Econ 353, Spring 2012
Instructor: Sunanda Roy
Homework #5 Answer Key 1. Consider the following assets and liabilities: I. Discount loans II. U.S. government securities III. Secondary reserves IV. Small time deposits V. Commercial loans VI. Savings accounts Bank liabilities include: A. I, II, IV, and VI only B. II, III, and V only C. I, III, and V only D. I, IV, and VI only E. II, III, and V only Ans.‐D 2. Which of the following correctly orders bank assets from lowest to highest interest rates paid to thebank? A. Checkable deposits, savings deposits, and large time deposits B. Reserves, U.S. government securities, and consumer loans C. Vault cash, discount loans, and state and local securities D. Small time deposits, large time deposits, and securities E. Real estate loans, reserves, and U.S. government securities Ans.‐B 3. Rosa banks with Olympia Credit Union and Rosa’s employer uses Washington National Bank. Rosa receives a salary of $2,500 every month which is directly deposited into her checking account. Assume that banks are required to maintain a 10% reserve ratio. a.Explain how this affects Olympia Credit Union’s assets and liabilities (including required and excess reserves), at the beginning of every month. Assets Excess Reserves +2250 Required Reserves +250 Liabilities Checkable Deposits +2500 b. Explain how this affects Washington National Bank’s assets and liabilities at the beginning of every month. Assets Reserves ‐2500 Liabilities Checkable Deposits ‐2500 4. Consider the balance sheet for River City Bank below. Use the information in the balance sheet toanswer the following question. Assume the reserve requirement is 10% on checkable deposits. Assets Liabilities Reserves $7000 Checkable deposits $70,000 Securities $3000 Non‐transactions deposits $140,000 Loans $210,000 Capital $________ a.What is the level of the Bank’s capital? Ans. $10,000 b. Jose, a checking account holder, withdraws $5000 from his account. How does this affect the Bank’sassets and liabilities? Ans. Checkable deposits are now $65,000, while reserves drop to $2,000. Bank is short of required reserves. c. Does the bank face an immediate problem as a result of this transaction? If so, what can the Bank doto overcome this problem? Ans. Yes,The bank is short of required reserves. Banks can borrow in the Federal Funds market or sell off some of its securities. It can also call in some of its loans early or borrow from the FED (discount loans). Each option has its costs. Borrowing from other banks implies interest costs. Selling off assets in secondary market implies possibility of capital losses and brokerage fees. d. Assume that because of a recession there is widespread default. $50,000 of the loans go bad andneed to written off. Does the Bank face a problem? What could the Bank have done to avoid thisproblem? Ans.‐The bank can write‐off $10,000 of bank capital against the loans, but this still implies that its liabilities exceed its assets by $40,000. The bank is insolvent! The bank could have maintained (i) a higher level of bank capital (a higher amount could be written off in that case), (ii) required more “compensating balances” (the bank could have written off some of the checkable deposits as liabilities) or (iii) screened loan applications better (to reduce the problem of defaults). Note: Getting discount loans from the FED does not correct for the insolvency problem, as it only adds to the bank’s liabilities. 5. Consider the following capital account of a bank. Assets: 1. Rate sensitive assets $160,000 2. Fixed rate assets $260,000 Liabilities: 1. Rate sensitive liabilities $200,000 2. Fixed rate liabilities $250,000 Suppose that the interest rate falls from 5% to 4.5%. Calculate the increase in the profits for the bank, as a result. Ans.‐ ∆
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800 1000 200 6. Which of the following causes or cause a decrease in the monetary base? I. A decrease in the discount rate II. An increase in the discount rate III. An open market sale IV. An open market purchase A. I and IV B. I and III C. II and III D. II and IV Ans.‐C 7. Suppose that the FED conducts an open market purchase of $1500 from Washington National Bank. a.How will this affect the assets and liabilities of the FED? FED Balance Sheet Assets Liabilities Securities +1500 Reserves +1500 b. How will this affect the assets and liabilities of Washington National Bank? Bank Balance Sheet Assets Liabilities Securities ‐1500 Reserves +1500 c. How will this affect the monetary base of the economy? Ans.‐ ∆
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0 1500 1500 d. Assuming that the reserve requirement for all banks is 10%, how will this affect the monetary aggregate M1? Ans.‐ ∆ 1 ∆
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0 10 1500 15000