on your V-R assets and pay out $100
2% = $2.00 less on your V-R liabilities. Overall, your profits would fall by $4.40 - $2.00 =
$120 2% = $2.40.
d) (3 pts.) What actions could you take to reduce the banks interest-rate risk?
[Answer] You can re-arrange the banks balance sheet so that the gap is zero. Or, you
can use financial derivatives to hedge the interest-rate risk.
ECO 350 Money and Banking Problem Set
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Question 4: Consider a bank with a positive gap, namely a bank that has more variable-rate
assets than variable-rate liabilities.
a) (3 pts.) Suppose the bank is concerned about its interest rate risk. In the absence of a
hedge, would the bank benefit or lose if future spot interest rates rose? What would
happen if spot interest rates fell?
[Answer] When spot interest rates rise, the bank earns more income on its variable-rate
(V-R) assets, and incurs more expenses on its V-R liabilities. Since there are more V-R
assets, the banks net income increases and gains. When spot interest rates fall,
everything works in reverse and the bank loses.
b) (3 pts.) Suppose the bank enters into a forward contract to buy Treasury bonds at some
future date. As future spot interest rates fell, would the banks profits from that contract
rise of fall?
[Answer] i
spot
P
spot
profits from contract to buy (as you want your forward
purchase price to be below the spot price in effect when the contract comes due). i
spot

P
spot
profits from contract to buy or losses from contract become bigger.
c) (3 pts.) Suppose the bank enters into a forward contract to sell Treasury bonds at some
future date. As future spot interest rates fell, would the banks profits from that contract
rise or fall?
[Answer] i
spot
P
spot
profits from contract to sell (as you want your forward
sales price to be above the spot price in effect when the contract comes due). i
spot

P
spot
profits from contract to sell .
d) (3 pts.) Explain how the bank could hedge against the risk described in part (a) with a
financial futures contract. In particular, would the bank contract to buy or sell Treasury
bonds?
[Answer] With a positive gap, the bank loses when spot interest rates fall. So, the
bank should hedge against a fall in spot interest rates. As spot interest rates fall, the
bank gains from a forward contract to buy and loses from a forward contract to sell. The
bank would thus contract to buy Treasury bonds (buy a futures contract), so that if
interest rates fall, its losses on its underlying portfolio of assets and liabilities would be
offset by gains on the contract.
e) (3 pts.) Explain how the bank could hedge against the risk described in part (a) with an
option instead. In particular, would the bank purchase a put or call option?
[Answer] Using the logic of part (d), the bank would purchase a call option.
f) (3 pts.) Suppose the bank is considering whether it should attract new deposits with 6-
month CDs or 10-year CDs. If it wanted to reduce the positive gap, which sort of CD would
it sell?
ECO 350 Money and Banking Problem Set
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[Answer] To eliminate the positive gap, the bank needs more V-R liabilities and fewer
fixed-rate liabilities. It should thus sell 6-month CDs.
g) (3 pts.) Suppose the bank is considering whether it should issue fixed-rate of adjustable
rate mortgages. If it wanted to reduce the positive gap, which sort of mortgages would it
make?
[Answer] To eliminate the positive gap, the bank needs fewer V-R assets and more
fixed-rate assets. It should thus issue fixed-rate mortgages.
Question 5 (3 pts): If the Fed sells $1 million of bonds and banks reduce their borrowings from
the Fed by $1 million, predict what will happen to the money supply.
[Answer] The Feds sale of $1 million of bonds shrinks the monetary base by $1 million,
and the reduction of borrowings from the Federal Reserve lowers the monetary base by
another $1 million. The resulting $2 million decline in the monetary base leads to a
decline in the money supply by a multiple.
Question 6 (3 pts): Suppose the required reserve ratio were 10% of checkable deposits, and the
simple deposit multiplier applied. Using negatives to represent a decrease, if the Fed bought
$250 of Treasury securities from a bank, the result would be a $___250___ increase in reserves, a
$___0___ increase in excess reserves, and a $__2500__ increase in checkable deposits. (Your
answer should be for the entire banking system.)
[Answer] The simple deposit multiplier is 1/r, so that D = R/r = $250/0.1. The simple
deposit multiplier is predicated on the assumption that banks hold no excess reserves,
so that excess reserves stay constant at $0. This means that required reserves must
increase by $250.
Question 7 (5 pts): Suppose that the Federal Reserves balance sheet contains:
Total assets (with float appearing as an asset) = $600
Treasury deposits = $45
Foreign and Other deposits = $20
Other Federal Reserve liabilities and capital accounts = $30
In addition, suppose that Treasury currency in circulation totals $50, and that the money
multiplier is 2.4. What is the money supply?
[Answer] Using the equation for the sources of the monetary base, it follows that:
MB = $50 + [$600 - $45 -$20 - $30 - $50] = $505.
ECO 350 Money and Banking Problem Set
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Using the relationship M = m MB, it follows that M = 2.4 $505 = $1,212.
Question 8: Consider an economy with the following quantities:
C = currency in circulation
D = checkable deposits
c = C/D = currency-deposit ration = 0.45
ER = excess reserves
e = ER/D = excess reserves-deposit ratio = 0.02
RR = required reserves = $50
r = required reserve ratio = 0.05
M = money supply (M1)
R = total reserves
MB = monetary base
m = (M1) money multiplier
a) (3 pts.) What are deposits, D?
[Answer] r = RR/D D = RR/r = $50 / 0.05 = $1000
b) (3 pts.) Using your answer to part (a), find excess reserves, ER, and currency, C.
[Answer] c = C/D C = c D = 0.45 $1000 = $450.
ER = e D = 0.02 $1000 = $20.
c) (3 pts.) What is the monetary base, MB?
[Answer] MB = C + R = C + RR + ER = $450 + $50 + $20 = $520
d) (3 pts.) Using your answer to part (a) and (b) find M.
[Answer] M (M1) = C +D = $450 + $1000 = $1450
e) (3 pts.) Using e, r and c, find m.
[Answer] m = (1 + c) / (c + r + e) = 1.45/0.52 2.7885
f) (3 pts.) Without using e, r and c, find m again.
[Answer] m = M/MB = $1450/$520 2.7885
Question 9: Answer the following questions.
a) (3 pts.) If reserve requirements on checkable deposits were set at zero, the amount of
multiple deposit expansion would go on indefinitely. Is this statement true, false, or
uncertainty? Explain.
[Answer] False. There would still be leakage into currency and excess reserves that
would limit deposit expansion. More formally, note that as long as c and/or e are
positive, m = (1 + c) / (c + r + e) will be finite, even if r = 0.
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b) (3 pts.) If the economy starts to boom and loan demand picks up, what do you predict will
happen to the money supply?
[Answer] The increase in loan demand would cause interest rates to rise. Banks would
then make more loans, thus increasing the money supply. Going into details, this rise in
interest rates increases both the cost of holding excess reserves and banks incentives
to borrow from the Fed (assuming fed fund rate doesnt change). Therefore, ER/D drops,
so that m rises, while discount loans increases, so that MB rises. In sum, M = m MB
rises.

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