Money, Banking and The Macro-Economy - Answers: 5.1 Checklist Questions
Money, Banking and The Macro-Economy - Answers: 5.1 Checklist Questions
Money, Banking and The Macro-Economy - Answers: 5.1 Checklist Questions
Chapter 5
2. What happens to the money supply and to aggregate demand when con-
fidence in financial markets is boosted? Assume the policy interest rate
stays the same throughout. Illustrate your answer using a 3-equation
model diagram (as in Fig. 5.5).
ANSWER:
The 3-equation model is represented in Fig. 5.5 in the chapter together
with the demand for money. The return of confidence to financial markets
Statement S1 is true. The riskier the loan, the higher the banking mark-
up that banks will charge on top of the policy rate. This stems from
the considerations explained in the previous answer. With greater credit
risk, banks insure themselves from borrower’s default by charging a higher
lending rate. Statement S2, in contrast, is false. Indeed, the lending rate
depends negatively on risk tolerance. Banks that are more willing to take
up higher risk will charge a lower lending rate, for a borrower of the same
risk, compared to a less risk tolerant bank. By doing so, they are able to
attract a higher share of risky borrowers.
5. The following four borrowers are categorised according to their level of
wealth and the quality of their proposed investment project. Which of the
borrowers will receive a loan from the bank for their project and why?
a. low wealth, low quality project
b. low wealth, high quality project
c. high wealth, low quality project
d. high wealth, high quality project
ANSWER:
To answer the question, we assume that the only difference across bor-
rowers and projects is their wealth, which is known to the bank and the
quality of the project, which is not. Based on these assumptions, of the
four borrowers, (d) will receive a loan. Higher wealth signals to the bank
the borrower’s ability to repay the loan. Higher wealth also allows the
borrower to signal the quality of the project by the borrower’s willingness
to contribute equity, which better aligns the borrower’s incentives with
those of the lender. In presence of asymmetric information, borrowers (a)
and (b) look alike and will not receive a loan. Because borrower (c) is
able to provide an equity contribution to the project and or provide col-
lateral, they are likely to receive a loan for a lower quality project than it
is possible for borrower (b) to finance.
6. Is deposit insurance always a ‘good thing’ ?
ANSWER:
Such schemes are beneficial in avoiding "coordination failures" and liquid-
ity risk stemming from self-fulfilling bank runs. However, they need to be
designed in order to avoid moral hazard. Such schemes dampen the incen-
tive for banks to take due care in their loan decisions and more broadly, in
their prudential behaviour. They also reduce the incentives for households
to be prudent. If a household knows their deposits are guaranteed up to
a certain amount, they may, for example, be less sceptical of the business
model of banks offering very attractive deposit rates. It is more likely that
bad management of banks will escape the notice of depositors.
7. Set out a simple balance sheet for a single commercial bank (as in Fig.
5.9). Define each item in turn and discuss why that item has been labelled
A
rS
Initial banking B
mark-up Z
r′S r P
r0
C IS
IS′
r P′
Period 1
banking y
mark-up
π
PC(π 0E = π T )
PC(π tE = π 0 )
A, Z
πT
π1 C
π0 B y
MR
y0 ye y1
10. Use the 3-equation model to show the impact of a reduction in consumer
confidence on the economy. Make sure you show the period 1 mark-up
on your diagram and discuss what happens to both the policy rate and
the lending rate (as in Fig. 5.13). How would you expect a reduction in
competition in the banking sector due to mergers between banks to affect
the macro-economy?
ANSWER:
A reduction in consumer confidence is modelled as leftward shift of the
IS curve, as in fig. 5.1. Aggregate demand is depressed and output goes
below the equilibrium level; inflation falls too. The central bank responds
by cutting the policy rate to rP ′ in order to achieve their desired lending
rate of r0 – the period one mark-up is shown on the figure. The decrease
in the lending rate boosts aggregate demand and raises inflation. The
central bank then gradually increases the policy rate over the following
periods until the lending rate reaches its new stabilising rate at rS′ . For
all types of market structure, the factors influencing the banking mark-up
are the same and work in the same direction: bank’s perception of loan
riskiness, bank’s risk tolerance and bank’s capital cushions. The market
structure simply affects the size of the mark-up. When banks have market
power they are able to charge a higher lending rate, holding everything