ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
CHAPTER 1
- What is the role of the financial system and why is it important to the economy?
Solution: The financial system facilitates the flow of saving to investment via direct and indirect financingrelationships formed in financial markets with the frequent help of financial institutions. Without it, financing relationships would arise only when preferences of SSUs and DSUs match as to amount, maturity, and risk. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize savings. The “production possibilities frontier” of society would be smaller.
2. What is a financial claim? How can a financial claim be an asset and a liability at the same time?
Solution: A financial claim (or “security” or “financial instrument”) is one’s claim against another’s wealth. To its holder, it is a financial asset; to its issuer, a liability or obligation. It may be debt (contractually promising repayment with interest on a certain schedule) or equity (partownership rewarded by participation in profits). DSUs issue claims in return for funds; SSUs exchange funds for claims.
3. What are some problems with direct finance that make indirect finance more attractive?
Solution: Direct financing requires a more or less exact match between the characteristics of the financial claims DSUs wish to sell and those the SSUs want to buy. Direct financing can thus involve a costly search and negotiation process, often complicated by information asymmetries concerning ultimate credit risk of the DSU. Intermediaries transform direct claims sold by DSUs and make them more attractive to SSUs, helping DSUs find financing and SSUs find appropriate investments.
4. Explain what is meant by the term financial intermediation.
Solution: Financial intermediation is the process by which financial institutions mediate unmatched preferences of DSUs and 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.
5. What are investment banks and what role do they play in the financial system?
Solution: Investment banks are financial institutions which “underwrite” new primary market issues of securities to the investing public: They purchase new securities from a business or government and resell them to other financial institutions and wealthy individuals. By purchasing the securities at a discount or reselling them at a premium, investment banks earn an “underwriting spread”. It is common for investment banking firms to function also as brokers, dealers, and financial advisors.
1. Why is denomination divisibility an important intermediation service to the typical household?
Solution: Typicalhouseholdsdonothaveenough cashtoinvestindirectcreditmarkets,whereminimumtransactionsareoften$1million. Financialintermediariesfacilitateindirectinvestmentbyhouseholdsbyofferingfinancialclaimswithsmallerdenominations.Otherwise,householdswouldhavetoaccumulatelargesumsofmoneybeforeinvesting.Duringthetimethis would take,thehouseholdwouldearnnointerestincome—asubstantialopportunitycost, and a disincentive to save and invest.
2. What are the three sources of comparative advantage that financial institutions enjoy?
Solution: (1) Economies of scale —large volumes of similar transactions; (2) transaction cost control—finding and negotiating direct investments less expensively; and (3) risk management expertise—bridging the “information gap” about DSUs’ creditworthiness.
3. What would be the implications for investment in physical assets such as oil refineries or long- distance telephone cable if financial intermediarieswerenotwillingtoinvestmoneyforlong periodsoftime?
Solution: Suppose such a project costs $300 million and returns $30 million per year in cash flow. A 10% return seems attractive, but would enough direct investors be willing to commit to such a long payback? Such projects would have to be financed out of savings of the firms’ owners, many of whom would then be under-diversified and demand a higher return, assuming they were willing to commit in the first place.Valuable projects could be delayed indefinitely, curtailing economic growth and social progress.
4. Why are economies of scale important to the viability and profitability of financial intermediaries?
Solution: Economies of scale give financial intermediaries a cost advantage. If their average cost decreases as the size of the transaction increases, financial intermediaries can profitably engage in denomination intermediation while remaining adequately diversified.
1. Why do casualty insurance companies devote a greater percentage of their investments to liquid U.S. government securities than do life insurance companies?
Solution: Because casualty losses are less predictable than deaths, a casualty insurer cannot predict future claims as systematically as a life insurer. Thus the timing of cash outflows at casualty insurance companies is less certain, and a casualty insurer must keep more of its assets liquid, ready to pay claims. U.S. Government securities have a more active secondary market and lower risk profile than other securities. They can be converted to cash quickly with less chance of loss.
2. What are credit unions and how do they differ from commercial banks?
Solution: Credit unions are not-for-profit, tax-exempt, mutual associations of small savers; banks are shareholder-owned, for-profit, taxpaying corporations. Credit union members share some meaningful "common bond"; banks serve the general public. Credit unions traditionally make small consumer loans; banks have diversified portfolios of commercial, consumer, and real estate loans.
3. Why have mutual funds grown so fast compared to commercial banks?
Solution: As capital market (especially stock market) returns have risen in the last 20 years, moneytraditionally deposited in banks for safety has moved to mutual funds. For many years, bankscould not offer capital market opportunities to ordinary individuals. The securities industry, which could not issue deposits and did not want to be regulated like banks, attracted more of the public’s savings.
4. For a consumer, what is the difference between holding a checking account at a commercial bank and holding a money market mutual fund?
Solution: The major difference is deposit insurance. The checking account is insured by the government; the MMMF is not insured by anyone. Consequently the MMMF should pay a higher return. Providing liquidity, higher return, and only slightly higher risk, MMMFs have attracted billions away from banks over the last 20 years. Although uninsured, they invest their shareholders’ money in the some of the safest, most liquid instruments available in the financial system—Treasury bills, commercial paper, etc.
CHAPTER 2
1. What were the objectives of the National Banking Acts and what problems existed in the U.S. banking system before those acts were passed in the 1860s?
Solution: For much of the 19th century there was no systematic regulation of banking or overall control of the size or quality of the money supply. Banks, state-chartered but otherwise largely unsupervised, were free not only to engage in unsound lending practices but to fund themselves by issuing banknotes—IOUs against themselves—without restraint. Consequent and frequent bank failures weakened public faith in banks and the money supply, and exacerbated downturns in the normal business cycle. The National Banking and Currency Acts (1862-64) created a new class of federally chartered banks, called “National Banks”. These banks could issue banknotes, but they had to have them printed at the U.S. Treasury in standard form and denominations to reduce counterfeits. National bank notes also had to be backed above face value with U.S. government bonds, thus “enlisting” national banks to help finance the Civil War and assuring redemption of any national bank note at face value, even if the bank failed. To encourage circulation of national bank notes, the federal government also taxed state banknotes practically out of existence. Beyond this first systematic effort at a reliable, standardized national currency, the Acts also represented the first systematic federal regulation of banking: They required that national banks have adequate capital to absorb losses before opening, hold adequate reserves, be examined regularly by the Office of the Comptroller of the Currency, and avoid such unsound lending practices as financing risky ventures or making loans too large relative to their capital.
2. What were the problems posed by the National Banking Acts?
Solution: The currency was inelastic after bond issuance to finance the war ended, but before there was political consensus for an alternate way of backing it (gold, silver, etc). The tax on state banknotes increased the popularity of demand deposits which, despite the lack of deposit insurance and the difficulty of clearing checks at face value, became a main source of funding for bank lending. Although required to hold reserves, banks could “pyramid” reserves by counting deposits at other banks, so multiple contractions in reserves occurred when cash was drained from banks during planting and cultivation seasons or banking panics. There was no lender of last resort to provide banks with additional reserves when they needed them, and thus no way to moderate wide swings in the business cycle.
3. Why was the Fed initially established?
Solution: To provide an elastic currency, be a lender of last resort, improve bank supervision, and provide for a more efficient payments system.
4. How did the Federal Reserve System try to solve problems from the National Banking Act period?
Solution: The Fed could act as a “lender of last resort” to member banks needing extra liquidity. The Fed could legally create, circulate, and de-circulate currency to keep the money supply elastic in relation to the economy. The Fed provided free check clearing services to member banks and required that checks cleared through it clear at par, converting the payment system from a hindrance to a handmaiden of commerce. The Fed included all national banks as member banks and required all member banks, state or national, to be examined regularly to ensure that they were sound and maintained adequate reserves.
5. Why is the Fed chairman called the second most powerful person in the country?
Solution: The Chairman sets the agendas and runs the meetings of the Board of Governors and FOMC, and thus can have a major effect on monetary policy. As the public face and voice of the Fed, the Chairman can literally move financial markets with a few well-chosen—or ill-chosen—words.
CHAPTER 3
1. What is likely to happen to the monetary base if (a) the Treasury department sends out Social Security checks payable from its account at the Fed, (b) the Fed buys more government securities, (c) banks in general borrow less from the Fed’s discount window and repay their past borrowings?
Solution: (a) the MB will increase as the Treasury checks clear the Fed providing increased bank reserves; (b) the MB will increase as the Fed buys securities, increasing the bank reserve deposit account in the Fed; (c) the repayment of Fed borrowings will reduce the bank reserve component of the MB.
2. What is likely to happen to the Fed Funds Rate under the previous question’s scenarios?
Solution: Any action which increases bank reserves increases the supply of loanable funds and should decrease the FFR. Any transaction which decreases bank reserves should decrease the FFR.
3. What is likely to happen to the Fed Funds rate if the Fed increases the reserve requirement? Explain.
Solution: An increase in reserve requirements on a given level of deposits will immediately convert more total reserves into required reserves or create a reserve deficiency if total reserves on hand are not adequate to comply. Either way, the reallocation of resources to comply with the higher reserve requirement will pull loanable funds out of the system, pressuring the FFR upward.
4. Why do the financial markets pay so much attention to the Fed Funds rate given that the Fed can’t really control that interest rate in the long run?
Solution: In the short run open market operations can influence the fed funds rate, money market rates, and indexed rates in lending agreements. The FFR is a “benchmark” rate in the financial system, usually representing the lowest available cost of loanable funds to a depository institution.
1. Describe the likely consequences for GDP growth when the FOMC directs the trading desk at the New York Fed to sell Treasury securities.
Solution: Assuming the sale is of “monetary policy” magnitude and not “technical” magnitude, selling securities reduces reserves and thus pressures interest rates upward, serving the slow the economy.
2. What defensive actions do you suppose the Fed takes during periods of time when cash holdings by the public increases? In other words, how does the Fed offset these cash drains?
Solution: The Fed seeks to control the total monetary base, not the individual components, so when the public cash holdings increase, decreasing bank reserves, the Fed would purchase Treasury securities, (open market operations) increasing reserves and offsetting the public’s increased cash holdings.
3. As a college student that will be entering the workforce soon, if not already, which of the objectives of monetary policy would you like the Fed to focus on in the coming years?
Solution: As you near graduation, full employment is likely to be your main concern in the short term, but you should also care about the long-term purchasing power of your earnings.
CHAPTER 4
1. Explain why the interest rate depends on the rate of return business firms expect to earn on real investment projects.
Solution: The expected return on investment projects sets an upper limit on the interest rate firms are willing to pay on borrowed funds. Unless a project earns more than the firm’s cost of capital (i.e., the interest rate), it will be rejected.
2. How does a consumer’s time preference for consumption affect the level of savings and consumption? How does the interest rate affect the consumer’s decision to spend or save?
Solution: If a consumer has a stronger preference for current consumption relative to future consumption, she will save less and consume more at a given interest rate. If the interest rate decreases, the opportunity cost of current consumption decreases and the consumer will spend more today. If the interest rate increases, saving becomes relatively more attractive than consumption.
3. How do you think an increase in personal tax rates would affect the supply of loanable funds, holding other things equal? Why? How would the equilibrium interest rate be affected?
Solution: Higher tax rates decrease disposable income, reducing maximum potential saving. Less saving decreases the supply of loanable funds. Holding demand for loanable funds constant, a reduced supply puts upward pressure on the interest rate.
1. If you believe that the real rate of interest is 4 percent and the expected inflation rate is 3 percent, what is the nominal interest rate?
Solution: i = r + Pe = 4% + 3% = 7%. The correct compounding calculation is (1.04)(1.03) - 1 = 7.12%.
2. If actual inflation turns out to be less than expected inflation, would you rather have been a borrower or a lender? Why?
Solution: Youwouldratherhavebeenlender.Wheninflationislessthanexpected,thenominalinterestrateovercompensateslenders.Thus,lower-than-anticipatedinflationtransferswealthfromborrowerstolenders.
3. During what period in the last 30 years were realized real rates of return negative? What causes negative realized real rates of return?
Solution: Realized real rates were negative during much of the 1970s. Economists do not have a firm explanation why market participants persistently underestimated inflation over this period.
4. Explain why interest rates move with changes in inflation.
Solution: Interest rates change in response to changes in inflation because inflation is a primary component of nominal interest rates. Short-term rates respond more to monthly changes in inflation than long-term rates because the inflation component of a contract rate is for the rate of inflation expected across the life of the contract and accordingly, a monthly change has a larger effect on expectations across a short-term contract than a long-term contract.
CHAPTER 5
1. Why is a dollar today worth more to most people than a dollar received at a future date?
Solution: Investing means deferring consumption. Deferred consumption has an opportunity cost. In the absence of risk, the minimum return must at least compensate the investor for this opportunity cost. Thus a future dollar should be discounted by at least this rate, and a present dollar invested for at least this rate.
2. If you were to invest $100 in a savings account offering 6% interest compounded quarterly, how much money would be in the account after three years?
Solution: ($100)(1+(.06/4))12 = $119.56
3. Your rich uncle promises you $10,000 when you graduate from college. What is the value of this gift if you plan to graduate in 5 years and interest rates are 10%?