Money and Banking
- Graphically illustrate a response to an increase in the default risk on corporate bonds (two graphs). Explain the graph.
Money and Banking
The government safety net creates an adverse selection problem and a moral hazard problem. Explain.
Answer) When there is the information that is asymmetric between two parties, then the occurrence of adverse selection is possible. The party who has more information than another party will take advantage. The government safety net creates an adverse selection problem because a risk-loving individual can view the banking system as a beautiful opportunity to use to funds of others as it is known that other's funds are protected. So more information has provided to customers than the bank, and they are an advantage.
After getting protection, when people's behaviour changes then more hazard occurs, moral hazard problem is created by the government safety net because the depositors do not maintain discipline. After all, funds of depositors are protected. The bank is aware that this will lead to more risk than the risk otherwise.
How did the increase in the interest rates in the early 1980s contribute to the S&L crisis?
Answer) In the 1980s, the saving and loan crisis took place because of the failures of association regarding savings and loans in the United States from 1986 to 1995, and more than half of the associations are to be blamed. The central bank of the United States, in the early 1980s, increased the rate of discount 9.5 per cent to 12 per cent so that inflation could be prevented. The increased discount rate caused an increase in borrowing cost for saving and loan associations.
The loans become more costly for the associations that have issues at the fixed rate of interest because the interest rate was higher than the fixed interest rate at the rate they were able to borrow from Central Bank. When the interest rate increased at which they were able to borrow, adequate capital could not be attracted by the saving and loans institutions, and it became insolvent. Despite this insolvency, however, some saving and loans institutions invested in the investment strategies that were highly speculative and those institutions were adversely affected by those strategies by extending economic loses and their insolvency period.
Discuss the provisions and implications of the following banking legislation:
a. Depository Institutions Deregulation and Monetary Control Act of 1980
b. Reform, Rehabilitation, and Compliance Act of 1989 on Financial Institutions
c. Improvement Legislation of
the Central Deposit Insurance Company of 1991
Answer) a. The Depository Institutions Deregulation and Monetary Control Act gave much greater control to Federal Reserves over non-member banks, and this act was passed in 1980. All the banks under this act were brought under the rules of the Fed, and they were allowed to be merged. The Governor's Federal Reserve Board power was remover under the Glass-Steagall Act, and withdrawal accounts' negotiable order was allowed to offer nationwide.
b. The Financial Institutions Reform, Recovery, and Enforcement Act enacted in the saving and loan crisis wake during the 1980s; the act was passed in 1989. To insolvent's close hundred provided funds and thrifts to give the insurance to the respective depositor and establishment of Resolution Trust Corporation took place. The authority of thrift regulatory was transferred to the Thrift Supervision's office from the Federal Home Loan Bank Board.
c. The Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed in 1991 during the 1980s S&L (savings and loans) crisis in the U.S. This act strengthened the power and authority of the Federal Deposit Insurance Corporation. FDIC was allowed by this act to borrow from the department of treasury directly, and it was mandated that failed bank to be resolved by FDIC using the available methods that are least costly. FDIC was also ordered to assess the premiums regarding insurance according to risk and challenges, and new requirements of capital were created.
Take too much risk
Depositors who come first have the strongest ability to remove their funds.
moral hazard; much
the severe recession in 1981-82
increased $40,000 to $100,000 bank protection
regulatory forbearance; moral hazard
the tactic introduced in the 1980s by thrift regulators to reduce capital requirements and seek regulatory forbearance in the hope of enhancing conditions in the S&L industry
Explain two concepts of central bank independence. Is the Fed politically independent? Why do economists think central bank independence is important?
Answer) Freedom of instruments is a central bank's ability so that it could set its instruments, and on the other hand, goal independence is the central bank's ability so that it could set its goal. The Fed is enjoying both types of independence, i.e. instrument independence and goal independence as Fed is not under the political pressure and it is mostly independent because of its appointment conditions of its chairman and the board of directors, and earnings. Some political pressure, however, can be applied to the fed through legislative enactment or threat that affect the Fed. Economists think that independence is essential because the independent central banks are pursuing lower rate of inflation without harming the economic performance of the country.
Make a case for and against an independent Federal Reserve.
Answer) Case for: the independent Federal Reserve can shield the economy from the business cycle involving politics, and inflationary bias is less likely to occur to monetary policy. Moreover, money supply control is too important that it cannot be left to inexperienced politicians.
The case against Having the monetary policy of the state to be controlled by some autonomous individual sounds undemocratic as they will not be accountable. The freedom of the Fed has not used wisely in the past, and the independence of the Fed may encourage the own self-interest priority than the interest of the public.
Who are the voting members of the Federal Open Market Committee, and why is this committee important? Where does the power lie within this committee?
Answer) The FOMC determines the money supply in the United States of America through its strategies and decisions regarding operations of an open market. The FOMC is effectively determining reserve requirements and discount rate. On the board of governors, there are seven members, and voting happens on a rotating basis, along with the New York Fed's president, who is also involved in the voting process. The board of governor's chairman wields power.
was disbanded in 1811 when its charter was not renewed
the United States 'First Bank and the United States' Second Bank
a central bank was needed to prevent future panics
concern over declining Fed membership
all banks whether or not they are members of the Federal Reserve System
Seven executives of the Board of Directors and five of the Fed's regional bank leaders.
European Central Bank
they have been allowing their central banks more freedom
Assume that no banks retain surplus capital, and the public owns no money. If a bank sells protection of $100 to the Fed, clarify what happens to this bank and two additional measures, assuming a 10 per cent reserve provision, in the deposit expansion phase. How much does the financial sector increase in deposits and lending until the process is completed?
Answer) The security for the reserves will be changed first by the Bank A, and reserves will be lent to create the loans. $100 will be received by it in the reserves form the securities' sale. As all of the available reserves will be considered as the excess reserves and in checkable deposits, there will be no change, so all $100 will be loan out by the bank. Then this amount will be deposited eventually in the Bank B and Bank B would have the $100 change in its reserves, out of this $100, the excess reserve will be $90. This excess reserve will be loan out by the bank B that will be deposited ultimately in Bank C. The reserves of the bank C will be increased by $90, and the amount of excess reserve will be $81. This excess reserve will be loan out by bank C, and this process will keep going till the time when no more excessive reserve will be left in the banking system. Both deposits and loans will be increased by $1000 for the banking system.
Explain two reasons why the Fed does not have complete control over the level of bank deposits and loans. Explain how a change in either factor affects the deposit expansion process?
Answer) The level of bank loans and bank deposits is not entirely controlled by the Fed since the markets, and the banks will keep the excess reserve, and the public can change the currency holdings. The change in any of the factors can change the process of deposit expansion. The increase in excess reserve or currency can lower the number by which loans and deposits are increased.
Explain why the simple deposit multiplier overstates the true deposit multiplier?
Answer) The simple model ignores role banks, and their customers are playing the creation process. The bank's clients will continue to keep the currency or not, and the bank can decide whether or not to retain the surplus reserve. Both banks and consumers would limit the willingness of the financial industry to make loans and deposits. Therefore, the estimate of the necessary deposit multiplier is better than the real multiplier.
What factors determine a bank's holdings of excess reserves? How does a change in each factor affect excess reserves, the money multiplier, and the money supply?
Answer) The rise in the interest rate on the market decreases the banks' surplus capital, as additional credit would be lucrative for the banks. On the other side, a rise in the outflow of the planned deposit would increase the surplus balance. Owing to the growth in the rate of inflation, raising the money supply as well as a multiplier, the surplus savings will be diminished. The rise in projected outflows, the reduction of the money supply and the multiplier will increase excess reserves.
Explain two developments in recent years that have led to the decreasing importance of reserve requirements in determining the money multiplier and the money supply?
Answer) The first one is known as the sweep account; it means that two different accounts are tied together. The sweeps account usually consists of the money market fund account and the checking account. At each business day's end, in the checking account, the balance over some specific amount is swept into the account of MMF. This process has caused the lower balance of checking accounts and minimum required to reserve, as only checkable deposit accounts are applicable by the reserve requirements.
The second one is the ATMs' increasing availability. The banks found that more cash is needed to be supplied to the banks increased the ATMs all over the world. Thus, the mean of this increased vault cash is that the banks are holding more excess reserves. The behaviour of banks will not be altered by the change in reserve requirement, as long as extra vault cash that the bank is holding is more than the change in reserve requirements.
currency; excess reserves
the nonborrowed monetary base
the increase from 2.33 to 2.55
a decrease in the money supply