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Money and Banking


Question #1 (28 Points)
a. Suppose that the reserve requirement is 8%. If the Fed buys $1 million in bonds from the First national Bank, what is the total deposit creation in the banking system using the simple deposit multiplier? (7 Points)
b. Suppose that the reserve requirement is 6%. If the Fed buys $1 million in bonds from the First national Bank and the currency ratio is 33% and the excess reserve ratio is 1%, what is the change in money supply? (7 Points)
c. If the reserve requirement were doubled, what effect would this have on the size of the money supply? This question does not require a mathematical answer. (3 Points)
d. What is the difference between the discount rate and the Fed Funds rate in relation to lending? (5 Points)
e. What is the practical justification of the reserve requirement, besides as a monetary policy tool? (3 Points)
f. What are the three types of Discount Loans offered by the Federal Reserve? (3 Points)

Question #2 (14 Points)
a. Please explain how adverse selection and moral hazard apply to deposit institutions.
2-a-i Please explain how Federal Deposit Insurance (FDIC) could potentially create adverse selection for the managers of deposit institutions. (4 Points)
2-a-ii. How can information asymmetries in the bond market give professional investors an advantage over the small investor.You can use other examples if they are appropriate. (4 Points)
b. These questions concentrate on the game theory of money and banking.Consider the Principle-Agent problem in relation to banking.A person is a Vice-President of a Bank, serving as the head of Commercial Lending. They receive a substantial bonus based on the volume and profitability of their department. The department both makes loans and collects the loans. Answer the following questions using this information.
2-b-i. Simply identify the Principal and the Agent in this problem? (3 Points)
2-b-ii. What is the moral hazard Problem regarding the Vice-President and his bonus? (3 Points)
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Question #3 (27 Points)
3-a-i. What is the difference between a bank that is insolvent and one that is illiquid? Consider the issue of retained earnings (2 Points)
3-a-ii. Draw the loanable funds framework, identify the two axes, and the supply and demand curves). (6 Points)
a-iii. Why are banks restricted in the assets that they can own? For example, why do you think banks are prohibited from owning common stock? Consider the concept of Glass Steagull. (6 Points)
c. In one paragraph or less, explain why bank owners might like to employ business strategies that generate a high ROA and a high asset-to-equity ratio? Why might depositors prefer strategies that lead to low ROA and low asset to equity ratios? (7 Points)
d. Why is the business goal of having high levels retained earnings? How can high levels of retained earnings be contrary to the investors goals? (6 Points)

Question #4 (15 Points)
Given a required reserve ratio is 10%. Assume that the banking system has excess reserves equal to $2 billion. Further, the currency in circulation equals $425 billion, and the total amount of demand deposits equals $900 billion. Based on these numbers, calculate
(a) required reserves held by the banking system (3 Points)
(b) total reserves held by the banking system (3 Points)
(c) monetary base (3 Points)
(d) total money supply (M1) (3 Points)
(e) the money multiplier (3 Points)
Question #5 (12 Points)
Consider this Table and the equation of exchange of MV = PY (you can rewrite it as

Assume P =1

2001 2002 2003

Ms 100 110 121
Y 1000 1210 1390


5-a-i Calculate velocity for each year. At what rate is velocity growing? (6 Points)
5-a-ii In the face of constant velocity, explain what happens to aggregate demand if the growth rate of money is less than the rate of inflation ? (6 Points)

Question #6 (22 Points)
According to Interest Rate Parity, how would the dollar respond (appreciate, depreciate, no change) against the Euro in reaction to an average European inflation rate of 4%? The US inflation rate is 2% in this example. (5 Points)
Consider the relationship between contractionary monetary policy. the value of the dollar, and net imports.
B. How does US expansionary monetary policy affect the value of the dollar (holding foreign money supplies constant)? (3 Points)
C. How does this new dollar value impact net exports? (4 Points)
D. Do these two work with each other in regards to economic growth? Explain. (3 Points)
E. Suppose the current exchange rate is $1 buys .8644Euro, and key interest rates in the US are at 1% while they are at 3.5% in Europe for a one year bond.
a. What is the expected value of the Euro in a year using the interest rate parity
equation? (4 Points)
b. If the US Federal Reserve raises interest rates, how would you expect the Euro to move (appreciate or depreciate)? (3 Points)

Question #7 (11 Points)
These questions refer to the readings assigned in the syllabus.
A. Using the Wizard of Oz paper, how can the absence of fiat money result in deflation and economic distress? You must use the concept of Money Demand in this answer. (6 Points)

B. In the Merchant of Venice paper, how did Shakespeare use Portia to represent a Capital Good? (5 Points)

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