Week 3

Question 1

Free Banking

Answer 1

Private banks issued their own money (banknotes) redeemable in a homogenous unit of account (Dollar or pound on the gold standard)
Along with deposit banking and transfers, issuing redeemable paper banknotes lowered transactions costs

Question 2

Costly ways to increase demand to hold a bank’s notess

Answer 2

1. Attract more depositors
2. make redemption easier
3. Advertise
4. Anti-counterfeiting measures
5. Make the currency more attractive (aesthetics)

Question 3

What happens if the system overissues?

Answer 3

Direct effect:
- extra spending due to the increase in the money supply
- gets funneled into imports which exports specie and drains bank’s reserves

Indirect effect:
- increase in money supply raises domestic price level higher then the post price level
- depressed exports and stimulates imports
- precious metal flows to where it has a higher purchasing power (foreign countries)

Question 4

Bank Runs

Answer 4

occure when depositors fear that they won’t be able to access they money at the bank

Question 5

Illiquid

Answer 5

Assets>Liabilities, but does not have liquid assets (cash) on hand at a specific time
Illiquid banks can be saved.

Question 6

Insolvent

Answer 6

Assets<Liabilities. “Underwater”
Most often happens when loans are defaulted on.
If saved through a bailout, an insolvent bank cannot pay back the loan.

Question 7

Sunspot Theory

Answer 7

Depositors run because others run

Question 8

Bad News Theory

Answer 8

Depositors run on a banks that are insolvent. Depositors watch bank activity to make sure their deposits are safe. If they think the bank is in a risky position (Too many bad loans, not enough reserves), they run.

Question 9

Problems with DD Model

Answer 9

• debt-equity hybrid. Real-world banks have equity owners
• non-spendable deposits
• DD model imposes first come first serve redmeption

Question 10

Costs of Bank Runs

Answer 10

1. Depositors lose deposits
2. Shareholders lose out
   - After the run, banks liquidate assets quickly to try and stay liquid.
   - Assets are sold at low prices to move them quickly. “Fire sale losses”.
3. To Borrowers
   - Interrupts bank-borrower relationship
4. For banking panics
   - Money supply contracts
   - Can cause recession in its own right

Question 11

Benefits of Bank Runs

Answer 11

1. Runs on insolvent banks stop a “wealth destroying machine”
2. The threat of runs encourages banks to run a sound operation

Question 12

Fire Sale Losses

Answer 12

A fire slae describe the vicious circle during which the forces sale of a financial asset drives down the price of related assets forcing more sales further driving down the prive

Question 13

Arguments for Regulated Banking

Answer 13

1) An unregulated banking system is inherently run prone and open to contagion.
2) Runs have negative spillover effects (externalities)
3) Regulations can reduce runs and panics, and cost less than the benefits they provide by mitigating panics.

Question 14

Why are banks run prone?

Answer 14

The expected payoff of arriving earlier to remove your deposit is higher than when arriving later

Question 15

Solutions to being prone to runs

Answer 15

1) Equity claim (like shares in a MMMF)
- bad news reduces the price of all assets. Each depositor only has claims to a limited number of shares. Value of shares moves together. No incentive to run

2) Conditional redemption
- notice-of-withdrawal and option clauses. Avoids fire sale losses

3) Solvency Assurances
- advertised capital. Diverse portfolio of safe assets. Extended liability for shareholders

Question 16

The role of government and banking regulation

Answer 16

• lender of last resort (FED)
• Deposit Insurance (FDIC)
• Various restriction
• minimum equity ratio
• equity restriction
• reserve requirements
• asset portfolio supervision
• activity restriction (Glass Steagall)