Chapter 14: Money and Banking

Question 1

In the history of the world, what item was used for money over the broadest geographic area and for the longest period of time?

Answer 1

Cowrie shells

Durable, measurable in either quantity or weight, impossible to counterfeit, controlled but not scarce

Question 2

Main goals of Macroeconomics

Answer 2

1. Low unemployment
2. Economic growth
3. Low inflation

Question 3

Monetary Policy

Answer 3

Manipulation of interest rates and credit conditions by a nation’s central bank. Reduced interest rates and increased available credit > increased business investment and consumer spending > growing GPD and employment

Question 4

Fiscal Policy

Answer 4

Policy on government spending, taxes, and borrowing

Question 5

Purposes of Money

Answer 5

1. Medium of exchange (not stuck in barter system)
2. Store of value (nonperishable)
3. Unit of account (standardized metric)
4. Serves as standard of deferred payment (allows for loans)

Question 6

Are we on the Gold Standard?

Answer 6

No, we went off the gold standard in the 1930s. Money is about confidence now.

Question 7

US Central Bank

Answer 7

Federal Reserve

The Fed

Question 8

European main bank

Answer 8

European Central Bank / ECB

Question 9

In the US, does the Fed have the power to tell banks what interest rates to charge?

Answer 9

No, so instead the Fed manipulates interest rates by changing the money supply (increase $ supply = more money for banks to loan out, lowering interest rates > increase borrowing and spending)

Question 10

How does the Fed increase money supply?

Answer 10

1. Decreasing the reserve requirement that banks are required to hold in reserves (frees up money)
2. Change interest rate (called the discount rate) the Fed charges banks
3. Open Market Operations - Fed buys or sells short term government bonds to banks. Buying back bonds from banks increases banks’ money supply. This is the most commonly used method.

Question 11

Why has inflation not increased even though the Fed increased the money supply around 2009?

Answer 11

Multiple explanations.

1. Excess Reserves - banks increased their reserves, so money never made it into the market/system.
2. Uncertainty in Europe, causing foreigners to hold dollars
3. US economy is still struggling

Question 12

Barter

Answer 12

Trading one good or service for another. Inefficient to coordinate.

Question 13

Double Coincidence of Wants

Answer 13

Situation in which two people each want some good or service that the other person can provide

Question 14

Problems with Barter

Answer 14

1. Inefficient to coordinate (double coincidence of wants)
2. Does not allow us to enter into future contracts for purchase (perishable items)
3. Ok in small economies, but does not allow for growth

Question 15

Medium of Exchange

Answer 15

Created by money, which acts as intermediary between buyer and seller

Question 16

Fiat Money

Answer 16

Has no intrinsic value, but is declared by a government to be the legal tender of a country
(example: US paper money)

Question 17

How is money defined?

Answer 17

Based on liquidity - how quickly can it be used to buy a good or service?

Question 18

M1 Money Supply

Answer 18

Very liquid monies such as cash, checkable deposits, and traveler’s checks

Question 19

M2 Money Supply

Answer 19

Includes everything in M1, but also less liquid monies such as savings and time deposits, certificates of deposit, and money market funds

Question 20

Which of the following is considered money?

a. checkable deposits
b. debit card
c. paper check

Answer 20

a. checkable deposits

Question 21

Where is most money in the economy?

Answer 21

In bank accounts, which exist only as electronic records on computers

Question 22

What functions do banks provide?

Answer 22

1. Act as financial intermediary, bringing together savers and borrowers
2. Play a key role in the creation of money
3. Lower transaction costs of finding a lender or borrower

Question 23

Depository Institutions

Answer 23

Institutions that accept money deposits and then use these to make loans. All deposited funds are mingled in one big pool, which is then loaned out.

Question 24

Credit Unions

Answer 24

Nonprofit financial institution that its members own and run. Accepts deposits from members and focuses on making loans back to its members. More credit unions than banks in the US.

Question 25

Who owns most of the banking assets (69% as of 2013) in the US?

Answer 25

The 12 largest banks

Question 26

What are banks’ assets?

Answer 26

Cash held in its vaults
Reserves (monies the bank holds at the Federal Reserve)
Customer loans
Bonds

Question 27

What are banks’ liabilities?

Answer 27

Deposits made by customers

Question 28

Primary Loan Market

Answer 28

Market where loans are made to borrowers

Question 29

Secondary Loan Market

Answer 29

Market where loans are bought and sold by financial institutions

Question 30

In a secondary loan market, if the original loan made in the past requires the borrower to pay a low interest rate, but the current interest rates are relatively high - will a financial institution pay more ore less to acquire the loan?

Answer 30

More

Question 31

Are bonds an asset or liability for banks?

Answer 31

An asset. Banks buy low-risk bonds from the government, and they will provide a stream of revenue later when the government repays the bond plus interest.

Question 32

Reserves

Answer 32

Money the bank keeps on hand, that is not loaned out or invested in bonds, and thus does not lead to interest income. Federal Reserve requires banks reserve a certain percentage of depositors’ money.

Question 33

Net Worth

Answer 33

Total Assets - Total Liabilities

Question 34

Securitization

Answer 34

Loans are bundled together into a financial security that is sold to investors

Question 35

What is an advantage of Securitization for a local bank?

Answer 35

If a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid being exposed to local financial risks.

Question 36

What the huge disadvantage of banks participating in Securitization?

Answer 36

A bank that is going to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make Subprime Loans

Question 37

Subprime Loans

Answer 37

Loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments after that. Some subprime loans made in the mid-2000s were later dubbed NINJA loans: loans made even though the borrower had demonstrated No Income, No Job, or Assets.

Question 38

What lead to the Financial Crisis of 2008-2009?

Answer 38

Many banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are “securitized,” which means that they are bundled together into a financial security that is sold to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.

Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. But if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid being exposed to local financial risks. (In the simple example in the text, banks just own “bonds.” In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have lots of extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can be pooled into a financial security.

But securitization also offers one potentially large disadvantage. If a bank is going to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the loan is likely to be repaid. However, a bank that is going to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what are called “subprime loans,” which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments after that. Some subprime loans made in the mid-2000s were later dubbed NINJA loans: loans made even though the borrower had demonstrated No Income, No Job, or Assets.

These subprime loans were typically sold and turned into financial securities—but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.

The economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. But as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could end up being worth much less than they had expected—and so the banks were staring bankruptcy in the face. In the 2008–2011 period, 318 banks failed in the United States.

Question 39

Why are high levels of loan defaults risky for banks?

Answer 39

Asset-Liability mismatch: A bank’s liabilities (customer deposits) can be withdrawn quickly, but banks’ assets like loans and bonds are repaid over many years

Question 40

How can banks protect themselves against unexpectedly high rates of loan defaults?

Answer 40

Diversifying its customer type

Question 41

How do banks “create” money?

Answer 41

By making loans out of its excess reserves to customers that are deposit the loan money into a demand deposit account at another bank. Increases the M1 money supply.

Question 42

Money Multiplier

formula

Answer 42

Money Multiplier = 1 / (Reserve Requirement)

Question 43

Change in Money Supply

formula

Answer 43

Total Change in M1 Money Supply = (1 / Reserve Requirement) x Excess Requirement

Question 44

When an economy is in recession, are banks likely to hold more or less money in reserves?

Answer 44

More money held in reserves, because banks fear loans and less likely to be repaid when economy is slow

Question 45

Mattress Savings

Answer 45

Money people are hiding in their homes because they do not trust banks. Most common in low-income economies. Means the money multiplier does not operate effectively and money/loans in an economy declines.

Question 46

If interest rates in the economy as a whole have fallen since the loan was made, are you willing to pay more or less for it?

Answer 46

More

If interest rates in the economy have fallen, then the loan is worth more.

Question 47

If interest rates in the economy as a whole have risen since the loan was made, are you willing to pay more or less for it?

Answer 47

Less
If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it.