Chapter 24

Question 1

Who are debtors?

Answer 1

Borrowers, are economic agents who borrow funds.

Question 2

What is credit?

Answer 2

Refers to the loans that the debtor receives

Question 3

What is the interest rate?

Answer 3

Also referred to as the nominal ineterest rateI, i, is the annuual cost of a 1$ loan, so i * L is the annual cost of an $L loan.

Question 4

What happens when the interest rate goes up?

Answer 4

As the interest rate goes up, fewer firms and individuals are willing to pay the high price to acquire credit.

Question 5

What is the general rule of the infaltion rate?

Answer 5

The higher the inflationn rate is (holding all else equal) the higher the prices will be the GS that firms sell, and tthe easier it will be to pay back loans given the nominal rate of interest.

Question 6

What is nominal interest rate?

Answer 6

annual grwoth rate of what you owe on a loan, principal plus interest.

Question 7

Real interest rate

Answer 7

Inflatio adjusted nominal interest rate. The nominal r- inflation rate.

rr=nr-inflation rate

Real interest rate is the opportunity cost of current consumption. For most people: A higher rr increases the opportunity cost of current consumption and encourages higher level of saving.

Specifically a higher rr encourages more saving, increasing the amount of funds that banks can lend thereby increasing the quantity of credit supplied.

-represents the economic trade-off between borrowers and savers

Question 8

What is the credit demand curve?

Answer 8

-the schedule that reports the relationship between the quantity of credit demanded and the real interest rate

Credit is a function of the real interest rate.

Question 9

Describe the credit market

Answer 9

when price of GS goes up, consumers tend to buy less of it. Credit works the same way, where the real price of credit is the real interest rate.

Question 10

What does the steepness of the credit demand curve?

Answer 10

The steepness tells us about the sensitivity of the relationship between the real interest rate and the quantity of credit demanded.

1) When the credit demand curve is relatively steep, the quantity of credit demanded doesn’t change as much in response to varitation in the real interest rate.
2) When the credit demand curve is relatively flat, the quanitity of credit demanded is relatively senitive to variation in the real interest rate.

Question 11

What causes the demand curve to shift?

Answer 11

1) Changes in perceived business opportunities (increasing demand=shift to the right)
2) Changes in household preferences or expectations. If household preferences change for more consumption , they will tend to borrow more. (more optimistic households (shift to the right)
3) Changes in government policy (government borrowing in the credit market can swing widly from year to year).

during recession=> income falls => this reduces tax revenues =>gov spending rises to stimulat the contracting economy (shift to the right)

Government tax policies can shift the demand curve too. Sometimes th government stimulates investment bin physical K by loweing taxes on profits or explicitly introducing subsidies for physical capital investment. Such tax cuts/subsidies can shift the market credit demand curve to the right.

Question 12

Why bankes are the middlemen?

Answer 12

• banks provid credit to businesses and household that wish to borrow. Economic agents with excess cash have deposited their money in the bank. Banks match savers and borrowers.

Question 13

What is the credit supply curve?

Answer 13

the schedule that reports the relationship between the quantity of credit supplied and the real interest rate.

Question 14

Why are ineterest payed to depositors?

Answer 14

Money can be spent now, or can be saved for future consumption. Because saving requires giving something up (current consumption) people will only save if they get something worthwile in return. The real interest rate is the compensation that people receive for saving their money, because 1$ saved today is 1$+r dollars of purchasing power in the future.

Question 15

What shift the credit supply curve?

Answer 15

1) Changes in the saving motives of houseolds (motives change over time). When they save more, because they want to build up a store of wealth) => shifts to the right
2) Changes in the saving motives of firms (profits can be saved in banks for future investment. (shift to the right)

Question 16

What is the credit market?

Answer 16

Where borrowers obain funds from savers. It improves the allocation of resources in the economy.

Question 17

describe the equilibrum

Answer 17

At the eqm, rr, the quantity of credit demanded is equal the supply of credit, which would tipcally put downward pressure on the rr.

Question 18

Where would a rr below eqm lead?

Answer 18

exces demand for credit, creating upward pressure on the rr

Question 19

Describe what happens when the rr is below the eqm with an example

Answer 19

Assume that the gov introduces a tax credit for business investment so that every dollar a firm invests by building plants or purchasing equipment reduces
the taxes that it owes by 30 cents.

Such tax credit reduces the the cost of investment to firms and thus raises the net benefit of invesment.

As a consequence an optimizing firm’s willingness to borrow will increase.

Consequently credit demand shifts to the right.

Question 20

What are financial intermediaires? Give examples

Answer 20

channel funds from suppliers of financial capital to users of financial capital

-banks
-asset management companies: enable investors to buy financial securities like stocks and bonds.
(investing in mutual funds is an example, which in turn invest in a diversified pool of securities (mixture of stocks in a stock mutual fund, mixtures of bonds in a bond mutual fund, or both in a fully diversified mutual fund).
-hedge funds: investment pools gathered from a smal number of wealthy individals or institutions, like pension funds or university endowments. (risky, non-traditional investment strategies). Charge fees much higher than mutual fund.
-private equity funds: investment pools gathering funds from a small number of wealthy institutions. (mostly hold securities that are not publically traded)
-venture capital funds: particular type of private equity funds. Investing in new companies and start-ups. Highly risky.
-shadow baking system made upp by bank-like businesses: thousands of institutions that are not officially banks. (raise money and than offer loans)

Question 21

What does a bank’s balance sheet summarize?

What are assets and liabilities?

Answer 21

Assets and Liabilites.

Assets: investment that the bank has made, gov securities held by the bank, money the bank is owed by borrowers

Liabilities: claims of depositors and lenders, money that the bank owes

Question 22

What are assets in more depth?

Answer 22

1) bank reserves include vault cash and holdings of reserves at the Federal Reserve Bank. (deposits that a bank has made at the FRB).
2) cash equivalents: liquid assets that a bank can immadiately access. Any asset is liquid if it can quickly and easily be converted into cash, with little or no loss in value.
3) Long term investments mostly comprise loans to households and firms but also include things like the value of the real estate that the bank uses to operate.

Question 23

What aee liabilities in more depth?

Answer 23

1) demand deposits: funds loaned to the bank by depositors. Depositors can withdraw the money at any time.
2) short term borrowing comprises short term loans that the bank has obtained from other financial institutions. (overnight loans too). Heavy realiance on short-term debt generates some fragility in the banking system.
3) long term debt is defined as debt that is due to be repaid
4) stockholders equity, which is:

total assets-total liabilities=stockholder’s equity
total assets= stockholder’s equity+total liabilities

It is the estimated value of the company.

Question 24

What are the 3 interrelated functions that banks perform as financial intermediaires:

Answer 24

1) banks identify profitable lending opportunities
- find creditworthy borrowers and channel savings of depositors to them

2) banks transform short term liabilities like deposits into long term investment in a bank process called maturity transformation
- maturity is the time untik the debt must be repaid
- the transfer of short term liabilities like demand deposits into long ter investment is called maturity transformation. Maturity transformation is what enables society to undertake significant long-term investments (also maturity mismatch=to ensure that they can fulfill depositors demands for withdrawals, banks hold back some fraction of the deposit known as reserves.
- bank’s assets become illiquid, that is by turning short term liabilities into long term illiquid assets, the bank effectively locks up money that it might need to give back to depositors or other creditors on short notice.

3) banks manage risk by using diversification strategies and also by transfering risk from depositors to the banks stockholders and in some cases to the us government
- banks hold a diversified portfolio (diverse set of assets like, gov debt, business loans, loans to other financial institutions=all of the or highly unlikely to undererform at the same time.

Question 25

Who bairs bank’s risks?

Answer 25

as long as stockholder’s equity is greater than zero, they bear the risks. In other words, as long as the bank’s assets exceed its liabilities, every change in the value of the assets is absorbed one-for-one by stockholders

• below zero, banks owes more than it owns. => bank is shut down by the FDIC and pays out the depositors until 250000
• or arranges a takeover

Question 26

When does a bank become insolvent?

Answer 26

When the value of the bank’s assets become insolvent.

A bank is solvent when the value of its assets is greater than the value of its liabilities.

Question 27

What is a bank run?

Answer 27

a bank run occurs when a bank experiences and extraordinary large volume of withdrawals driven by a large concern that the bank will run out of liquid assets with which to pay withdrawals. It forces banks to liquidate its long-term illiquid.

Question 28

What is credit?

Answer 28

Credit is essential for the efficient allocation of resources in the economy, for ex, credit allows firms to borrow for investment of households to borrow to purchase a house.

Question 29

The federal funds rate is the

Answer 29

interest rate in the federal funds market where banks obtain overnight loans of
reserves from one another

Question 30

An economic recession will imply

Answer 30

. An inward shift in the demand curve for reserves at the central bank

Question 31

How does the Federal Reserve usually work to affect the federal funds rate?

Answer 31

It shifts supply through open market operations.

Question 32

Who bears the risk that a bank faces when stockholders’ equity is greater than zero?

Answer 32

The bank’s stockholders.

Question 33

A8. Which of the following statements about the Bank of England is INCORRECT?
a) The Bank seeks to meet the Government’s Inflation Target by setting the interest
rate paid on reserve balances.
b) Whenever the inflation is above the inflation target, the Governor of the Bank must
write an open letter to the Chancellor.
c) There is no practical upper limit to the level of the Bank’s rate, but there is an
effective lower bound.
d) The interest rate decisions are taken by the Monetary Policy Committee every month
and the Bank publishes its Inflation Report every quarter.

Answer 33

A8. Which of the following statements about the Bank of England is INCORRECT?
a) The Bank seeks to meet the Government’s Inflation Target by setting the interest
rate paid on reserve balances.
b) Whenever the inflation is above the inflation target, the Governor of the Bank must
write an open letter to the Chancellor.
c) There is no practical upper limit to the level of the Bank’s rate, but there is an
effective lower bound.
d) The interest rate decisions are taken by the Monetary Policy Committee every month
and the Bank publishes its Inflation Report every quarter.

ONLY B IS NOT TRUE