Money and Banking (econ 121)
Problem Set 3
Answer Key
Instructor: Chao Wei
1. Mishkin P166 Q17
Because inflation is less than expected, expectations of future shortterm interest rates will be lowered, and as a result, long-term interest
rates would fall. The decline in long-term interest rates implies that
long-term bond prices will rise.
2. Is a large firm with thousands of shareholders more or less likely to
suffer a principal-agent problem than a small firm with just a few
shareholders? Explain.
A large firm with many shares is more likely to suffer principal-agent
problems because it is more costly and difficult to organize challenges
to management when the interests of shareholders and management
do not coincide.
3. Why might the founder of a young firm in the growing biotechnology
industry not raise funds by selling new shares in the firm, even to
finance a very profitable investment opportunity?
Adverse selection causes firms in emerging, growing industries to
have the highest information costs. Faced with the high information
costs of distinguishing between good firms and lemons, savers
investing in financial markets require a higher return on investments
in all firms in these industries to compensate them for the risk of
investing in lemons. As a result, shares of good firms will be undervalued, and entrepreneurial firms will prefer to grow by using internal
funds or loans from banks, which specialize in reducing problems of
adverse selection.
4. Prepare the balance sheet of a bank that has $20 million in reserves,
$40 million in securities, $140 million in loans, $150 million in
deposits, and $50 million in equity capital.
a. What are the bank’s excess reserves if the reserve requirement
is 10% of deposits?
Excess Reserves = 20 – 0.1*150 = 5 million.
b.
Suppose that checks drawn on the bank’s accounts
withdraw $10 million. Show what the revised balance
sheet looks like. What are the bank’s excess reserves?
Assets side: reserves $10 million, securities $40 million,
loans $140 million;
Liabilities side: deposits $140 million, capital $50 million.
Excess Reserves = 10 – 0.1*140 = -$4 million.
As a result, the bank needs to raise its reserves by $4
million to satisfy the reserve requirement.
c.
Suppose that the bank borrows half of its reserve deficiency
from other banks and sell securities to make up the other half
of its reserve deficiency. Now what does its balance sheet
look like?
Assets side: reserves $14 million, securities $38 million, loans
$140 million;
Liabilities side: deposits $140 million, borrowing from other
banks $2 million, capital $50 million.
d.
Asset side: Reserves 14m, Securities 40m, Loans 140m;
Liabilities side: Deposits 140m, bank capital(or equity, net
worth) 54m.
5. Mishkin P228, Q15.
The gap is $10 million ($30 million of rate-sensitive assets minus $20
million of rate-sensitive liabilities). The change in bank profits from
the interest rise is +0.5 million (5%*10 million). The interest risk can
be reduced by increasing the rate-sensitive liabilities to $30 million or
by reducing the rate-sensitive assets to $20 million. Transactions in
financial derivatives, like interest rate swap, can also reduce the
interest rate risk.