Problems for Week 11
1. Explain how a bank can promise to pay depositors on demand when, in fact, they
have loaned out most of the depositors’ money.
2. When you deposit $100 cash into your checking account, is the bank’s net worth
(immediately) affected? Support your answer, using the definition of net worth, and
showing how the deposit will affect the components of net worth.
3. When the banker lends (or invests) $80 of the $100 you deposited, is the bank’s net
worth affected? Explain by showing how the loan is recorded on the bank's balance
sheet.
4. How can a bank's net worth be destroyed?
5. What does it mean for a bank to be insolvent?
Assets
Cash:……………………………..8.000
Loans & other investments………42,000
Total Assets……………………..50,000
Liabilities
Deposit liabilities………………$42,000
Total Liabilities………………….42,000
Net Worth…………………………8,000
Liabilities and Net Worth…………50,000
6. Refer to the table above.
a. If the reserve requirement is 10%, then this bank has _______________ in
excess reserves.
b. This bank will be insolvent if it suffers a loan loss larger than
______________________.
7. Refer again to the table above.
a.
This bank is technically insolvent, since its cash is much lower than the
amount it owes its depositors. True or false? Explain.
b.
Suppose this bank’s entire loan portfolio of $36,000 had to be written
down. (“Written down” means the borrowers defaulted, so the loan is now
worth zero; the amount in the bank’s loan portfolio must be adjusted to
reflect this). Would the bank still be solvent since it has more than that
amount in total liabilities?
8. For each of the following, indicate whether the money supply will increase,
decrease, or remain unchanged. Explain your answer.
a. The public collectively withdraws money from their checking accounts and holds
it as cash instead. The initial effect on M1 is (expansionary; neutral;
contractionary); Once the banks adjust their lending to reflect this new reality,
though, M1 will (expand; not change; shrink).
b. Assume the banking system starts out from a position where it is “fully loaned
up”. Normally, as loans are repaid, new loans are immediately extended.
Otherwise, the bank would have excess reserves, and would not be making as
much profit as possible. Suddenly, however, an atmosphere of pessimism and
uncertainty grips the financial markets, and bankers start to worry about the
credit-worthiness of their customers. In response, they decide to accumulate
excess reserves by restricting lending.
9. If the banking system is fully loaned up, the reserve requirement is 20%, and
Reserves of the banking system = $400 billion, what is the dollar value of the demand
deposits in the banking system?
10. A banking system with a reserve requirement of 25% loses $10,000 of reserves as
customers collectively decide to hold more of their wealth in the form of currency instead
of checking account deposits. Analyze the ultimate change in M1, taking into account
the fact that banks will have to allow their loan portfolios to shrink.
11. Which account(s) in the balance sheet above would be included in M1?