Questions
Chapter 5
1. Assume that the following data describes the condition of the banking system in
Zealandia.
Total reserves
Transaction account balances held by the public
Notes and coins held by the public
Prudential (desired) reserve ratio (R)
a.
$300m
$1000m
$100m
0.25
How large is the money supply (M1)?
$1100m = $1000m transaction a/c + $100m cash.
b. What is the amount of loans (advances) that the banks have currently made?
loans = deposits (trans a/c) – reserves
= $700m
c.
Are the banks at their desired reserve ratio? If not, how much are their excess
reserves?
No. Banks want R = reserves/deposits = 0.25
To satisfy R = 0.25 with $1000m deposits need reserves of
0.25 x $1000m = $250m.
They have $300m in reserves, i.e. have excess reserves of $50m.
d. By how much could lending increase? What are total loans after the banks
reach their desired R?
There are two ways to answer:
(i) deposits = reserves x 1/R
= $300m x 4 = $1200m.
total loans = deposits – reserves = $900m
So loans = $200m (from answer b).
(ii) loans = excess reserves x 1/R
= $50m x 4 = $200m.
so total loans = $900m.
e.
How large would the money supply (M1) now become if the banks fully
utilised their lending capacity?
There are two ways to answer:
(i) Deposits = reserves x 1/R
= $300m x 4 = $1200m.
So M1 = $1200m + $100m = $1300m.
(ii) deposits = $200m so M1 = $200m (from answer d)
f.
During the credit expansion process, what happens to the reserves of the
banking system?
Reserves will be transferred from bank to bank within the system but
the total for the system will not change (ignoring leakages at this stage).
g. Draw up the balance sheet after all adjustment have been made.
h. Now suppose the public transfer $200m of their transaction account balances
to fixed deposits at the banks.
(i) What is the change in M1? M1 = –$200m
(ii) What is the change in M3? M3 = $0
We can think of a set diagram, where M1 is a subset of M3. The
reduction in
M1 (dotted rectangle) remains as part of M3, so M3 = $0.
M3 –$200m
+$200m M1 –$200m
2.
a.
Define liquidity. What type of money is most liquid?
Liquidity: the ease with which an asset can be converted into a means of payment
without loss of capital value. M1 is the most liquid.
b. What is a speculative bubble?
A speculative bubble is where the market is driven by a belief that prices will keep
rising, without regard to the underlying value of the asset. There are many buyers who
expect to be able to sell later on and make a capital gain. There are few sellers. Hence
P is high. The bubble bursts when expectations change; then there are many sellers
and few buyers. P falls, as people try to sell to stave off the possibility of capital
losses (or ruin).
c.
Where would you put personalised plates on the liquidity spectrum and why?
They are not very liquid – maybe less liquid than a car or a house for
example. There is not a well-developed market for number plates in New Zealand
which makes them difficult to sell. There are readily available second-hand markets
for cars and houses with plenty of buyers which make them easy to sell. There are
likely to be few number plate buyers available at any time – the market is ‘thin’. This
implies either taking some time to sell (e.g. waiting for an auction) or accepting a
capital loss, i.e. not liquid.
d. Where would you put investment apartments on the liquidity spectrum and
why?
They are not very liquid –but maybe more liquid than plates as there is a well
developed market . However they may also be considered a speculative investment
and may prove difficult to sell at prices investors expect if confidence in this market
evaporates. They are likely to be less liquid than conventional houses.
e.
Why are asset price bubbles hard to manage?
If officials try to restrain the bubble through interest rates, the real economy may be
damaged (by hurting export and investment). If the bubble is burst, a recession may
be triggered. In the case of the property market in NZ and other countries if the
monetary authorities raise interest rates, low income people in their first homes are
likely to be badly affected. In 2004 the exchange rate was high, leading the Reserve
Bank to be cautious abut containing the property bubble with higher interest rates.
3.
a.
Define the following money market terms: face value, coupon rate, effective yield.
Face value: The nominal value of a bond that is paid to the holder
when the bond matures.
Coupon rate: The annual rate of interest paid to the holder of a bond.
Interest is calculated on the face value of the bond.
Effective yield: The actual return secured by a bond-holder based on the
price paid and the interest received.
b. Distinguish between the following money market instruments: Treasury Bills
and Government Bonds.
Treasury Bills: Short-term (90 day) government securities used to
finance seasonal variations in the government’s income flows. They
may also be bought and sold by the Reserve Bank in its conduct of
OMOs. These are usually sold at discount. They have no face value.
Government Bonds: Longer-term government securities with a face
value and maturity date (5–10 years).
c.
Distinguish between primary and secondary expansion of the money supply.
A primary expansion occurs when new money enters the system. This
increase in reserves allows the registered banks to increase their lending
by the amount of any excess reserves they acquire. This increased
lending is the secondary expansion of the money supply – the credit
creation process.
4. Suppose you are holding some Government Stock which you wish to sell. The stock has a
face value of $10,000, a coupon rate of 8% and a maturity date of 2010. How will the
prevailing interest rate affect the price you are likely to receive for your bonds?
Since the price (value) of a bond and the current market interest rate are
inversely related, as interest rates rise, the value of the bonds will fall (and
vice versa). Assuming that they were purchased when the interest rate was 8%,
the bond would have had a present discounted value of $10 000. Current
interest rates of around 6% suggest that the price of the bond has risen and you
would realise a capital gain on sale. If interest rates were to rise to 10%, the
price of the bond would fall and you would suffer a capital loss on sale.
5. Assuming a floating exchange rate regime how would the reserve base be affected by:
a. increased use of notes and coin at Christmas?
reserves fall – but effect small
b. open market operations?
depends: if RBNZ sells bills, reserves fall
c.
government budget transactions?
payments made to government reduce the monetary base and vice
versa
d. overseas exchange transactions?
no change.
6. Should New Zealand and Australia have a common currency? Try to think of the
advantages and disadvantages and any practical problems of achieving this from the point
of view of the functions of money.
Possible advantages:

more certainty for exporters and importers of goods to
Australia (stable value)

less administrative costs in changing currency (ease of use)

Australia is a strong economy and the value of the currency
may be more assured ( store of value)
Possible disadvantages:
7.

Loss of control over monetary policy for New Zealand

Complex time of change over

Loss of national identity
a. Complete the balance sheet below for the banking system of New Hopeland where
the observed capital asset ratio is 5% and the observed reserve ratio (liquid assets
to deposits) is 20%.
Aggregate balance sheet of banks of New Hopeland ($B)
Assets
Liquid assets
Other loans
Total assets
19
81
100
Liabilities
Capital
Deposits
Total liabilities
5
95
100
b. If the public of New Hopeland also hold notes and coins to the value of $4 billion,
what is money supply as defined by M3?
M3 = deposits plus notes and coin held by the public
= 95 + 4 = $99 B
c.
Consider an injection of equity by the owners of the banks in (a) over the
following year of $5 billion. If the banks retain the current capital and liquidity
ratios and the public are keen to borrow as much as possible, what will the
aggregated balance sheet look like at the end of the year?
Aggregate balance sheet of banks of New Hopeland ($B)
Assets
Liquid assets
Other loans
Total assets
38
162
200
Liabilities
Capital
Deposits
Total liabilities
10
190
200
d. If nominal GDP was $100 billion at the start and the amount of notes and coins
held by the public remain $4 billion, what would be a reasonable estimate of
nominal GDP after the credit expansion?
M3 increases from 99B to 194B. GDP = MV = PY. If V remains the same,
GDP should rise proportionately with the increase in M3.
New GDP = 100 x 194/99 = 196B.
e. This nominal GDP increase will be the result of higher real output and also of
inflation. Explain what combination of growth and inflation a nominal GDP
increase of the magnitude of (d) might reflect. You may find use of the AD/AS
diagram helpful.
This is a very large increase in nominal GDP. It would be difficult for any
economy to produce almost twice as much output as the year before, so it I
likely that the nominal figure represents a large increase in prices. Thus A
expands along a steep SAS.