How You Believe Economic Activity Would Be Affected If We Did Not Have Financial Markets and Institutions

1. Explain how you believe economic activity would be affected if we did not have financial markets and institutions.

Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would underutilize their savings. The productivity of society would almost certainly be less.

1. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system? 

Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus promoting the 3 forms of efficiency—allocational, informational, and operational.

1. What would happen to the monetary base if the U.S. Treasury collected $4 billion in taxes, which it deposited in its account at the Fed, and the Fed bought $3.5 billion in government securities? What effect might this have on the Fed Funds rate?

The first transaction would lower bank reserves and increase Treasury deposits at the Fed by $4 billion. The second transaction would restore $3.5 billion in bank reserves. The net reduction of $0.5 billion in reserves might only put the smallest upward pressure on the Fed Funds rate. This is why, to keep the Fed Funds rate on target, the FOMC cannot ignore large Treasury transactions when formulating open market operations.

1. If the Fed bought $3.5 billion in government securities and the public withdrew $2.0 billion from their transactions deposits in the form of cash, by how much would the monetary base change? By how much would financial institutions' reserves change? By how much would financial institutions' required reserves change if all proceeds from bond sales and all withdrawals from transactions accounts were deposited in or taken from accounts subject to a 10 percent reserve requirement? By how much would depository institutions' net excess reserves change?

The open market purchase increases the depository institution deposits at the Fed by $3.5 billion. The cash withdrawals, coming from vault cash, have no effect on depository institution deposits at the Fed. However, they cause reserves in the banking system to come down by $2 billion. Since Federal Reserve Notes outstanding remains the same, the net effect of the monetary base is +$3.5 billion. But the net effect on reserves in the banking system is +$1.5 billion. After allocating $150 million to required reserves, the banking system would then seek to lend or invest immediately $1.35 billion of excess reserves.

2*(1.5b)=

1. What is the essential difference between the Keynesian and the Monetarist view of how money affects the economy?

Monetarists believe the key financial variable for changing economic activity is the money supply. They assume that propensity to consume rises or drops as people perceive they have “more” or “less” money. Thus the money supply can be used to influence aggregate demand. To monetarists, short-term interest rates merely indicate monetary policy’s effects. Keynesians believe the key financial variable is interest rates: Real sector economic growth is stimulated by falling rates as economic activity costs less to finance, or lowed by rising rates as economic activity costs more to finance. To Keynesians, money supply changes reflect reactions to interest rates.

1. Assuming PaperMoney = $1.4T, coin = $50B, DepositoryInstBalances = $30B and PersonalCheckingAccounts = $0.9T, what are the monetary base and M1?

Monetary Base = $50B + $1.4T + $30B = $1.48 trillion

M1 = $50B + $1.4T + 0.9T = $2.35 trillion

1. If Federal Reserve Notes = 1,342, coin = 60, savings accounts = 460, depository inst balances = 2,753, and checking accounts = 1,108, what are currency, the monetary base, and M1?

Currency = 1,342 + 60 = 1,402

Monetary base = 1,402 + 2,753 = 4,155

M1 = 1,402 + 1,108 = 2,510

1. If a $2 billion securitization pool has outstanding $200 million in CP, $1.2 billion in senior securities, $360 million in mezzanine securities, and $240 million in equity securities, upon which it pays 1.5%, 3.0%, 5.0% and 7.0%, respectively, in yearly interest, what is the pool’s average rate of interest?

.10(1.5) + .60(3.0) + .18(5.0) +.12 (7.0) = 3.69%

1. If a bank charges 12.5 basis points per annum (365-day year) for a backup line of credit, how much is this on $2 billion of 30-day CP?

.00125(30/365)($2 billion) = $205,479.50

(.125%)(30/365)(2billion)

1. Consider an economy whose money supply is $200 billion. If the velocity of money is 9.5, what is the economy’s GDP? 

9.5(200) = $1.9 trillion

1. A corporation wishes to raise $2 billion in 45-day commercial paper via a dealer. The dealer’s charge is one-tenth of a percent of par, and a bank charges 12 basis points (per 360-day year) for a $2 billion backup line of credit. In dollars, these charges amount to what?

$2 million + 45(.0012/360)(2,000,000,000) = 2,000,000 + 300000 = $2,300,000

1. Let k = 12.5%. Assume a banking system with 400 in transaction deposits that is all loaned/invested up. Suppose the central bank injects 10 into the system (by buying 10 of securities), and that the system again becomes loaned/invested up. With the “Open Market Injection” in mind, what would be the entries in all three T-accounts for this example (to nearest integer)?  50-required reserve 10-excess reserve

Top T-account                    50  (bank has to hold 50)       400 (liability)

                                              350