Credit Market - Verständnisfragen Flashcards
The 1970s was a period of high inflation in many countries, including the US. a) Due to the increase in the rate of inflation, lenders, including credit card companies, revised their nominal interest rates upward. How is the rate of inflation related to the nominal interest rate that credit card companies charge? Why would lenders need to increase the nominal interest rate when the inflation rate increases?
r = i – π, Nominal interest rate is not adjusted for inflation, the real interest rate is.
When the inflation rate increases, the nominal interest rate also needs to increase to keep the real interest rate constant. Without an increase in the nominal interest rate lenders would get less interest payment.
A Law in the US places an upper limit on the nominal rate of interest that lenders can charge on their loans. In the 1970s, in order to avoid this law, some credit card companies moved to states where there were no ceilings on interest rates. Why would credit card companies move to states without such a law during a period of high inflation like the 1970s?
In times of high Inflation lenders need to increase their nominal interest rate so they can hold the real interest rate.
An upper limit may constrain lenders which is why they would move to states without upper limits.
Explain how the equilibrium real interest rate and the equilibrium quantity of credit would change in each of the following scenarios, and illustrate your answer with a well-labeled graph of the credit market.
a) As the real estate market recovers from the 2007 – 2009 financial crisis, households begin to buy more houses and apply for more mortgages to enable those purchases.
b) Congress agrees to a reduction in the federal deficit, which results in a significant decrease in the amount of government borrowing.
c) Households begin to fear that the recovery from the 2007-2009 recession will not last, and become more pessimistic about the economy.
a. -> Increase in credit demand due to demand for mortgages
b. -> Significant decrease in government borrowings => decrease in demand
c. 1. Decline in borrowings by households = leftward shift of demand curve
2. Households increase savings = credit supply curve shift to the right
3. Interest rate will definitely fall, but we cant know for sure the quantity because we don’t know how much each curve shifts
Banks that practice narrow banking match the maturity of their investments with the term of the deposits that they collect from the public.
a) Suppose that all banks decide to adopt narrow banking. What would happen to the level of risk in the banking system?
b) Why then do banks still practice maturity transformation?
a. Why then do banks still practice maturity transformation?
b. otherwise they could just earn money through services like Bank account leading fees or consultation. Also this crucial function allows the economy to undertake significant long-term investments and lets bank make considerable profit
Regulations require banks to hold at least a certain defined percentage of their checking deposits as reserves. Usually, banks held very few reserves beyond that percentage. However, starting in the financial crisis of 2007 –2009, the amount of reserves held by banks went from virtually zero to over 1.8 trillion dollars.
a) Why would banks usually hold no more reserves than
regulation requires?
b. Why did this change during the crisis?
a. holding more reserves reduces the return on equity and goes along with a significant opportunity cost for the banks. The ratio L/E is greater if E is smaller.
b. Bank runs may occur = People want to get their money which is due to maturity transformation stuck in long-term investments
. also, less demand for credit and banks don’t give out many loans anymore -> instead they held their money as reserves
Due to an economic downturn, the value of a banks long term investment declines by 10% and thus also the Equity. The equity is now in minus.
What do regulators typically do to minimize the iccurence of situations like this?
1.
2.
3.
- minimum capital requirements
- emergency sales plan (living will)
- stress tests
