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1. According to Lewis and Mizen, which of the following is NOT a primary role of a financial intermediary?
Financial intermediaries facilitate the flow of funds from lenders to borrowers. Their key functions include administrative efficiencies, risk pooling (diversification), and maturity transformation. Setting monetary policy is the role of the central bank, not private financial intermediaries.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics. (see also Tobin (1963) cited in McCallum, p. 27)
2. Why is maturity transformation considered a crucial function of banks?
Maturity transformation is vital because it reconciles the conflicting desires of savers (who prefer to keep their assets liquid and accessible, i.e., 'go short') and borrowers (who prefer to have financing for longer-term projects, i.e., 'go long'). Banks bridge this gap by taking short-term deposits and making long-term loans.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 34.
3. On a commercial bank's balance sheet, where are customer deposits and loans to businesses typically listed?
For a commercial bank, deposits represent money it owes to its customers, so they are liabilities. Loans represent money that is owed to the bank, so they are assets from which the bank earns interest income.
Source: McCallum, B. T. (1989). Monetary Economics, p. 57; EC3115 - Monetary Economics Unit E Lectures, Slide 4.
4. The fundamental reason a bank's balance sheet must always balance is due to:
A balance sheet is an expression of the fundamental accounting equation. A bank's assets (what it owns) must equal the sum of its liabilities (what it owes to others) and its net worth or equity (the owners' stake). Net worth is the residual that ensures the sheet balances.
Source: McCallum, B. T. (1989). Monetary Economics, p. 57-58.
5. What is the monetary base (or high-powered money)?
The monetary base (MB or H) consists of the total liabilities of the central bank. This is comprised of currency in the hands of the public (C) and the reserves of the commercial banking system (R), which includes vault cash and deposits held at the central bank. Thus, MB = C + R.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 4-5; McCallum, B. T. (1989). Monetary Economics, p. 56.
6. How does a central bank typically increase the monetary base?
The primary tool for changing the monetary base is open market operations. To increase the base, the central bank purchases government bonds from the banking system. It pays for these bonds by crediting the reserve accounts of the commercial banks, thereby increasing total reserves (R) and, consequently, the monetary base.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 8-10.
7. In a fractional reserve banking system, the reserve ratio (r) is defined as:
The reserve ratio (r) is the proportion of total deposits that a bank holds in reserve (either as vault cash or as deposits at the central bank) rather than lending out. In a fractional reserve system, this ratio is less than 1 (r < 1).
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 11.
8. If the central bank conducts an open market purchase of $100 million in bonds, what is the immediate effect on the balance sheet of the commercial banking system?
When the central bank buys bonds from a commercial bank, the commercial bank exchanges one asset (bonds) for another (reserves). Its holdings of government bonds decrease, and its reserve account at the central bank is credited, increasing its reserves. There is no immediate change in liabilities or total assets.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 13.
9. The money multiplier model demonstrates that an initial increase in the monetary base leads to:
The process of fractional reserve banking means that an initial injection of reserves into the banking system is lent out multiple times. Each round of lending creates new deposits, which are then partially held as reserves and partially lent out again. This re-lending cycle results in a total expansion of the money supply that is a multiple of the initial increase in the monetary base.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 18-19.
10. The formula for the money supply (M) is given by \( M = m imes MB \), where \(m\) is the money multiplier and \(MB\) is the monetary base. The multiplier \(m\) is formally expressed as:
The simple deposit multiplier (1/r) does not account for the public's decision to hold currency. The more sophisticated money multiplier incorporates both the banks' reserve ratio (r = R/D) and the public's currency-deposit ratio (c = C/D). The derivation shows that \( m = rac{C/D + 1}{C/D + R/D} = rac{c+1}{c+r} \).
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 28-30; McCallum, B. T. (1989). Monetary Economics, p. 56 (uses 'cr' and 'rr').
11. How does an increase in the public's desire to hold currency (a higher currency-deposit ratio, c) affect the money multiplier?
When the public holds more currency, less money is deposited in the banking system. This leakage of funds from the banking system weakens the re-lending cycle. With less money available for banks to lend out at each stage, the overall expansion of the money supply is smaller. Therefore, an increase in 'c' decreases the money multiplier 'm'.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 31.
12. If the central bank increases the mandatory reserve ratio (r), what is the likely effect on the money supply, assuming the monetary base remains constant?
A higher reserve ratio means that for every dollar of deposits, commercial banks must hold a larger fraction in reserves and can lend out a smaller fraction. This reduces the amount of money created at each step of the re-lending cycle, thus decreasing the money multiplier and contracting the overall money supply.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 30; McCallum, B. T. (1989). Monetary Economics, p. 59.
13. In the context of monetary standards, what is a 'fiat money' system?
Fiat money is money that a government has declared to be legal tender, but it is not backed by a physical commodity. Its value derives from the trust that it will be accepted by others in exchange for goods and services, and its supply is controlled by the monetary authority. It is not convertible by law into anything other than itself.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 27, 43.
14. Under the classical gold standard, exchange rates between two member countries were anchored by the:
The exchange rate was determined by the 'mint par of exchange,' which was the ratio of the gold content of the two currencies. The rate could only fluctuate within a narrow band defined by the 'gold points' (or specie points), which were determined by the cost of shipping gold between the two countries. Arbitrage ensured the rate stayed within this band.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 35-36.
15. McCallum distinguishes between two main types of monetary control procedures for targeting the money stock. These are:
A central bank can try to achieve its money stock target (M) by either controlling a quantity variable or a price variable. It can set the level of high-powered money (the H-instrument) and let the market determine the interest rate, or it can set the interest rate (the R-instrument) and supply whatever amount of H is necessary to maintain that rate.
Source: McCallum, B. T. (1989). Monetary Economics, p. 64.
16. What is the primary reason banks hold 'excess reserves' (reserves above the legally required minimum)?
Banks hold excess reserves as a precaution. An unexpected loss of deposits (e.g., a large withdrawal) could cause a bank's total reserves to fall below the legally required minimum, incurring penalties. Excess reserves provide a cushion to prevent this. However, holding them is costly as they do not earn interest.
Source: McCallum, B. T. (1989). Monetary Economics, p. 58.
17. The demand for excess reserves by banks, \(e(R)\), is typically assumed to be a decreasing function of the interest rate (R). Why?
The interest rate (R) represents the opportunity cost of holding reserves, which are non-interest-bearing. When the interest rate is high, the forgone income from not lending out reserves is also high. Therefore, banks have a stronger incentive to minimize their holdings of excess reserves and lend more, making the demand for excess reserves a decreasing function of R.
Source: McCallum, B. T. (1989). Monetary Economics, p. 58.
18. If the reserve ratio \(r = 0.1\) and the currency-deposit ratio \(c = 0.2\), what is the value of the money multiplier \(m\)?
Using the formula \( m = rac{c + 1}{c + r} \): \[ m = rac{0.2 + 1}{0.2 + 0.1} = rac{1.2}{0.3} = 4 \] This means that for every $1 increase in the monetary base, the total money supply will increase by $4.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 30.
19. Which of the following best describes the concept of "financial intermediation"?
Financial intermediation is the process performed by firms that "intermediate" between surplus spending units (lenders) and deficit spending units (borrowers). They gather funds from savers and channel them to investors or other borrowers.
Source: McCallum, B. T. (1989). Monetary Economics, p. 27.
20. The "simple deposit multiplier" (1/r) is considered 'simple' because it ignores the effect of:
The simple deposit multiplier assumes that all money lent out is redeposited back into the banking system. It does not account for the fact that the public will choose to hold some of their money as currency, which represents a leakage from the deposit expansion process. The more sophisticated multiplier incorporates these currency holdings.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 22.
21. What is a key difference between a "commodity money" standard and a "fiat money" standard?
The fundamental characteristic of a commodity-money system is that the medium of exchange is a good that would be valuable even if it were not used as money (e.g., gold, silver). Fiat money, by contrast, is intrinsically useless and has value only because it is accepted as a medium of exchange by social convention and government decree.
Source: McCallum, B. T. (1989). Monetary Economics, p. 22-23.
22. In the money supply relationship \(M = ́u(R; k, cr)H\), the money multiplier \(́u\) is shown to be a function of the interest rate (R). This is because:
The overall reserve-to-deposit ratio (rr) is the sum of the required reserve ratio (k) and the excess reserve ratio (e(R)). Since banks' desired holdings of excess reserves are a decreasing function of the interest rate R (the opportunity cost), the overall reserve ratio 'rr' and thus the money multiplier \(́u\) are dependent on R.
Source: McCallum, B. T. (1989). Monetary Economics, p. 58-59.
23. The determination of the money supply depends on the actions and interactions of which three key players?
The money supply process is a result of the combined behavior of: 1) The central bank, which controls the monetary base; 2) The banking system (commercial banks), which creates money through lending; and 3) Depositors (the public), whose decisions about holding currency versus deposits affect the multiplier.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 2.
24. What is meant by "inside money"?
"Inside money" refers to the portion of the money supply created by the private banking system, primarily through the process of loan creation (e.g., checkable deposits). This is contrasted with "outside money" (or high-powered money), which is created by the central bank.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 2.
25. A "gold bullion standard" differs from a "gold specie standard" in that:
Under a gold specie standard, gold coins circulate freely and banknotes are convertible into these coins. Under a gold bullion standard, gold coins are withdrawn from circulation, and banknotes are only convertible into large gold bars (bullion), often restricted to specified groups. It represents a more managed and less automatic form of the gold standard.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 28 (Table 2.2).
26. Which role of financial intermediaries is described as borrowing 'at call' and lending 'longer' to accommodate the different 'preferred habitats' of savers and borrowers?
This describes maturity transformation. Savers prefer short-term, liquid assets ('borrowing at call'), while borrowers need funds for long-term investments ('lending longer'). Banks intermediate between these two groups, transforming short-term liabilities (deposits) into long-term assets (loans).
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 34.
27. If a bank has $1000 in deposits, a required reserve ratio of 10%, and it holds $150 in reserves, how much does it hold in excess reserves?
Required reserves are 10% of $1000, which is $100. The bank holds $150 in total reserves. Excess reserves are the difference between total reserves and required reserves: $150 - $100 = $50.
Source: McCallum, B. T. (1989). Monetary Economics, p. 58.
28. A central bank's liabilities consist of:
The liabilities on a central bank's balance sheet are the components of the monetary base: currency in circulation (cash held by the public) and the reserves of commercial banks (which are assets for the commercial banks but liabilities for the central bank).
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 4.
29. The process where an initial injection of reserves leads to a chain of new loans and deposits throughout the banking system is known as the:
The re-lending cycle describes how money is created in a fractional reserve system. A bank with excess reserves lends them out; the borrower deposits the funds in another bank, which then has excess reserves to lend; this process continues, creating a multiple expansion of deposits and money.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 20, 31.
30. According to the lecture slides, what is the primary reason a bank like First National Bank (FNB) would want to lend out its excess reserves after the central bank buys its bonds?
Reserves held by a bank typically earn no interest. Therefore, holding reserves in excess of the required amount is costly for a profit-seeking bank, as those funds could instead be lent out to earn interest income. This opportunity cost incentivizes banks to "shed" their excess reserves by making new loans.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 14; McCallum, B. T. (1989). Monetary Economics, p. 58.
31. A "bimetallic" monetary standard is characterized by:
In a bimetallic system, the monetary unit is defined as a specific weight of either gold or silver, and the mint stands ready to coin both metals at a legally fixed price ratio. This is distinct from symmetallism, where the relative price could vary.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 28 (Table 2.2), p. 31.
32. Gresham's Law, "bad money drives out good," suggests that in a bimetallic system:
If the mint ratio (legal price) of two metals differs from the market ratio, the metal that is undervalued at the mint ("good money") will be more valuable as bullion in the open market. People will therefore melt it down or export it, causing it to disappear from circulation, while the overvalued metal ("bad money") remains in use.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 31.
33. The total reserve-to-deposit ratio (rr) chosen by banks is a combination of:
Total reserves (TR) are the sum of required reserves (kD) and excess reserves (ER). The total reserve-to-deposit ratio (rr = TR/D) is therefore the sum of the legally mandated required reserve ratio (k) and the bank's chosen excess reserve ratio (e(R)), so \(rr = k + e(R)\).
Source: McCallum, B. T. (1989). Monetary Economics, p. 58-59.
34. A key argument for why financial intermediaries exist is that they provide "administrative economy." What does this mean?
This refers to the efficiencies gained from specialization. Individual lenders may lack the time, skill, or scale to efficiently evaluate borrowers, draw up contracts, and collect payments. Financial intermediaries specialize in these tasks, reducing the overall costs of lending and borrowing in the economy.
Source: McCallum, B. T. (1989). Monetary Economics, p. 27 (citing Tobin).
35. If the money multiplier is 5, a $20 billion open market sale of bonds by the central bank will ultimately:
An open market sale of bonds reduces the monetary base. The change in the money supply is the change in the monetary base multiplied by the money multiplier. Here, the monetary base decreases by $20 billion. So, the change in the money supply is \(5 imes (-$20 ext{ billion}) = -$100 ext{ billion}\).
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 27, 21.
36. The "gold-exchange standard" differs from the pure gold standard because countries on a gold-exchange standard:
Under a gold-exchange standard, a country maintains its currency's value by pegging it to the currency of another country that is on the gold standard. This means it holds reserves of that foreign currency (e.g., sterling or dollars) to maintain convertibility, effectively linking its own currency to gold indirectly.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 28 (Table 2.2).
37. Why does a bank's balance sheet have to balance?
The balance sheet is a statement based on the fundamental accounting equation: Assets = Liabilities + Net Worth. Net worth (or capital/equity) is the residual claim of the owners, and it is by definition the amount that makes the two sides of the sheet equal.
Source: McCallum, B. T. (1989). Monetary Economics, p. 57-58.
38. Which of the following is an asset for a commercial bank but a liability for the central bank?
Reserves that commercial banks hold as deposits at the central bank are an asset for the commercial bank (it is money they can access). However, for the central bank, these deposits are something it owes to the commercial banks, and thus they are a liability.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 4.
39. If the reserve ratio is 10%, a new deposit of $1,000 into the banking system will require the receiving bank to keep how much in reserves?
The reserve ratio dictates the fraction of deposits that must be held in reserve. With a 10% ratio, the bank must keep 10% of the $1,000 deposit, which is $100. The remaining $900 becomes excess reserves that can be lent out.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 15.
40. The re-lending cycle is weakened, and the money multiplier is smaller, if:
Both holding more excess reserves (a higher 'r') and the public holding more currency (a higher 'c') represent "leakages" from the re-lending cycle. In both cases, less money is available to be lent out in the next round of the cycle, thus reducing the overall multiplicative effect on the money supply.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 31.
41. Which of the following is a primary role of financial intermediaries according to Tobin's analysis cited by McCallum?
Tobin's essential point is that financial intermediaries exist to satisfy the different portfolio preferences of borrowers and lenders. Lenders often want safe, liquid assets, while borrowers wish to finance holdings of real assets beyond their own net worth. Intermediaries bridge this gap by creating liabilities (like deposits) that are safer and more liquid than their assets (like loans).
Source: McCallum, B. T. (1989). Monetary Economics, p. 27.
42. If the central bank wishes to contract the money supply, it will:
To contract (reduce) the money supply, the central bank needs to reduce the monetary base. It does this by selling government bonds to commercial banks. The banks pay for these bonds with their reserves, thus reducing the total reserves in the banking system, which leads to a multiple contraction of the money supply.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 8-10 (inferred).
43. The total money supply (M) is defined as:
The most common measure of the money supply (approximating M1) is the sum of currency held by the public (C) and the total value of checkable deposits held in the banking system (D). The equation is M = C + D.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 18; McCallum, B. T. (1989). Monetary Economics, p. 56.
44. In the context of a bank's balance sheet, Net Worth is:
Net worth, also known as owners' equity or bank capital, is the residual value after subtracting total liabilities from total assets. It represents the owners' stake in the bank and serves as a cushion against losses.
Source: McCallum, B. T. (1989). Monetary Economics, p. 57.
45. A "resource cost" of a commodity money standard like the gold standard is that:
A significant drawback of a commodity standard is the cost of producing the monetary commodity itself. As Sir Roy Harrod remarked, it involves using valuable labor and capital to dig gold out of the ground in one place only to rebury it in vaults in another. Fiat money, being nearly costless to produce, avoids this inefficiency.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 34.
46. The stability of a fractional reserve banking system relies heavily on:
Because banks hold only a fraction of their deposits as reserves, they cannot satisfy all depositors if everyone tries to withdraw their funds at once (a bank run). The system's viability depends on the confidence of depositors that their funds are safe and can be withdrawn when needed. Once confidence exists, few feel the need to withdraw, allowing the bank's liabilities (deposits) to serve as money.
Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 34.
47. If the currency-deposit ratio (c) is zero, the money multiplier formula \( m = rac{c + 1}{c + r} \) simplifies to:
If c=0, it means the public holds no currency and all money is held as deposits. The formula becomes \( m = rac{0 + 1}{0 + r} = rac{1}{r} \). This is the simple deposit multiplier, which represents the maximum possible multiplier effect when there are no currency leakages from the banking system.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 22, 30.
48. Which of the following is a reason why a central bank might choose to use an interest rate instrument instead of a monetary base instrument to control the money supply?
The choice of instrument depends on the source of instability. If money demand is stable but the money supply multiplier is volatile (e.g., due to unpredictable bank behavior), fixing the monetary base (H) will lead to large fluctuations in M. In this case, fixing the interest rate (R) can lead to more accurate control over M, as it insulates the outcome from money supply shocks.
Source: McCallum, B. T. (1989). Monetary Economics, p. 65-66.
49. The "zero-profit condition" in a competitive banking market, as described in the lecture slides, implies that:
In a perfectly competitive market, economic profits are driven to zero. For a bank with no other costs, this means the revenue from its assets (interest on loans) must equal the cost of its liabilities (interest paid on deposits). Therefore, the loan rate would equal the deposit rate, and the credit spread would be zero.
Source: EC3115 - Monetary Economics Unit E Lectures, Slide 37.
50. How does the introduction of a mandatory reserve ratio act like a "tax on bank lending"?
Because required reserves cannot be lent out and typically earn no interest, they impose an opportunity cost on the bank. To maintain profitability (the zero-profit condition), the bank must compensate for this cost. It does so by increasing the spread between its loan rate and deposit rate, effectively charging a higher loan rate than it would without the reserve requirement. This increase in the cost of lending is analogous to a tax.
Source: EC3115 - Monetary Economics Unit E Lectures, Slides 43-45.