Session 10 - Household financing & banks Flashcards
Consider an agent choosing how much to consume between now (on the x axis) and later (on the y axis). How does her budget constraint change as investment opportunities available to her improve and pay a higher interest rate?
a. The budget constraint will shift inward, as the agent will have less current consumption to allocate between the present and the future.
b. The budget constraint will pivot upwards, indicating that the agent can afford more future consumption for each unit of present consumption foregone.
c. The budget constraint remains unchanged because it is determined by the agent’s initial wealth, not by the rate of return on investments.
d. The budget constraint will shift outward, indicating that the agent can afford more consumption in both periods without changing her current consumption-savings decision.
Correct: B
Consumption smoothing follows from:
a. Diminishing marginal returns to consumption.
b. The cost of borrowing.
c. The interest rate on investments.
d. A preference for current consumption over future consumption.
Correct: A
Option A is correct. Consumption smoothing has to do with the shape of the utility function (and consequently of the indifference curves). It arises from the principle of diminishing marginal returns to consumption, which posits that the utility gained from additional consumption decreases as one consumes more. This encourages individuals to spread their consumption over different periods to maintain a stable level of utility over time. Options B and C, while important factors in determining how much to consume now versus later, and do not directly explain the motivation behind consumption smoothing. The cost of borrowing and the interest rate on investments can influence the decision of when to consume, because they determine the budget constraint, but they don’t inherently lead to the principle of smoothing consumption. Option D describes a preference that actually works against the principle of consumption smoothing.
Modigliani’s Life Cycle Hypothesis fails to explain:
a. Why some individuals do not save at all during their working years.
b. The increase in consumption at retirement despite a drop in income.
c. The accumulation of wealth by individuals well into retirement.
d. The tendency of individuals to save for post-retirement life.
Option C is correct.
Modigliani’s Life Cycle Hypothesis suggests that individuals plan their consumption and savings behavior over their life-cycle to smooth consumption. It assumes that people save during their working years and decumulate in retirement, aiming for a stable level of consumption throughout their life. However, the hypothesis has difficulty explaining why some individuals continue to accumulate wealth well into retirement, which is not consistent with the prediction of planned decumulation to smooth consumption. Options A, B, and D are phenomena that the Life Cycle Hypothesis can explain to some extent, considering that individuals may not save if they expect a steady or increasing income stream, they may dissave at retirement, and they are generally predicted to save for retirement.
Which of the following risks are tightly related to maturity transformation?
a. Foreign exchange risk.
b. Market risk.
c. Liquidity risk.
d. Operational risk
Option C, liquidity risk, is the most closely related risk to maturity transformation. Financial institutions engage in maturity transformation when they fund long-term loans with short-term liabilities. This process can create a mismatch between the maturities of assets and liabilities, leading to liquidity risk if the institution is unable to meet its short-term obligations due to this mismatch. Foreign exchange risk (Option A) pertains to the impact of currency value changes on an institution’s finances but is not specifically related to the process of maturity transformation. Market risk (Option B) is a broader risk of losses in positions arising from movements in market prices, and operational risk (Option D) refers to failures in internal processes, people, and systems.
Which of the following policies to prevent bank runs can actually make them more likely?
a. Deposit insurance schemes that guarantee a certain amount of depositor funds.
b. Central bank facilities that banks can use as a last resort for liquidity.
c. Higher capital requirements for banks to ensure they can absorb losses.
d. Reduction of reserve requirements to increase banks’ lending capacity.
Option B is the correct answer. While central bank facilities are designed as a safety net for banks to access additional liquidity, using these facilities can be perceived as a sign of financial distress by investors and depositors. If the market interprets a bank’s use of these facilities as a signal that the bank is in trouble, it may inadvertently trigger the very bank runs it aims to prevent. The other policies, such as deposit insurance (Option A) and higher capital requirements (Option C), typically serve to build confidence and reduce the likelihood of bank runs. Option D, the reduction of reserve requirements, is intended to increase banks’ lending capacity, but this policy could potentially make banks more vulnerable to runs if it leads to overextension and reduces liquidity buffers, though it is not as directly related to signaling weakness as Option B.
Consider an agent choosing how much to consume between now (on the x axis) and later (on the y axis). How does her budget constraint change as the interest rate at which she can borrow increases?
a.
The budget constraint will pivot downwards because present consumption becomes more expensive relative to future consumption.
b.
The budget constraint will shift outward, allowing for more consumption now and later.
c. The budget constraint will pivot upwards as present consumption becomes cheaper relative to future consumption.
d. The budget constraint will not change because it is only determined by the agent’s current income.
Correct: A
Option A is correct. When the interest rate increases, the cost of borrowing money to finance current consumption also increases. This means that for each unit of consumption an agent decides to move from the future to the present, they will have to give up more future consumption than before the interest rate increase. Thus, the budget constraint pivots downwards, reflecting that present consumption has become relatively more expensive. The outward shift in option B would suggest that the agent can consume more in both periods, which is not the case. Option C incorrectly suggests the opposite effect of what an increase in interest rates would have. Option D is incorrect because while the budget constraint is indeed determined by current income, it is also affected by the interest rate which determines the trade-off between current and future consumption.
What is the difference between base vs. bank money? What does broad money refer to?
Base Money:
legal tender including
- cash held by households, firms, and banks
- balances held by commercial banks at the central bank (reserves)
Bank money:
money effectively created by commercial banks when they hand out loans
- Example: when a person borrows money from a bank, the bank doesn’t use existing base money to make this loan; instead, it generates a new deposit in the borrower’s account -> new bank money
- base money remains essential, as the bank has to transfer base money when the loan is spent
- In practice, banks make many transactions to one another, most cancelling each other out, so they do not need to have available the base money to cover all transactions
Broad money: includes both bank money & base money, representing the total money supply circulating in the economy
Describe the money market
What is the short-term interest rate and what does it have to do with the money Market?
To manage daily transactions, commercial banks regularly borrow base money from each other in the money market
The price of borrowing base money from other financial institutions is the short-term interest rate
This price is determined by:
- demand for base money: amount of transactions commercial banks have to make (the fractions that isn’t cleared with bank money between banks)
- supply of base money: set by the central bank
Policy and bank lending rates
Explain the following terms and describe the relationship between them:
- policy (interest) rate
- policy rate
- bank lending rate
Policy (interest) rate:
- Central bank sets it through supply of base money
- this rate applies to banks that borrow base money from each other, and from the central bank
- policy rate is also called base rate or official rate
Bank lending rate:
= average interest rate charged by commercial banks to firms and households
- therefore, affected by policy interest rate
- bank needs to make profit -> rate will typically be above the policy interest rate: the difference is the markup or spread on commercial lending
Maturity transformation
Maturity transformation:
- provided by the banks as a service to the economy
- involves: accepting deposits which can be withdrawn on demand (short-term) & making loans which have a fixed repayment date, often in the long-term (e.g. 30 years mortgage)
- Maturity transformation bridges the gap between short-term savers and long term borrowers, facilitating long-term investments and planning in the economy
Risks:
- Liquidity risk: the risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss
- default risk: the risk that loans Woll not be repaid
