2 Cecchetti Solution 2 e

Chapter 11 Problems and Solutions
1. Use the concept of adverse selection to explain why the value of a new car drops as
soon as you drive it off the dealer’s lot.
Answer: When you buy a new car from a dealer, you know the quality of the car you are
purchasing. However, when buying a used car, it is difficult to distinguish good cars
from bad cars, so you will only be willing to pay the expected value of the car. Once
you drive a new car out of the dealer’s lot, it falls into the category of used cars. Even
though the quality of the car hasn’t changed and it is still just as good as a new car,
prospective buyers, because they can’t be completely sure of the quality of the car, won’t
pay as much as if the car were “new.”
2. Describe the problem of asymmetric information that an employer faces in hiring a

new employee. What solutions can you think of? Does the problem persist after
the person has been hired? If so, how? What can be done about it? Is the problem
more or less severe for employees on a fixed salary? Why or why not?
Answer: Prior to hiring a new employee, an employer may have difficulty identifying
candidates who would do the best job. After someone has been hired, the employer may
not know whether that person is working hard. Probationary periods when the new
employee can be terminated are a simple solution, as are salaries based on performance.
A fixed salary makes it difficult to create the proper incentives for employees to do their
best.
3. In some cities, newspapers publish a weekly list of restaurants that have been cited
for health code violations by local health inspectors. What information problem is
this feature designed to solve? How?
Answer: This solves both adverse selection and moral hazard. People who dine out at
restaurants may have a difficult time identifying restaurants that don’t meet certain health
standards. Because of this, some people may not want to eat out at all. Also,
restaurants don’t have an incentive to follow health regulations since diners can’t
distinguish restaurants that meet the health standards from those that don’t. However,
publishing the names of restaurants cited for health code violations allows people to
identify unsanitary restaurants and thus holds restaurants accountable for following health
regulations.
4. In some countries it is very difficult for shareholders to fire managers when they do a
poor job. What type of financing would you expect to find in those countries?
Answer: When shareholders can’t fire managers, people will be less willing to purchase
equity because there is no way to discipline managers who fail to act in the interests of
the shareholders. Companies in those countries are more likely to issue bonds or seek
bank loans to obtain funding.
Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 133
Chapter 11 The Economics of Financial Intermediation
5. Define the term economies of scale and explain how a financial intermediary can take
advantage of such economies.
Answer: Economies of scale is when average costs fall as production increases. By

using standardized forms for gathering information about potential borrowers and for
issuing loans, financial intermediaries can take advantage of economies of scale.
6. Explain the Internet’s impact on asymmetric information problems.

a. How can the Internet help to solve information problems?
b. Can the Internet compound some information problems?
c. On which problem would the Internet have a greater impact, adverse selection or
moral hazard?
Answer:
a. The Internet provides people with a wealth of information, whether they are
evaluating a company before deciding whether to purchase its stock or doing a
“Google” search on someone before going out on a date.
b. Not all of the information available is accurate, which can make the problem of
adverse selection worse.
c. The Internet provides information to reduce adverse selection, but isn’t very
helpful in reducing moral hazard.
7. The financial sector is heavily regulated. Explain how government regulations help
to solve information problems, increasing the effectiveness of financial markets and
institutions.
Answer: The government requires firms to disclose information.
8. Define deflation and explain how it reduces the value of a borrower's collateral.
What is the effect on the information problems a lender faces?
Answer: Deflation is a fall in the overall price level. A borrower’s liabilities will remain
the same, but the value of the borrower’s assets will decline, decreasing the net worth of
the borrower. Lenders use the net worth of borrowers to overcome information
asymmetries; with a low net worth, it will be more difficult to borrow.
9. How can a sharp rise in interest rates reduce the creditworthiness of potential
borrowers?
Answer: When the interest rate rises, potential borrowers who know they are a good
credit risk won’t be willing to borrow at the elevated rate, leaving only those who are bad
credit risks.
10. Many insurance companies insist on a physical examination before insuring

applicants for life insurance. Why do the companies collect this information?
What might happen if they didn’t?
Answer: Companies collect this information because they don’t want to insure people
who are probably going to die shortly. If companies didn’t require physical exams of
applicants, then people with a high probability of dying soon would all purchase
insurance. Companies would raise their premiums and healthy people wouldn’t buy
insurance.
11. In 2002 the trustworthiness of corporate financial reporting was called into question
when a number of companies corrected their financial statements for past years.
What impact did their action have on the financial markets?
Answer: Investors became less sure of their ability to distinguish good firms from bad
ones, so their willingness to purchase stocks and bonds decreased.
12. Firms in some sectors of the economy have more leverage than firms in other parts.
Explain how differences in businesses might create such differences in leverage.
Answer: Sectors where information problems are worst will have the hardest time
obtaining funds. Firms where output and performance are difficult to observe, such as
small consulting businesses, will find it very difficult to borrow or issue stock. By
contrast, companies with easy to observe output and effort, such a small manufacturing
firms, will find borrowing easier.
13. Would you be happy or unhappy if a company whose stock you owned was bought
by a leveraged buyout specialist who financed the purchase with junk bonds? Why?
Answer: If the buyer paid a high price and purchased my stock, I would be happy. If,
instead, left me holding stock, then that stock will be much more risky, and I would be
unhappy. I would also be unhappy because I would not have information about the new
owner.
14. Would you expect the lemons problem to be more or less severe in the emerging
markets countries of Latin America, Eastern Europe, and Asia than in the major
industrialized countries? Why or why not? Does your answer depend on the
stability of the countries’ political regimes?
Answer: The lemons problem is more severe in emerging markets countries because there
is not as much accurate information available about firms. The stability of the
countries’ political regimes is important because government required disclosure of
information can help reduce the lemons problem.
15. While it is possible to obtain medical insurance as an individual, it is cheaper to get it

as part of a large group through your employer. Why?
Answer: When obtaining insurance as an individual, the insurer has no idea about the
risk, and charges a high price. That is, the insurance company assumes you are a lemon.
In the case of a large employer, the insurance company can measure the likely payout
associated with the group. That information allows the premium to fall.
1. Explain why one bank might want to borrow from another bank.
Answer: Banks borrow from other banks when their reserves run low. Bankers
prefer to deal with deposit outflows by borrowing, rather than by selling securities or
loans, because they do not want to shrink the size of their balance sheets.
Furthermore, a bank that has a good lending opportunity does not want to turn it
down for lack of funds.
2. Why are checking accounts no longer an important source of funds for

commercial banks in the United States?
Answer: Checkable deposits make up only 10 percent of banks’ total liabilities. As

a result of financial innovations, consumers can keep their funds in accounts that pay
a higher rate of interest than checking accounts and have funds automatically
transferred to their checking accounts when their balances are low. This has reduced
the importance of checking accounts as a source of funds for commercial banks.
3. Why would bankers be pleased with a reduction in the reserve requirement?
Answer: Holding reserves is costly for banks, so bankers prefer to hold less reserves.
4. Suppose you have decided to invest in a bank, and are trying to choose which one
would make the best investment. You have asked your investment adviser for
information on each bank you are considering, including its return on equity.
Should you invest in the bank with the highest ROE? Why or why not?
Answer: ROE is the bank’s net profit after taxes divided by the bank’s capital. It is
a measure of bank profitability and leverage. If you invest in the bank with the
highest ROE, you will face higher risk due to higher leverage.
5. Banks hold more liquid assets than most businesses do. Explain why.
Answer: Banks are required to meet depositors’ demands for cash. In order to be
able to do this, they need to hold assets that are relatively liquid. Most businesses do
not need to be able to come up with cash on short notice, so they do not need to hold
as many liquid assets.
6. The volume of commercial and industrial loans made by banks has declined over
the past few decades. Explain why. What item has counterbalanced the
decline in the value of loans on banks’ balance sheets?
Answer: The rise of the commercial paper market has enabled businesses to raise
funds directly, so they do not need to borrow from banks. An increase in mortgage
lending has counterbalanced the decline in commercial and industrial loans.
146 Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets
Chapter 12 Depository Institutions: Banks and Bank Management
7. Explain how a bank uses liability management to respond to a deposit outflow.

Why do banks prefer liability management to asset management?
Answer: Banks can respond to another outflow by borrowing from another bank or
from the Federal Reserve or by issuing large-denomination time deposits. Banks
prefer liability management to asset management because asset management shrinks
the size of a bank’s balance sheet, while liability management does not.
8. Banks carefully consider the maturity structure of both their assets and their
liabilities. What is the significance of the maturity structure? What risks are
banks trying to manage when they adjust their maturity structure?
Answer: Banks adjust their maturity structure to manage interest rate risk. Banks’
assets tend to be long-term, while their liabilities are generally short-term. If the
short-term interest rate rises, banks will have to pay a higher level of interest on their
liabilities, but the interest income from their assets will stay the same. This will
reduce the banks’ profits. Banks try to match the interest rate sensitivity of their
assets and liabilities in order to manage this risk.
9. Define ROA, ROE, and leverage and show how the three are related. Using
these concepts together with the information in Tables 12.2 (page 290) and 12.5
(page 313), determine the amount of equity capital in the U.S. and Japanese
banking systems in 2001. Comment on the difference.
Answer: Return on assets (ROA) is a bank’s net profit after taxes divided by the
bank’s total assets. Return on equity (ROE) is a bank’s net profit after taxes divided
by the bank’s capital. One measure of leverage is the ratio of bank assets to bank
capital. ROA times leverage equals ROE. Therefore, capital equals ROA times
assets divided by ROE.
For the U.S. in 2001, capital = (0.0169)*($6, 454,543 million)/(0.1860) = $586,461
million.
For Japan in 2001, capital = (-0.0076)*(¥772 trillion)/(-0.1796) = ¥33 trillion.
Japanese banks had much higher leverage than U.S. banks.
10. Define credit risk. Banks face both firm-specific and economy-wide credit risk.
How do they manage each?
Answer: Credit risk is the risk that a bank’s loans will not be repaid. Banks manage
firm-specific credit risk by carefully evaluating potential borrowers and by
diversifying their loans. Diversifying loans by lending to different geographic areas
helps banks to manage economy-wide credit risk.
11. A bank has issued a one-year certificate of deposit for $50 million at an interest
rate of 2 percent. With the proceeds, the bank has purchased a two-year
Treasury note that pays 4 percent interest. What risk does the bank face in
entering into these transactions? What would happen if all interest rates were to
rise 1 percent?
Answer: The bank faces the risk that the short-term interest rate will rise, increasing
the amount of interest the bank has to pay on the CD, but leaving the interest income
that the bank receives from the Treasury note unchanged. With an interest rate of 2
percent for the CD and 4 percent for the Treasury note, the bank’s annual interest
income is 4% * $50 million = $2 million and the bank’s annual interest expenses are
2% * $50 million = $1 million. The bank makes a profit of $2 million – $1 million
= $1 million. If the interest rate rises 1 percent, the bank’s profit falls to (4% * $50
million) – (3% * $50 million) = $500,000.
12. You live in a small town and are having coffee with the owner of the local bank.
The bank, which has only a single branch, has been accepting deposits from you
and your neighbors for decades. In the course of your conversation, the banker
states, “We are an integral part of this community, so we lend only to the people
who live here.” Is this strategy a sound one? What advice would you give the
banker?
Answer: This is not a sound strategy. If the local economy suffers, then a large
portion of the bank’s borrowers will default. The bank should diversify its assets by
lending to people from different geographic locations.
13. You are managing a bank with $1 billion in assets, 3 percent of which are
reserves; 15 percent, securities; 74 percent, loans; and 8 percent required bank
capital. Twenty percent of the bank’s liabilities are transactions deposits; 70
percent, nontransactions deposits; and 10 percent, borrowings.
a. Construct the bank’s balance sheet.
b. If the reserve requirement on transactions assets is 10 percent, what are the
bank’s required reserves? Its excess reserves?
c. In the event of a $20 million withdrawal, what options are available to you to
meet the demand for funds? List them in preferential order, and explain your
preferences.
Answer:
a.
The bank’s balance sheet
Assets Liabilities
Reserves $30 million Transactions deposits $200 million
Securities $150 million Nontransactions deposits $700 million
Loans $740 million Borrowings $100 million
Capital $80 million
b. Required reserves = $200 million * 10% = $20 million

Excess reserves = $30 million - $20 million = $10 million
c. The bank can manage the withdrawal by adjusting its assets or liabilities.
The bank will prefer to adjust its liabilities since doing so does not shrink the
size of its balance sheet. The bank can adjust its liabilities by borrowing
from other banks or by attracting new deposits (issuing large-denomination
time deposits). If the bank were to adjust its assets, it could sell securities or
loans, or use some of its capital to meet the withdrawal. It could also refuse
to renew a loan that has come due.
14. Define operational risk and explain how a bank manages it.
Answer: Operational risk is the risk that a bank will become physically incapable of
operating (because its computer systems have failed or its building has become
inaccessible). This risk can be managed by having backup sites that are far away
from the bank’s primary location.
15. On the Federal Reserve Board’s web site,

http://www.federalreserve.gov/releases/, under statistical releases, you will find a
weekly release called H.8, “Assets and Liabilities of Commercial banks in the
United States.” Download the most recent release and construct a table that
matches Table 12.1 (page 288) using the data in the release.
a. Compare your table to Table 12.1. What are the differences in the data?
How can you explain them?
b. Find the current level of nominal GDP in the United States and use it as a
scale for the numbers in your table. Describe what you find.
Answer:
I. Balance Sheet of U.S. Commercial Banks, May 2004

Assets in billions of dollars (numbers in parentheses are percentage of the total assets)
Cash Items (including reserves) 336.5 (4.4)
Securities 1922.3 (25.0)
U.S. Government and agency 1187.0 (15.4)
State and Local Government and other 735.4 (9.6)
Loans 4900.3 (63.7)
Commercial and Industrial 877.1 (11.4)
Real Estate (including Mortgage) 2378.2 (30.9)
Consumer 647.5 (8.4)
Interbank 313.8 (4.1)
Other 683.7 (8.9)
Other Assets 599.8 (7.8)
Total Commercial Bank Assets 7686.8
Liabilities in billions of dollars (numbers in parentheses are percentage of the total

liabilities)
Checkable Deposits 676.7 (9.6)

Nontransaction Deposits 4337.6 (61.4)
Savings Deposits and Time Deposits 3245.9 (45.9)
Large, Negotiable Time Deposits 1091.7 (15.4)
Borrowings 1527.4 (21.6)
From banks in the U.S. 431.8 (6.1)
From nonbanks in the U.S. 1095.6 (15.5)
Other Liabilities 503.0 (7.1)
Total Commercial Bank Liabilities 7066.6
Bank Assets – Bank Liabilities = Bank Capital 642.1
Source: Data are for May 26, 2004, seasonally adjusted, from Board of Governors of the
Federal Reserve System statistical release H.8. “Assets and Liabilities of Commercial Banks in
the United States,” available at www.federalreserve.gov/releases/h8/current.
a. Because the data in this table and the data in Table 12.1 are only a month
apart, there aren’t any significant differences between the two. However,
changes in the interest rate could change the composition of both the assets
and liabilities of U.S. banks.
b. In May 2004, nominal GDP, as estimated by the Bureau of Economic

Analysis was $11,459.6 billion. Bank assets were equivalent to 67.1 percent
of GDP. Cash was 2.9 percent of GDP, the value of securities held by banks
was 16.8 percent of GDP, and the value of loans by banks was 42.8 percent of
GDP. Bank liabilities were equal to 61.7 percent of GDP. The value of
checkable deposits was 5.9 percent of GDP, the value of nontransaction
deposits was 37.9 percent of GDP, and the value of bank borrowing was 13.3
percent of GDP. Bank capital was equivalent to 5.6 percent of GDP.
1. For many years, you have been using your local small-town bank. One day you hear
that the bank is about to be purchased by Bank of America. From your vantage
point as a retail bank customer, what are the costs and benefits of such a merger?
Answer: The benefits are that you will have access to a larger network of ATMs and you
will be able to use your bank for a larger scope of financial services. However, you will
receive less personal service. Furthermore, the costs of the services you use are likely to
fall for two reasons. Economies of scale mean that larger banks have lower per unit
costs; and economics of scope mean that banks with a broader array of services have
lower costs as well. But the larger bank could use its monopoly power to raise costs, as
well.
2. Consider the impact of the merger in Question 1 from the point of view of a small
business owner. Is the purchase of your small community bank good or bad?
Explain your answer.
Answer: The small business owner had likely developed a relationship with the
community bank, allowing him to borrow funds more easily. Unless some care is taken,
information asymmetries could worsen. He will have to reestablish himself as a good
credit risk with Bank of America, but won’t be able to receive the same level of personal
service he experienced with the community bank.
3. Why have technological advances hindered the enforcement of legal restrictions

on bank branching?
Answer: Most people don’t go into a physical bank building to withdraw cash from their
accounts or make a deposit; instead they go to an ATM. ATMs do not qualify as
“branches” of a bank, so a bank can expand its customer base across a larger geographic
area without violating branching regulations. The advent of the Internet and electronic
banking has made the location of bank buildings even less relevant.
4. Banks have been losing their advantage over other financial intermediaries in
attracting customers’ funds. Why?
Answer: Other financial firms now exist to provide individuals with services typically
performed by banks. Money market mutual funds offer customers access to financial
instruments that pay a higher rate of interest than bank deposits, yet are still very liquid
and can easily be converted into a means of payment. Banks no longer have an
advantage in screening loan applicants because of the ease with which individuals can
transmit information, so a customer who needs a loan can go online to get price quotes
instead of going to the local bank. Discount brokerage firms provide individuals with
low-cost access to the financial markets.
5. What has been the impact of the Internet on the structure of the banking industry?
Chapter 13 Financial Industry Structure
Answer: The Internet has rendered the physical location of a particular bank irrelevant,
allowing large banks to expand across the country, and reducing the number of small
local banks.
6. Describe the economies of scope that large financial holding companies hope to
realize. Do you believe they will be successful?
Answer: The companies hope to reduce costs by offering customers a wide range of
services. Enabling customers to complete all of their financial activities with one
institution should help to reduce costs, but the people who run the large companies are
probably more interested with increasing the size of their institutions.
7. Discuss the problems life insurance companies will face as genetic information
becomes more widely available.
Answer: Insurance companies can’t predict when a particular person will die, but when
they pool together a group of individuals with uncorrelated risks, they can predict fairly
accurately the outcome for the group as a whole. However, if the companies have
access to genetic information, they will be able to estimate with some accuracy when
each individual is likely to die. Companies won’t want to issue insurance to individuals
who will probably die soon, and individuals who are likely to remain healthy won’t want
to buy insurance. If the information were able to completely eliminate the uncertainty
about when someone will die, then there is no longer anything left to insure.
8. How can the favorable tax treatment of pension funds encourage saving?
Answer: When people can reduce their taxes by contributing some of their income to a
pension fund, they are more likely to do so. These individuals will save more money for
their retirement.
9. Why would property and casualty insurers have balance sheets that differ from those
of life insurance companies?
Answer: Property and casualty insurance companies have a different time horizon from
life insurance companies. Property and casualty insurance companies often have to
make a large number of payments in the near future, so their assets are primarily
short-term securities; life insurance companies do not have to make most of their
payments until well into the future, so their assets consist of longer-term securities.
10. Insurance companies will not provide fire insurance for the full value of your house
and its contents. Why not?
Answer: Providing fire insurance for the full value of one’s house and its contents
increases moral hazard; the individual would have less of an incentive to protect his
house from burning down and would not take appropriate precautions, such as having
smoke alarms and fire extinguishers. Remember, one of the solutions to the moral
hazard problem is to ensure that borrowers and the insured have something of their own –
some net worth – at stake.
11. What are the benefits of collaboration between a large appliance retailer and a finance
company?
Answer: The appliance retailer has customers walk in the door that will need financing to
make purchases. Meanwhile, the finance company has access to funds in financial
markets. So, there are economies of scope that they two can exploit through
collaboration.
12. Why might a person who changes jobs frequently have a lower retirement income
than someone who stays with the same employer for a long time?
Answer: Companies with defined-benefit pension plans base the size of the retirement
income of a former employee on the number of years the employee worked at the
company and on the employee’s final salary. Someone who does not stay with any
particular company for very long would have a lower retirement income.
13. How do insurance companies address the problem of adverse selection?
Answer: Insurance companies screen applicants and adjust their premiums accordingly.
Someone applying for life insurance will have to undergo a physical examination, and
someone with a poor driving record will have to pay a larger premium for car insurance.
14. Earnings on the savings accumulated under a whole life insurance policy are not
taxed. Such a policy provides insurance that pays benefits when the policyholder
dies, plus savings the policyholder can cash in before death. What would happen to
the relative demand for whole life insurance if Congress passed a law making the
earnings on all savings exempt from taxes? Would insurance companies be for or
against such a law? Why?
Answer: If Congress passed a law making the earnings on all savings exempt from taxes,
then there would be no advantage to investing one’s savings in a life insurance policy
instead of in another type of account. Insurance companies would be against this
because less people would purchase whole life insurance.
15. California experiences periodic wildfires that destroy significant numbers of homes.
What would happen to the insurance market if the government passed a law requiring
that any insurance company operating in the state must provide fire insurance to all
those homeowners who ask for it?
Answer: If the insurance companies have reinsurance, then they are already willing to
provide insurance to all homeowners who ask for it. If the insurance companies do not
have reinsurance, they will stop selling insurance policies or will raise the premiums
dramatically.
16. Could the financial system operate without securities firms? Why or why not?
Answer: It would be difficult for the financial system to operate without securities
firms. Without the underwriting services of investment banks, firms would find if very
difficult to issue stock. Without brokerage firms, individual investors would not have
access to the financial markets. And without mutual funds, small investors would not be
able to create diversified portfolios (and so would not invest).
17. An industry with a large number of small firms is usually thought to be highly
competitive. Is that supposition true of the banking industry? What are the costs
and benefits to consumers of the current structure of the U.S. banking industry?
Answer: When the banking industry consisted of a large number of small firms, the
industry was less competitive than it is today. This is because each small bank had a
monopoly within its geographic area. As large banks branch across the country and the
number of small local banks falls, consumers benefit by having access to a larger network
of ATMs and by being able to engage in a wider range of financial activities through their
banks. Costs to consumers have fallen as a result of increased competition. However,
the level of personal service that consumers receive has declined.
18. Explain the following quotation:
“For the farmers who needed credit in the rural South in the early years of the 20th
century, the alternatives were dismal. Few banks would even consider making
agricultural loans, and those who did charged extremely high interest rates.
Rural credit was fertile ground for loan sharks, and year after year, farmers turned
over their crops to help pay exorbitant interest charges on loans made to keep
their farms operating. Should a crop fail, the chances of a farmer extricating
himself and his family from a loan shark’s clutches were virtually non-existent.”
(Raghuram G. Rajan and Luigi Zingales. Saving Capitalism from the Capitalists.
New York: Crown Business, 2003, pg. 13.)
Answer: Banks were unwilling to make agricultural loans to local farmers because if
there were a bad growing season, then a large portion of the banks’ borrowers would
default. The only way farmers could borrow money was from loan sharks. Because
farmers had no other options, the loan sharks could charge very high interest rates.
19. When the values of stocks and bonds fluctuate, they have an impact on the balance
sheet of insurance companies. Why is that impact more likely to be a problem for
life insurance companies than for property and casualty companies?
Answer: Property and casualty insurance companies have a different investment horizon
from life insurance companies. Because property and casualty insurance companies are
likely to have to make a large number of payments in the near future, they invest
primarily in short-term assets, like money market instruments. Payments from life
insurance companies don’t occur until far into the future, so they invest in longer-term
instruments, including stocks and bonds. Life insurance companies face the risk that
they will have to sell stocks or bonds when prices are low in order to pay policyholders’
claims.
20. Explain how assumptions about the rate of return on a firm’s pension fund portfolio
can affect a firm’s profitability. Why might government regulators want to monitor
those assumptions?
Answer: If the rate of return on a firm’s pension fund portfolio is high, the firm does not
need to contribute as much money to the fund in order to be able to make the promised
payments to its retired employees. When a firm expects the rate of return on its pension
fund to be high, it will invest less money in the fund (or even take money out of the fund)
in order to increase its profits. However, if the rate of return is less than expected, then
the firm will have difficulty meeting its obligations to retired employees. Government
regulators monitor assumptions about rate of return, because many private,
defined-benefit pension funds are insured by the government, so if the firm can’t meet its
obligations, then the government has to step in and make payments to retirees.
1. Explain how a bank run can turn into a bank panic.
Answer: Bank runs occur when people fear that their bank has become insolvent. Depositors rush
to their bank to withdraw their funds. Depositors at other banks become concerned about their
own bank!s solvency, so they also hurry to withdraw their funds. Bank runs can turn into
system-wide bank panics because customers have a difficult time distinguishing insolvent banks
from solvent ones.
2. In analyzing data from around the world, a researcher observes that countries whose
governments offer deposit insurance are more likely to have financial crises than other countries.
Why?
Answer: When depositors! funds are insured by the government, depositors do not care about
risks being taken by the bank!s managers, because they know that no matter what happens, they
will be able to get their funds back. Because they are not being monitored by depositors, bank
managers take on additional risk; if the risky investments are profitable, the bank gets the benefits,
while if the investments fail, the government assumes the costs. The additional risk means that
individual institutions are more likely to fail, increasing the likelihood of a financial crisis.
3. Will knowing about the too-big-to-fail policy affect your choice of where to open a bank account?
Why or why not?
Answer: For a small depositor, knowing about the too-big-to-fail policy is unlikely affect where the
depositor chooses to open an account. Because his account is covered by deposit insurance, the
depositor will get all his money back even if the bank does fail. Nevertheless, having ones bank fail
could create an inconvenience. So if given a choice between a bank that you know will not be
allowed to fail, and one that could, you might choose the larger bank.
4. Discuss the regulations that are designed to reduce the moral hazard created by deposit
insurance.
Answer: Regulators can restrict competition so that banks are not under as much pressure to engage
in risky investments. They can also prohibit banks from making certain types of risky loans and
from purchasing particular securities. U.S. banks are not allowed to hold common stock or bonds
that are below investment grade. Their bond holdings from a single issuer cannot exceed 25
percent of their capital. Likewise, they cannot make loans to single borrowers that exceed 25
percent of their capital. Regulators have also developed minimum capital requirements.
5. How does the existence of a lender of last resort create moral hazard?
Answer: Because bank managers know that the government will lend to them if they need it, they
are more likely to take on additional risk.
6. Distinguish between illiquidity and insolvency. Why is it difficult for a lender of last resort to
tell insolvency from illiquidity? Does the distinction matter?
Answer: Illiquidity is when a bank does not have enough reserves to meet depositors!
withdrawals. Insolvency is when a bank!s assets do not cover its liabilities. During crisis, it is
difficult for a lender of last resort to determine if a bank is solvent because computing the value of
the bank!s assets is almost impossible. The distinction between illiquidity and insolvency is
important; a bank that is illiquid is facing a temporary problem and will be able to recover, while a
bank that is insolvent will repeatedly need to borrow.
7. A government is considering changing its deposit insurance system from one in which deposits
are implicitly guaranteed (that is, if a bank fails, people trust the government to put enough
resources into the bank so that depositors will lose nothing) to one with an explicit ceiling. What
would be the impact of such a change on depositors? On bankers?
Answer: This can go both ways. If, with implicit guarantees, everyone really believes that there
deposits are guaranteed with no limit, then the change will induce more monitoring by borrowers,
reducing moral hazard. Alternatively, if the explicit ceiling makes depositors whose account
values are below the ceiling feel even more confident in the security of their funds, while
depositors whose accounts are above the ceiling seek out ways to ensure that all of their funds are
insured (for example, dividing their deposits into different accounts), then the change could
increase moral hazard.
8. Why do regulators insist that banks hold a minimum level of capital?
Answer: Capital cushions banks against a decline in the value of their assets, and also reduces the
problem of moral hazard by ensuring that owners have an interest in the bank remaining solvent.
9. Many of the people the government employs to supervise and monitor banks eventually leave the
government in order to work for the banks. Is this revolving door a problem? Why or why not?
Answer: This could be a problem because the former supervisors could give banks advice on how
to work around existing regulations to take on more risk. However, bank employees who
formerly worked for the government probably help banks to maximize their returns while keeping
risk at an acceptable level.
10. Before the Federal Reserve!s creation, banks tried banding together against the threat of bank
runs. Under what circumstances would such an approach work? When would it not work?
Answer: If there is a bank run at just one bank, the other banks would be able to provide enough
liquidity to the bank. However, in the event of a system-wide banking panic, all of the banks
would be facing illiquidity and would not be able to loan reserves to each other to stop the bank
runs.
11. Given the increasing complexity of the banking system, some people have proposed that banks
be required to issue uncollateralized bonds, whose market prices could provide valuable
information about banks! financial health. What is the logic behind such a proposal? Do you
think it would work?
Answer: Holders of these bonds would have an incentive to monitor the risk-taking behavior of the
bank (since, unlike depositors, they would lose their money if the bank failed). The price of the
bonds would provide information about the financial soundness of the issuing banks.
12. Could an insurance company or a pension fund be subject to a run? Why or why not? Does
the government need to guarantee deposits in these institutions?
Answer: Insurance companies and pension funds are not subject to runs because they do not allow
investors to withdraw funds on demand. However, they can still mismanage investors! funds,
so there is reason for government intervention to protect investors.
13. Current technology allows large bank depositors to withdraw their funds electronically at a
moment!s notice. They can do so all at the same time, without anyone!s knowledge, in what is
called a silent run. When might a silent run happen, and why?
Answer: Depositors may have their accounts set up so that funds are automatically withdrawn
under certain conditions. If the value of the depositors! other assets decreases (because of a fall
in the stock market, for example), the depositors may have difficulty meeting their liabilities and
will need to have funds withdrawn from their deposit accounts. Depositors are likely to need to
withdraw funds at the same time, leading to a silent run.
14. If you ran a large international bank headquartered in the United States, would you be for or
against uniform regulations for all international banks, regardless of where they are based? What
difference would it make if each country regulated its own banks, even those that have operations
abroad?
Answer: I would be for uniform regulations. Regulations for U.S. banks are relatively strict
compared to banks in other countries; if banks were subject only to the regulations of their country
and not to a set of standardized regulations, then banks from countries with lax regulations would
have an advantage over banks from countries with strict regulations.
15. Using the example of the Great Depression, explain why the existence of a lender of last resort
is no guarantee of financial stability.
Answer: During the Great Depression, the Federal Reserve existed as a lender of last resort.
However, the Fed adopted a policy that made it very difficult for banks to obtain loans. Just
because someone can be the lender of last resort, doesn!t mean they will do the job competently.
1. For many central banks, the primary goal is to control inflation.

a. What are the costs of inflation?
b. Does anyone benefit from inflation? If so, who benefits and how?
Answer:
a. High and unpredictable inflation increases uncertainty, which reduces investment and
hinders economic growth.
b. Borrowers who owe money benefit from inflation because the real value of their
required payments falls.
2. Provide arguments for and against the proposition that a central bank should be allowed to
set its own objectives.
Answer: One could argue that a central bank should be able to set its own objectives so as to be
free from political influence. However, this would reduce accountability, since the central bank
would be able to change its objectives in accordance with the monetary policy it is following at
any particular time.
3. Explain how transparency helps eliminate the problems that are created by central bank
independence.
Answer: Because it takes significant power away from elected politicians and gives it to a set of
appointed officials, central bank independence is inconsistent with representative democracy.
Even though they are not elected, monetary policymakers answer to the public. By forcing them
to communicate regularly with the public and explain exactly what they are doing and why,
transparency makes central bankers accountable.
4. In 1998, Brazil was on the verge of a financial crisis. Foreign investors did not believe
the government would be able to repay the bonds it had issued, so the interest rate began to
rise. That made investors even less confident of Brazil’s ability to make the required
payments, so the interest rate rose even higher. The solution to the problem involved both
monetary and fiscal policy. At the central bank, the governor was replaced and new policy
framework was put into place. Meanwhile, fiscal policymakers promised they would
restrain their profligate spending and cut the budget deficit. Explain why these events
helped to avert a crisis.
Answer: Redesigning the policy framework of the central bank signaled to investors that the
country was serious about controlling inflation and was not planning on covering its debts by
issuing more currency. Low inflation would be important in achieving the level of economic
growth required to reduce the burden of the debt. The promise by fiscal policymakers to cut the
budget deficit also helped assure investors that Brazil would be able to repay its debt; by cutting
spending, the government would free up funds to make interest payments on its debt, and
reducing the budget deficit would slow the growth of the debt.
Chapter 15 Central Banks in the World Today
5. The Maastricht Treaty, which established the European Central Bank, states that the
governments of the countries in the European Monetary Union must not seek to influence the
members of the central bank’s decision-making bodies. Why is freedom from political
influence crucial to the ECB’s ability to maintain price stability?
Answer: Because politicians are elected for short terms, they have an incentive to create
short-term prosperity at the expense of future inflation. If they can influence the central bank,
they will push for expansionary monetary policy that increases economic growth in the short run
but leads to inflation in the long run.
6. Most central banks publish volumes of material to inform the public about what they do
and how they do it. In many cases, they are responding to reporting obligations mandated
by the legislation that established the bank. Is such reporting important, or is it a waste of
paper?
Answer: Releasing information to the public is an important part of maintaining the transparency
of a central bank. Central banks that are required to release reports about their actions are held
to a higher degree of accountability. Being forthcoming with information also increases the
credibility of a central bank.
7. In 1900, there were 18 central banks in the world; 100 years later, there were 174. Why
does nearly every country in the world now have a central bank?
Answer: A central bank plays a vital role in any nation’s economy. By controlling the rate at
which it creates money, the central bank is able to affect inflation and economic growth.
8. The power of a central bank is based on its monopoly over the issuance of currency.
Economics teaches us that monopolies are bad and competition is good. Would competition
among more several central banks be better? Provide arguments both for and against.
Answer: Competition could force central banks to become more efficient and would increase
accountability. However, the central bank’s monopoly over the issuance of currency is what
allows it to control money growth and inflation.
9. In the 1970s and 1980s, Argentina experienced a series of hyperinflationary episodes,

during which inflation averaged about 300 percent per year. Finally, after two decades,
authorities decided to create a system in which the Argentinean peso could be converted to
U.S. dollars on a one-to-one basis. If the central bank wanted to print more pesos, it would
need to obtain dollars to back them. Discuss the possible sources of Argentina’s high
inflation, and explain why the change in policy was expected to eliminate it. (For 10 years,
the system worked with virtually no inflation. But in January 2002, the monetary system
collapsed, along with the Argentinean economy.)
Answer: High inflation is the result of high money growth. By creating a system in which the
peso could be converted to dollars on a one-to-one basis, the central bank lost its ability to
increase the money supply and instead adopted the monetary policy of the U.S.
10. During the 19th century, a $100 bank note (or check) issued in Philadelphia would not
necessarily be worth $100 in New York. Why not? How could the creation of a central
bank solve this problem?
Answer: Because bank notes were issued by different banks in different places, the value of the
bank note dropped the further you were from the issuing bank. This problem is solved by the
creation of a central bank because the central bank has a monopoly over the issuance of
currency.
11. As Chairman of the Federal Reserve, Alan Greenspan has never been willing to clarify
what he means by the objective of "price stability." The European Central Bank defines the
objective explicitly in terms of the rate of change in a particular price index. Why would
Greenspan shy away from an explicit definition? What are the pros and cons of the two
strategies?
Answer: By shying away from explicitly stating a target level of inflation, Greenspan has left the
Fed with more freedom to pursue goals other than price stability. For example, if the U.S.
economy is in a recession, the Fed can reduce interest rates even if doing so has the potential to
raise inflation above a target level. By clearly defining price stability, the ECB has reduced
uncertainty about future prices; however because it is bound by a specific inflation target, the
ECB does not have as much freedom to change the interest rate to affect economic growth.
12. Inflation hit 5,000 percent in the Ukraine in 1993. The government had promised to
provide many companies with subsidies, essentially giving them money. How was this
promise connected to the inflation? What was the solution?
Answer: By promising subsidies to companies, the government increased its liabilities. When
its revenue was not large enough to cover its liabilities and it became unable to borrow, the only
option for the government was to issue currency. This increase in money growth led to
inflation. Establishing an independent central bank that has control over the issuance of
currency can solve this problem.
13. Since 1993, the Bank of England has published a quarterly Inflation Report. Find a copy
of the report on the Bank's Website, www.bankofengland.co.uk. Describe its contents, and
explain why the Bank might publish such a document.
Answer: The Inflation Report describes current economic conditions and makes projections for
the future. It explains the reasoning for the target level of the interest rate. Publishing the
report helps maintain the transparency of the Bank of England, which is important for economic
stability.
14. After the end of the First World War in 1919, the Treaty of Versailles required the loser,
Germany, to make large payments called reparations to the winners, the United States, the
United Kingdom, and their allies. To make the payments, the German government had to
find a source of revenue. With the country in ruins, there were very few options. Over the
next four years, Germany experienced severe hyperinflation. Things got progressively
worse, and from January 1922 to November 1923, prices rose by a factor of nearly 22 billion.
Discuss the connection between the reparations payments and the hyperinflation.
Answer: Because the government didn’t have enough revenue to pay the reparations, its only
option was to print more currency. The increase in quantity of money led to hyperinflation.
15. Explain the costs of each of the following conditions, and explain who bears them.
a. Interest rate instability
b. Exchange rate instability
c. Inflation
d. Unstable growth
a. Interest-rate instability makes output unstable. It also increases the risk premium on bonds.
With a higher risk premium, it is more costly for firms to borrow. Firms will decrease their
investments, which will hurt economic growth.
b. Exchange rate instability makes the revenue from exports and the costs of imports
unpredictable. This hurts individuals engaged in foreign trade. This problem is particularly
severe in emerging markets countries.
c. Inflation creates uncertainty, which reduces investment and hurts growth. When inflation is
higher than expected, the real value of the payments received by lenders falls. Someone on a
fixed salary is also hurt by higher than expected inflation.
d. When growth is unstable, people are less sure about their future incomes and are less willing
to borrow. Another reason for the decrease in borrowing is that the uncertainty associated with
unstable growth increases the risk premium and makes borrowing more costly. Lower levels of
borrowing reduce investment and hurt future growth.
1. For many years, Federal Reserve officials kept their policy decisions secret,
claiming that surprises were more effective than announcements and that even
accurate information could mislead financial markets. What do you think of this
argument?
Answer: The primary argument for announcement and policy transparency is that
financial markets should respond to data, not to the policymakers. The
policymakers should be as predictable as possible, to avoid introducing instability
into the system. Uncertainty about policymakers’ actions introduces instability into
financial markets, reducing the efficiency of the price signals they generate, and
increasing the size of risk premia embedded in interest rates. So, real interest rates are
higher, reducing investment, and the price system doesn’t work as well.
2. What are the Federal Reserve’s goals? How are the Fed’s officials held
accountable for meeting them?
Answer: The goals of the Federal Reserve, as set by Congress are to “maintain long
run growth of the monetary and credit aggregates commensurate with the economy's
long run potential to increase production, so as to promote effectively the goals of
maximum employment, stable prices, and moderate long-term interest rates." The
Fed’s officials release large amounts of information in order to maintain
accountability. After each of the meetings of the FOMC, the target interest rate is
released immediately, along with a brief statement. Minutes and transcripts of the
meetings are also eventually made public. Members of the FOMC give public
speeches and the chairman reports to Congress and twice a year.
3. Go to the Federal Reserve Board's web site and locate the FOMC’s most recent
statement. What did the Committee members say at their last meeting regarding
the two goals of price stability and sustainable economic growth? What is their
current assessment of the balance of risks? Now read the committee’s last two
statements to see if the balance of risks has changed. If it has, can you figure out
why?
Answer: At the May 4, 2004 meeting, the FOMC kept the target federal funds rate at
1 percent. The Committee wrote that it can afford to raise the rate slowly since
inflation is low. Regarding the balance of risks, the statement says “The Committee
perceives the upside and downside risks to the attainment of sustainable growth for
the next few quarters are roughly equal. Similarly, the risks to the goal of price
stability have moved into balance.” The Committee’s assessment of the risks to
sustainable growth is unchanged from its last two meetings. The balance of risks to
price stability has changed slightly; at the previous two meetings, there was more of a
risk of a fall in inflation.
Chapter 16 The Structure of Central Banks:
The Federal Reserve and the European Central Bank
4. What do you think would have happened if President Truman had sided with the
Secretary of the Treasury in 1951? Describe how you think U.S. monetary
policy since then would have differed and what the consequences would have
been for growth and inflation.
Answer: If President Truman had sided with the Secretary of the Treasury, the
Federal Reserve would not be completely independent from the government.
Government officials would pressure the Fed to pursue expansionary monetary policy
in order to boost short-term growth. However, this would lead to high inflation, and
economic growth would be hurt.
5. Many people have argued that the FOMC should establish clear inflation
objectives. How would such goals enhance internal deliberations,
communication with the financial markets, and the accountability of the
Committee? If numerical inflation goals are set, do you think they should be
determined by the FOMC or by Congress and the President? Why would the
Chairman of the Board of Governors argue against setting such goals?
Answer: If the FOMC had clear inflation goals, then deliberations at meetings would
focus on identifying the level of the interest rate required to achieve the target
inflation rate, instead of the considering the effects of a given interest rate on both
inflation and economic growth.
Communication with the financial markets would be enhanced because investors
would know what to expect from the Fed. It would be easier to hold Committee
members accountable if there were an explicit inflation target.
If numerical inflation goals are set, they should be determined by the FOMC.
Allowing Congress and the President to set the inflation goals would sacrifice the
independence of the Fed.
The Chairman of the Board of Governors would argue against setting an inflation
target because doing so would prevent the Fed from taking both inflation and
economic growth into consideration when setting the interest rate. The Fed would
lose the freedom and flexibility that may be required to pull the economy out of a
recession.
6. Some people have argued that the high inflation of the late 1970s was a
consequence of the fact that Federal Reserve Board Chairman Arthur Burns did
what President Richard Nixon wanted him to do. Explain the connection.
Answer: Because politicians are elected for relatively short terms, they favor
expansionary monetary policy that will boost growth in the short run. However, this
will eventually lead to higher inflation. This is why it is important for the central
bank to be independent.
7. The Fed is very sensitive to the fact that Congress can always change the law that
created it. One way it defends its independence is by using the Reserve Banks'
boards of directors to lobby politicians. What do you think of this practice?
Answer: It is very important that the Fed retains its independence; however, by
lobbying politicians to defend the independence of the Fed, the directors seem to be
reducing its independence.
8. While the Chair of the Federal Reserve Board has only one of 12 votes on the
FOMC, he is never in the minority. What gives him the power to control the
Committee?
Answer: The Chairman controls the staff of the Board of Governors that produces the
material distributed to the Committee members prior to the meeting; he controls the
agenda of the meeting; he controls when people speak; and he is the first to make a
policy recommendation.
9. As Argentina’s economy was collapsing, the governor of its central bank

resigned, and the president of the Republic of Argentina appointed a new one.
Just months later, the new governor resigned after passage of a law that provided
he could be put on trial for failure to perform his duties. What do you think of a
system in which the governor of the central bank can be charged with such a
crime?
Answer: Charging the governor of the central bank with a crime for failing to perform
his duties would certainly hold him accountable; however, if the governor is charged
at the discretion of the president, then the central bank loses its independence and
becomes open to political influence. Also, it is possible for government officials to
engage in activities that make it impossible for the central bank to achieve its goals.
10. What are the goals of the ECB? How are its officials held accountable for meeting
them?
Answer: The primary goal of the ECB is to maintain price stability, which the ECB
defines as inflation of less than, but close to, two percent using the Harmonized Index
of Consumer Prices. Like the Federal Reserve, the ECB is held accountable through
releases of information, including the target interest rate along with an explanatory
statement, reports to the European Parliament, and public speeches.
11. Go to the ECB's web site and locate the most recent statement of the president of
the ECB about monetary policy. What was the Governing Council’s policy
decision? How was it justified?
Answer: On June 3, 2004, the Governing Council kept rates unchanged at relatively
low levels. Recent data indicated that the economy was recovering, and while
inflation for May was above 2%, the Council attributed this to rising oil prices and
felt that long-term inflation was still below 2%.
12. The Treaty of Maastricht gives the president of the Council of the European
Union the right to attend ECB Governing Council meetings. In early 1999,
German finance minister Oskar Lafontaine went to the meeting in an attempt to
obtain an interest rate reduction in his capacity as the official representative of the
European Union. What do you think of the rule that allowed the finance
minister to go to the meeting? What do you think of Lafontaine's decision to go?
What do you think the outcome was?
Answer: The rule allowing the finance minister to go to the meeting threatens the
independence of the ECB. In response to this attempted political interference, the
ECB’s Governing Council became even less inclined toward lowering the interest
rate. Lafontiane was heavily criticized for attending the ECB Governing Council’s
meeting. And, not surprisingly, the Governing Council refused to do what he
wanted.
13. Do you think the FOMC has an easier or a harder time agreeing on monetary
policy than the Governing Council of the ECB? Why?
Answer: The presence of national biases is likely to make agreement among members
of the Governing Council of the ECB more difficult. By contrast, the Federal
Reserve has very little regional bias. Also, a group of 12 (the number of voting
FOMC members) is likely to have an easier time coming to a decision than a group of
18 (the current number of ECB Governing Council members).
14. In 2001, Martin Mayer, a well-known financial commentator, wrote "The

European Central Bank is run by a governing board of technocrats and has
authority to set inflation for Europe without consulting any of the European
governments." Evaluate this statement.
Answer: Effective central banks are independent from political influence; the fact that
the ECB sets inflation targets without input from European governments is a good
thing. However, it may be better if the ECB took both inflation and growth into
account when setting its target rate, instead of focusing only on inflation.
15. The Monetary Policy Committee (MPC) of the Bank of England is responsible for
setting interest rates in the United Kingdom. Go to the Bank's web site at
www.bankofengland.co.uk, and get as much information about the MPC as you
can. How big is it? Who are its members? How often does it meet? What
sort of announcements and publications does it offer? Is it independent of the
United Kingdom’s Parliament?
Answer: The MPC includes a Governor, 2 Deputy Governors, the Chief Economist of
the Bank of England, the Executive Director for Market Operations and 4 external
members appointed by the Chancellor. It meets every month. Its decisions about
interest rates are released at 12 noon on the second day of its meeting, and the
minutes are released on the second Wednesday after the meeting. It also publishes a
quarterly Inflation Report. In 1997, the Bank of England became independent from
the government, but the Chancellor sets the inflation target.
1. In an effort to diversify, the Central Bank of China has decided to exchange some of
its dollar reserves for euros. Follow the impact of this move on the U.S. banking
system's balance sheet, the Federal Reserve's balance sheet, and the European Central
Bank’s balance sheet. What is the impact on the U.S. and Chinese monetary bases?
Answer: The decision by a foreign central bank to sell dollars moves them into the U.S.
commercial banking system, increasing U.S. commercial bank reserves and thus the U.S.
monetary base. The balances sheets of the various central banks are unaffected, as is the
Chinese monetary base.
2. The Fed buys $100,000 worth of U.S. Treasury bonds in an open market purchase.
Assume that the reserve requirement is 10 percent, the banking system as a whole
holds no excess reserves, and that the nonbank public is holding all the currency it
wants. Show the impact of this injection of reserves, assuming that some banks in
the system choose to purchase securities rather than to make loans with the increase
in reserves.
Answer: When the Fed purchases the bonds, the value of securities on the balance sheet
of the U.S. banking system falls by $100,000 and bank reserves rise by $100,000.
Banks will use some of the excess reserves to purchase securities and will then use the
remainder of the excess reserves to make loans. Let’s assume banks buy $30,000 in
securities; securities rise by $30,000 and reserves fall by $30,000, leaving banks with
$70,000 in excess reserves. Banks then extend $70,000 in loans; loans rise by $70,000
and reserves fall by $70,000. Then the deposit expansion multiplier comes into effect.
People who have been lent money will use it to purchase goods and services. The
people who sold them the goods and services will deposit the money in their accounts;
banks will then lend out 90 percent of the value of their deposits. This process
continues. If banks don’t hold excess reserves and if individuals deposit all of their
money into checking accounts, then the value of deposits eventually rises $700,000 above
the level it was at before the Fed purchased the bonds.
3. Follow the impact of a $100 cash withdrawal through the entire banking system,
assuming that the reserve requirement is 10 percent and that banks have no desire to
hold excess reserves.
Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A) needs to
increase its reserves by $90 in order to meet the required reserve ratio. To raise the $90,
Bank A will sell $90 of securities to someone. The deposit account of the person who
purchased the securities will fall by $90, as will the reserve balance of his bank, Bank B.
Bank B now needs to increase its reserves by $81 in order to meet the reserve
requirements so it will sell $81 of securities. This continues until deposits contract by
$100/0.1 = $1000.
Chapter 17 The Central Bank Balance Sheet and the Money Supply Process
4. Compute the impact on the money multiplier of an increase in desired currency

holdings from 10 percent to 15 percent of deposits when the reserve requirement is 10
percent of deposits, and banks’ desired excess reserves are 3 percent of deposits.
Answer:
1 + 1.1
When desired currency holdings = 10% of deposits, m = = 1.71
1.1 + 0.1 + 0.03
1 + 1.15
When desired currency holdings = 15% of deposits, m = = 1.68
1.15 + 0.1 + 0.03
1. Consider an open market purchase by the Fed of $3 billion of Treasury bonds.

Show the impact of the purchase on the bank from which the Fed bought the
securities. Then, using the assumptions in problem 4, compute the impact on M1.
Answer: The bank’s securities fall by $3 billion and reserves rise by $3 billion.
Assuming that the required reserve ratio is 10 percent, the bank does not want to hold
extra reserves, and the public does not wish to hold currency, the value of deposits will
rise by $30 billion.
6. Recall that the definition of M2 is currency plus demand deposits plus time
deposits. Assume that there is no reserve requirement on time deposits, but that
individuals hold time deposits in a constant ratio to demand deposits called the
time-deposit-to-demand-deposit ratio, or {TD/D}. Derive the M2 money multiplier
and discuss its properties.
Answer:
• M2 = C + T + D = D[C/D + T/D + 1]
o MB = C + R = =[{C/D}+ rD+{ER/D}]D
1
o D= xMB
{C/D} + rD + {ER/D}
{C / D} + (T / D) + 1
• M2 = xMB
{C/D} + rD + {ER/D}
{C / D} + (T / D) + 1
• m2 =
{C/D} + rD + {ER/D}
The M2 money multiplier increases when the time-deposit-to-demand-deposit ratio
increases, or when the currency-to-deposit ratio, required reserve-to-deposit ratio, or
excess reserve-to-deposit ratio decreases.
7. From the web site of either the Federal Reserve Board or the Federal Reserve Bank
of St. Louis, collect monthly data on the monetary base, M1, and M2 over the past
decade, seasonally adjusted and adjusted for changes in the reserve requirement.
Compute the M1 and M2 money multipliers and plot them. Discuss the patterns you
find.
Answer:
M1 Money Multiplier
3
M1/Monetary Base
2.5
1.5
1994 1996 1998 2000 2002 2004
M2 Money Multiplier
9
M2/Monetary Base
8.5
7.5
1994 1996 1998 2000 2002 2004
The M1 money multiplier has been falling. The M2 multiplier is more volatile.
8. List the factors that you suspect may have caused the Federal Reserve to lose
control of the quantity of money in the economy. Explain your reasoning.
Answer: Financial and technological innovations have had an impact on the various
components of the money multiplier. The increasing variability and unpredictability of
the money multiplier has weakened the link between the monetary base and the money
supply. Some factors that have contributed to the changing value of the money
multiplier include the introduction of ATM machines, rising use of credit cards, and
increased availability of relatively liquid financial instruments, such as money market
mutual funds; all of these have reduced the currency-to-deposit ratio. The practice of
“sweeping” balances from checking accounts into savings accounts each weekend has
rendered the reserve requirement irrelevant.
9. In fall 1999, people in the financial community were making their final plans for the
beginning of the year 2000. Everyone was concerned about the Y2K problem – the
fear that old computers would stop working because they used only 2 digits to record
the year, so that the year 2000 would be represented as “00” (the same as 1900).
The primary concern was that the public would panic and remove significant amounts
of cash from banks. What would you expect banks to do in anticipation of this
problem? What was the appropriate response by the Fed? Can you figure out from
the Fed’s balance sheet at the time what was done?
Answer: Banks increased their reserves, especially currency, in order to be able to meet
the anticipated withdrawal demands of their depositors. By looking at the weekly
balance sheet at www.federalreserve.gov/releases/h41/ we see that the size of the
monetary base went from $576.3 billion on December 1, 1999 to $644.6 billion on
December 29, 1999, and then back down to $571.1 billion on January 27, 2000. From
this we can infer that the Fed injected roughly $75 billion in reserves on a temporary
basis to ensure that there was sufficient liquidity in the banking system.
10. The U.S. Treasury maintains accounts at commercial banks. What would be the
consequences if the Treasury shifted funds from one of those banks to the Fed?
Answer: The balance sheet for the bank would reflect a decrease in reserves and a
decrease in deposits. The decrease in reserves would also appear on the Fed’s balance
sheet; however, it would be balanced by an increase in the government’s account. The
consequences would be a decline in the quantity of money.
11. Suppose the Fed buys $1 billion in Japanese yen, paying in dollars. What is the
impact on the monetary base? What would the Fed need to do to keep the monetary
base from changing following the purchase?
Answer: On the Fed’s balance sheet, currency and foreign reserves would both rise by
$1 billion; the monetary base would increase by $1 billion. If the Fed wished to keep its
balance sheet from changing (performing what is called a “sterilized intervention”) it
could then sell $1 billion in securities.
12. Suppose the Fed purchases $1 billion in securities from First Bank. What is the
impact on First Bank’s balance sheet?
Answer: First Bank’s securities would fall by $1 billion and the bank’s reserves would
rise by $1 billion.
13. The Fed occasionally considers paying interest on reserves, following the example
of central banks in a number of other countries. What impact would such a change
have on excess reserve holdings and the money multiplier?
Answer: If the Fed paid interest on reserves, banks would be more willing to hold
reserves and the excess reserve-to-deposit ratio would increase. This would decrease
the money multiplier.
14. In 1937, the Fed’s policymakers noticed the high level of excess reserves in the
banking system and became concerned about the potential for the banking system to
expand the quantity of money and spark inflation. As a result, the Fed raised the
reserve requirement. Why were banks holding excess reserves in 1937? What do
you think the banking system’s response was to the increase in required reserves?
What do you think happened to the quantity of money outstanding?
Answer: Banks were holding excess reserves because they were concerned about facing
illiquidity in the event of a bank run. When the Fed increased the required reserve ratio,
banks simply increased the levels of their reserves even further. This reduced the
quantity of money.
15. Footnote 19 mentions that the central bank of China raised the reserve requirement
on deposits in the summer of 2003. Describe the likely impact of this action on the
quantity of money in the Chinese economy.
Answer: Banks increased their reserves, which reduced the quantity of money in the
economy.
1. Recall from Chapter 15 that the central bank performs several functions. Describe how
each tool of monetary policy is used in fulfilling each of those roles.
Answer: The central bank uses open market operations to target a federal funds rate, which
enable it to control the quantity of money and credit in the economy. The discount rate and
discount lending allow the central bank to act as a lender of last resort, as does the use of open
market operations. Open market operations also allow the central bank to provide the liquidity
that is used to make the payments system run. Oversight of the financial system is separate
(and need not be done by the central bank).
2. Suppose the demand for reserves became less stable. How would monetary policy be
affected?
Answer: It would become more difficult for the central bank to determine the supply of reserves
required to achieve the target federal funds rate. The rate would become more volatile and
monetary policy will become less effective.
3. From 1979 to 1982, the FOMC used money growth as an intermediate target. To do so, the
committee instructed the Open Market Trading Desk to target the level of reserves in the
banking system. What was the justification for doing so? Explain why the result was
unstable interest rates. Would you advocate a return to reserve targeting? Why or why not?
Answer: In 1979, the Fed had to reduce inflation. It would not have been politically acceptable
for the Fed to explicitly raise interest rates to the level required to bring down inflation, so
instead the Fed targeted reserves. When the Fed attempts to keep the supply of reserves
constant, changes in the demand for reserves change the interest rate, resulting in increased
volatility. Because changes in the interest rate affect the real economy, targeting the federal
funds rate is a much more effective monetary policy than targeting reserves.
4. In 1992, the Bank of Canada eliminated the reserve requirement entirely. What do you
think would happen if the Federal Reserve followed the same course? Alternatively,
suppose that following an act of Congress, the Fed started to pay interest on required
reserves. Would the change have an impact on the market for reserves?
Answer: There are two reasons to require reserves. First, to force bank managers to behave
prudently, insuring that they will be able to meet requests for deposit outflows. Secondly, they
stabilize the demand for reserves. When reserve demand is more predictable, the Fed has an
easier time determining the supply of reserves required to achieve the target federal funds rate.
We know that the reserve requirement no longer constrains banks, so on they voluntarily hold
excess reserves in order to conduct their day-to-day business. So, bank managers now hold even
more reserves than regulators think necessary. Even so, eliminating the reserve requirement
would still make it more difficult to forecast reserve demand, making the market federal funds
rate more volatile so it would deviate further from the target rate. If Congress passed a law
Chapter 18 Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy
allowing the Fed to pay interest on reserves, holding reserves would become less costly for banks
and demand for reserves would rise.
5. Using economic data drawn from the web site of the Federal Reserve Bank of St. Louis, plot
the target federal funds rate and the Taylor rule for the past two years. Evaluate the result.
Answer:
4
3.5
3
2.5
2
1.5
1
0.5
0
02
03
04
20
20
20
Rate Implied by the Taylor Rule FOMC Target
The target federal funds rate generally tends to be very close to the rate implied by the Taylor
rule. However, over the past two years, the two rates have diverged and the FOMC target has
been comparatively low.
6. The web site of the Federal Reserve Bank of New York contains information on the target
federal funds rate. Find the data and describe the changes that have occurred over the past
year. Using the data and information you can gather from the FOMC’s press releases,
discuss the justification for the changes you see.
Answer: On June 8, 2004, the target federal funds rate was at 1 percent. It had been at that
level since January 25, 2003.
7. In Applying the Concept: Making January 1, 2000, Uneventful, we discussed the Fed’s
planning for Y2K. What would have happened if the Fed had failed to provide the
additional cash demanded by households?
Answer: If the Fed had failed to provide the additional cash demanded by households, banks
could have become illiquid. There would have been bank runs, which could have led to a
full-scale financial crisis.
8. Economists believe that central banks should be as transparent as possible, allowing the
public to accurately forecast changes in interest policy. Explain the justification for this
belief. What would happen if policymakers constantly surprised the public?
Answer: If policymakers constantly surprised the public, they would be undermining their goal
of financial stability.
9. Suppose Congress banned discount lending. What would be the consequences?
Answer: Banks would increase their reserve holdings. Despite this, there would still be times
when banks struggled with liquidity. Without being able to borrow from the Fed, illiquid banks
could fail (even if they were not insolvent), and there is the possibility of a system-wide bank
panic.
10. The European Central Bank’s web site contains information on the interest rates under the
Bank’s control. At what levels are they now and when did they last change? At the press
conference held at the time of the last change, how did the Governing Council justify the
action?
Answer: On June 3, 2004, the minimum bid rate on main refinancing operations was 2 percent,
the interest rate on the marginal lending facility was 3 percent and the deposit rate was 1 percent.
They have been at those levels since June 5, 2003, when they were each lowered by 0.50
percentage points. This was because of low growth during the first half of 2003, due in part to
events in Iraq. The Governing Council felt that the subdued level of economic activity was
likely to continue throughout 2003 and into 2004, and was confident that inflation was under
control.
11. The ECB pays a market-based interest rate on required reserves and a lower rate on excess
reserves. Explain why the system is structured this way.
Answer: Paying a market-based interest rate on required reserves reduces the costs to banks of
holding reserves. Paying interest on excess reserves helps reduce the volatility of the overnight
lending rate; banks would never be willing to lend to each other at a rate below the rate paid on
excess reserves.
12. Draw a supply-and-demand diagram for overnight interbank loans in Europe. Compare it to
Figure 18.1.
Answer:
Overnight Interbank
Loan Rate
Overnight Reserve
Lending Rate Supply
100 basis
points
Minimum
Bid Rate
100 basis
points
Deposit
Rate
Reserve
Demand
Quantity of Reserves
The two diagrams differ because of the way in which the ECB’s deposit and lending facilities
work. These restrict the movement of the overnight interbank loan rate to stay within a band
equal to the minimum bid rate plus or minus 100 basis points.
13. During the 1970s, the Fed was much more concerned with growth than it is today. The
result was that inflation climbed from less than 4 percent to over 10 percent. What do you
think the coefficients in the Taylor rule might be for that period? Would the coefficients for
the inflation and output gaps be larger or smaller than they are today?
Answer: The coefficient for inflation would have been smaller than it is today, and the
coefficient for the output gap would have been bigger than it is today.
14. Collect information on the current state of the economy – growth, unemployment, inflation,
interest rates. Using this information, predict what you think the FOMC is likely to do over
the next year. Explain your predictions.
Answer: In June 2004, the target federal funds rate was at 1 percent, its lowest level in over 30
years. Over the course of the next year, the FOMC is likely to raise the rate. Economic
growth has picked up, reducing the need for expansionary monetary policy; the annual rate of
real GDP growth was 4.1 percent during the fourth quarter of 2003 and 4.4 percent during the
first quarter of 2004 (from the Bureau of Economic Analysis). Inflation is also rising and the
FOMC will need to raise interest rates in order to keep prices stable; the compounded annual rate
of inflation (using the CPI) for the first quarter of 2004 was 3.9 percent (from the Bureau of
Labor Statistics). The unemployment rate for May 2004 was 5.6 percent (from the BLS).
15. As part of monetary policy strategy, the ECB continues to announce a “reference value” for
the growth of M3 (which is roughly equivalent to the U.S. M2) in the euro area. In contrast,
the FOMC has stopped announcing targets for growth in the monetary aggregates, stating:
“The FOMC believes that the behavior of money and credit will continue to have value for
gauging economic and financial conditions.” Can you justify either or both of these
strategies? How?
Answer: The FOMC’s decision to stop announcing targets for the growth of M2 is justifiable.
Because of the volatility of the money multiplier, the monetary aggregate is difficult to control,
making it an undesirable policy instrument.
Chapter 19 Problems
1. In June 1998, as the exchange rate was approaching 150 yen to the dollar, the
Bank of Japan appealed to the Federal Reserve to engage in a coordinated
exchange-rate intervention to prevent the yen from depreciating further.
a. Discuss the possible justifications for such a foreign exchange intervention.
b. What did the Bank of Japan and the Fed actually do? Show the impact of the
intervention on each central bank's balance sheet.
c. Do you think the intervention had an impact? Why or why not?
Answer:
a. The declining value of the yen would have reduced U.S. net exports and made
Japanese financial assets less attractive to investors.
b. The Bank of Japan and the Fed exchanged dollars for yen in sterilized
interventions.
Change in the Federal Reserve’s Balance Sheet Following a
Sterilized Purchase of Yen-Denominated Bonds
Assets Liabilities
Yen Reserves +$X Commercial Bank
(Japanese Government Bonds)
Reserves unchanged
Securities -$X
(U.S. Treasury Bonds)
Change in the Bank of Japan’s Balance Sheet Following a

Sterilized Sale of Dollar-Denominated Bonds
Assets Liabilities
Dollar Reserves -$Y
(U.S. Treasury Bonds)
Commercial Bank
Reserves unchanged
Securities +$Y
(Japanese Government Bonds)
c. The intervention may have had a small, temporary impact, but because the Fed
and the Bank of Japan kept their reserves constant and didn’t allow interest rates
to change, the intervention did not have a permanent effect on the exchange rate.
2. Go to the Web site of the Federal Reserve Bank of New York,

www.newyorkfed.org. Click on "Publications." Under “Online Publications,”
click on “Quarterly and Annual” and finally on “Treasury and Federal Reserve FX
Operations.” Can you find the last time the Fed intervened in the FX (foreign
exchange) market? How big was the intervention? In the full text of the report,
or in news reports filed at the time, can you find the justification for the
intervention?
Answer: The last time the Fed intervened in the FX market was September 22, 2000.
The Fed bought 1.5 billion euros after the dollar appreciated 8.2 percent against the
euro. [Note to instructors: The location of this report moves from time to time, but
it is always somewhere on the Federal Reserve Bank of New York’s website.]
3. How would you categorize the French, Italian, and German exchange rate
regimes?
Answer: France, Italy, and Germany have a fixed exchange rate with one another, but
a floating rate with countries outside of the euro area. It is the same as the fixed
exchange-rate regime among New York, Dallas, and Los Angeles.
4. A number of people have suggested the creation of a Monetary Union of the

Americas. What are the arguments for and against the countries of North and
South America adopting a common currency? Should the United States favor or
oppose the proposal?
Answer: By eliminating exchange rate risk, and the cost of converting currencies, a
Monetary Union could increase trade between the countries of North and South
America. Elimination of exchange rate risk would also encourage foreign
investment in the emerging markets countries of Latin America. However, in a
monetary union, all of the countries of North and South America would be forced to
adopt the same monetary policy. The economies of the countries are not always
highly correlated and situations would arise in which the economies of some countries
would be booming while others would be in a recession. Tightening monetary
policy would be warranted in the booming economies, but could be disastrous for
countries in a recession. Other than more stable trade with the rest of Latin America,
the U.S. does not have much to gain from the creation of a Monetary Union of the
Americas.
5. Explain the mechanics of a speculative attack.
Answer: Country A has a fixed exchange rate, and the central bank has foreign
currency reserves. Investors come to believe that a country will have to depreciate its
currency. They proceed to borrow that currency in the country’s financial market,
and take the proceeds of the loan to the central bank to exchange them for some other
currency (normally dollar, euro, or yen). If this happens in large enough amounts,
the central bank will run out of foreign currency reserves, and be forced to either
devalue its currency or abandon its fixed exchange rate. Investors know this, and
since they have nearly unlimited resources, they can continue to put pressure on the
central bank until Country A is forced to depreciate its currency. The result is a
profit for the investors, who can now repay their loans with depreciated currency.
6. Assume that the interest rate on one-year Japanese government bonds is

2 percent, one-year U.S. Treasury bills pay 3 percent, and the exchange rate is 100
yen per dollar.
a. Assuming the yen-dollar exchange rate is fixed, explain how you could make
a riskless profit.
b. Assuming the yen-dollar exchange rate is a floating rate, what would you
expect it to be in one year?
Answer:
a. You could sell futures contracts for Japanese government bonds and buy futures
contracts for U.S. Treasury bills.
b. If you invest $100 in a Treasury bill, you will have $103 after one year. If you
convert $100 to ¥10,000 and purchase a Japanese government bond, you will have
¥10,200 after one year. The exchange rate will adjust until people are indifferent
between these two investment strategies and ¥10,200 will equal $103, which
means the exchange rate will be ¥99 per dollar.
8. If U.S. inflation were 2 percent, Mexican inflation 10 percent, and you could
exchange 10 pesos for one dollar, what would you expect the dollar-peso
exchange rate to be in one year? If U.S. and Mexican government bonds were
equally risky, what would you expect the interest-rate differential to be?
Answer: If Mexican inflation were 10 percent and U.S. inflation were 2 percent, we
would expect the dollar to appreciate 8 percent against the peso; this would make the
exchange rate 10.8 pesos per dollar. If U.S. and Mexican government bonds were
equally risky, we would expect Mexican bonds to pay an interest rate 8 percent higher
than the rate on U.S. bonds so that the real returns would be equal.
9. In 1997, the Bank of Thailand was maintaining a fixed exchange rate at 26 Thai
baht to the dollar. At the same time, Thai interest rates were substantially higher
than those in the United States and Japan. Thai bankers were borrowing money
in Japan and lending it in Thailand.
a. Why was this transaction profitable?
b. What risks were associated with this method of financing?
c. Describe the impact of a depreciation of the baht on the balance sheets of Thai
banks involved in these transactions.
Answer:
a. Bankers could borrow money in Japan at a low rate, and lend in Thailand at a high
rate. Because the exchange rate was fixed, they profited from the difference in
the interest rates.
b. There was the risk that the baht could depreciate, making it more costly to repay
the money borrowed in Japan, as well as the risk that borrowers in Thailand could
default on their loans.
c. When the baht depreciated, the costs to the Thai banks of repaying their loans
rose, which caused their reserves to shrink.
10. During the time of the currency board, Argentinean banks offered accounts in
both dollars and pesos, but loans were made largely in pesos. Describe the
impact on banks of the collapse of the currency board.
Answer: The Argentinean banks had to pay interest payments in dollars on the
dollar-denominated account, but the interest revenues they received were in pesos.
When the currency board collapsed and the peso depreciated, it became more costly
for banks to make the dollar-denominated interest payments.
11. Investors became nervous just before the 2002 Brazilian presidential election.
As a result, the risk premium on Brazilian government debt increased dramatically
and Brazil’s currency depreciated significantly.
a. How could concern over an election drive up the risk premium?
b. How was the risk premium connected to the value of the currency?
Answer:
a. Investors were concerned that one of the candidates could cause Brazil to default
on its debt if he were elected president.
b. When Brazilian bonds became more risky relative to alternatives, demand for the
bonds fell. There was less of a demand for the Brazilian real and the real
depreciated.
12. During the Asian financial crisis in the summer and fall of 1997, investors became
concerned that the Hong Kong Monetary Authority would not be able to maintain
its currency board. As a result, the overnight interest rate in Hong Kong rose to
about 200 percent. Explain this phenomenon.
Answer: If the currency board collapsed, the Hong Kong dollar would have
depreciated by a large amount. The high interest rate was required to compensate
investors for this risk. (Put another way, with the possibility of a collapse of the
currency, the expected value of a transaction was very high: borrow Hong Kong
dollars; convert them to US dollars or Yen and purchase an interest-bearing bond;
after the Hong Kong dollar depreciates, repay the original loan.)
13. Should Texas have its own currency? How would you evaluate whether the 50
states should remain "dollarized?”
Answer: Because the economies of the different states of the U.S. are well integrated
with one another, there is no reason for states to have their own currencies.
Nevertheless, it would be possible to argue that the Texas economy is sufficiently
different from the rest of the U.S. economy – booming when energy prices go up –
that Texans might be better off with their own currency.
14. When asked about the value of the dollar, the Chair of the Federal Reserve Board
answers, "The foreign exchange policy of the United States is the responsibility of
the Secretary of the Treasury; I have no comment." Discuss this answer.
Answer: Since the U.S. Treasury is technically responsible for exchange rate policy
or decisions about exchange rate intervention, the Federal Reserve does not comment
on the value of the dollar. But since the value of the dollar is closely tied to interest
rates and monetary policy, there is something misleading about this. The Fed
Chairman might instead say that his focus is on monetary policy and its impact on the
domestic U.S. economy, and in formulating such policy he and the FOMC do take the
exchange value of the dollar into consideration.
15. Explain the costs and benefits of dollarization. Could a dollarized regime
collapse?
Costs of dollarization:
• Lost revenue from money printing.
• Eliminates monetary policy and lender of last resort.
• Eliminates stabilization effects of exchange-rate changes.
Benefits
• Eliminates exchange-rate risk, making international trade easier.
• Reduces risk of investing abroad.
• Ties policymakers’ hands.
• Helps integrate country into the world trading system.
Dollarization is reversible and so it can collapse. It does not preclude the fiscal
authorities from starting to issue currency again. The success of the regime depends
on fiscal policy restraint.

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Chapter 11 Problems and Solutions

2. Describe the problem of asymmetric information that an employer faces in hiring a

Answer: Economies of scale is when average costs fall as production increases. By

6. Explain the Internet’s impact on asymmetric information problems.

Answer: The government requires firms to disclose information.

10. Many insurance companies insist on a physical examination before insuring

15. While it is possible to obtain medical insurance as an individual, it is cheaper to get it

2. Why are checking accounts no longer an important source of funds for

Answer: Checkable deposits make up only 10 percent of banks’ total liabilities. As

3. Why would bankers be pleased with a reduction in the reserve requirement?

7. Explain how a bank uses liability management to respond to a deposit outflow.

b. Required reserves = $200 million * 10% = $20 million

15. On the Federal Reserve Board’s web site,

I. Balance Sheet of U.S. Commercial Banks, May 2004

Liabilities in billions of dollars (numbers in parentheses are percentage of the total

Checkable Deposits 676.7 (9.6)

b. In May 2004, nominal GDP, as estimated by the Bureau of Economic

3. Why have technological advances hindered the enforcement of legal restrictions

13. How do insurance companies address the problem of adverse selection?

18. Explain the following quotation:

1. Explain how a bank run can turn into a bank panic.

8. Why do regulators insist that banks hold a minimum level of capital?

1. For many central banks, the primary goal is to control inflation.

9. In the 1970s and 1980s, Argentina experienced a series of hyperinflationary episodes,

9. As Argentina’s economy was collapsing, the governor of its central bank

14. In 2001, Martin Mayer, a well-known financial commentator, wrote "The

4. Compute the impact on the money multiplier of an increase in desired currency

1. Consider an open market purchase by the Fed of $3 billion of Treasury bonds.

9. Suppose Congress banned discount lending. What would be the consequences?

Change in the Bank of Japan’s Balance Sheet Following a

2. Go to the Web site of the Federal Reserve Bank of New York,

4. A number of people have suggested the creation of a Monetary Union of the

5. Explain the mechanics of a speculative attack.

6. Assume that the interest rate on one-year Japanese government bonds is

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