ECON 102 Tutorial 5. TA: Iain Snoddy 8 June Vancouver School of Economics

Transcription

1 ECON 102 Tutorial 5 TA: Iain Snoddy 8 June 2015 Vancouver School of Economics

2 Announcement In the midterm Q25, if you put answer B we will change your midterm grade. See me either in my office hours next week or after the labs next Wednesday. Or see Shubo. 2/36

3 Question 1 Consider the following data from the economy of Adanac: Currency outside banks: $15 billion Personal and non-personal chequable deposits: $40 billion Personal non-chequable deposits: $50 billion Non-personal non-chequable deposits: $125 billion Fixed term deposits: $200 billion Assuming all the deposits are in charter banks, what is the value of M1 and the value of M2 in this economy (in billions of dollars)? 3/36

4 Money Review M1 Money Supply M1 is the most liquid measure of the money supply and includes Coins and Currency, Checkable Deposits (money in checking accounts) and Traveller s checks. M2 Money Supply M2 is less liquid than M1 and in addition to M1 money it includes savings deposits, money in money market funds, certificates of deposit and other time deposits. 4/36

5 Money Review Just to give some context, as of February 2015 M1 for the United States was $3 trillion, M2 was $11.8 trillion. What about debit cards and credit cards? Neither of these are considered money. A debit card draws on money in checkable deposits which is indeed money. A credit card allows you to take on a short term loan from the bank to finance payments. 5/36

6 Q1: The Answer Currency and checkable deposits are considered part of M1. So M1 is $40 billion + $15 billion=$ 55 billion. M2 includes the other 3 components also. Which gives $430 billion. These additional components are essentially time deposits or savings accounts. 6/36

7 Question 2 The reserve ratio of a depository institution is the (a) ratio of excess reserves to total deposits. (b) ratio of a bank s total reserves that are held in its vault or on deposit with the Bank of Canada to total deposits. (c) ratio of a bank s total reserves that are held in its vault in cash only to total deposits. (d) ratio of a bank s total reserves that are held in an account with the Bank of Canada only to total deposits. (e) ratio of a bank s total reserves that a bank regards as necessary to conduct its business to total deposits. 7/36

8 Question 2 The reserve ratio of a depository institution is the (a) ratio of excess reserves to total deposits. (b) ratio of a bank s total reserves that are held in its vault or on deposit with the Bank of Canada to total deposits. (c) ratio of a bank s total reserves that are held in its vault in cash only to total deposits. (d) ratio of a bank s total reserves that are held in an account with the Bank of Canada only to total deposits. (e) ratio of a bank s total reserves that a bank regards as necessary to conduct its business to total deposits. 8/36

9 The Reserve Ratio One way the central bank can improve financial security or ensure the financial system is sustainable is to require that banks hold more cash on hand. If there is a sudden economic shock or people decide to withdraw money all at once, the bank can more easily meet these payments. 9/36

10 The Reserve Ratio The problem with this of course is that the money multiplier is lower and the bank can create less money. The bank cannot lend money as easily and the financial system is less fluid. A higher reserve ratio ensures stability but lowers liquidity in the market. 10/36

11 An introduction to Financial Crises Often the way a crisis happens is that a bubble bursts and people suddenly believe the bank is now insolvent. If the bank does not have enough cash on hand to meet the demands of customers it must begin to sell its assets. But these assets are not liquid and so they must be sold at a discount. This is often called a fire sale. If the bank cannot meet its liabilities it is insolvent and will typically seek government assistance. Banks are often considered to be too big to fail. 11/36

12 Question 3 Whenever target reserves exceed actual reserves, the bank (a) can make new loans. (b) will call in loans. (c) will go out of business (d) is in a profit-making position. (e) has excess reserves. 12/36

13 Question 3 Whenever target reserves exceed actual reserves, the bank (a) can make new loans. (b) will call in loans. (c) will go out of business (d) is in a profit-making position. (e) has excess reserves. 13/36

14 Question 4 Suppose that a country has $50 billion in bank reserves, $100 billion in currency held by the public, and $500 billion in bank deposits. The cash drain ratio is (a) 18% (b) 50% (c) 30% (d) 10% (e) 20% 14/36

15 The Cash Drain The Cash/Currency drain When people hold money as cash rather than in a current account, the money multiplier is lower. When the bank lends money out, some of it is held as cash and less new deposits are created. The new money multiplier formula is 1+c c+r. 15/36

16 Q4: The Answer The cash drain ratio is the proportion of new deposits that individuals wish to hold as cash ( C = c D). Here $100 billion is held as cash, that is 1/5 of all deposits in the economy. The cash drain ratio is therefore 20% 16/36

17 Question 4 Suppose that a country has $50 billion in bank reserves, $100 billion in currency held by the public, and $500 billion in bank deposits. The cash drain ratio is (a) 18% (b) 50% (c) 30% (d) 10% (e) 20% 17/36

18 The Money Multiplier with a Cash Drain Let s work through an example. Suppose the reserve ratio is 10% and the cash drain ratio is 25%. If $100 in new deposits are initial created then the following rounds of deposits take place: 18/36

19 The Money Multiplier with a Cash Drain First let s be careful of a few things. The cash drain is the proportion of new deposits individuals hold as cash, not the proportion of new money they hold as cash. So C = c D. We know that C + D = M, or the change in cash and deposits equals the change in money held by the person. Using this we can show C = of new money held as cash. We can also show that D = 1 1+c M Plugging in these numbers we can see that and 1 1+c = 0.8 c 1+c M, which gives the proportion c 1+c = 0.25/1.25 = /36

20 The Money Multiplier with a Cash Drain M C D L The total new deposits each round are M = M (1 c) (1 R) The formula giving total new deposits is D 0 1 c+r Total new money is D + C = M 0 1 c+r + M 0 c c+r = 1+c c+r 20/36

21 Question 5 If households and firms find they are holding less money than desired, they will (a) sell bonds, and the interest rate will rise. (b) sell bonds, and the interest rate will fall. (c) buy bonds, and the interest rate will rise. (d) buy bonds, and the interest rate will fall. (e) buy goods, and the price level will rise. 21/36

22 Question 5 If households and firms find they are holding less money than desired, they will (a) sell bonds, and the interest rate will rise. (b) sell bonds, and the interest rate will fall. (c) buy bonds, and the interest rate will rise. (d) buy bonds, and the interest rate will fall. (e) buy goods, and the price level will rise. 22/36

23 Question 5 To increase cash holdings firms and governments will sell their bonds for cash. The price of bonds will fall. The price of bonds and the interest rate are inversely related. So if the price of bonds fall, the interest rate must rise. When bonds become cheaper the interest rate offered by banks must rise to equalize returns between the two assets. 23/36

24 Present Value We know that the price of bonds and the market interest rate are inversely related. The reason for this is that if the interest rate increases, individuals could deposit money in the bank instead, making bonds less attractive. The concept of present value asks how much would you be willing to pay for an asset today that pays out in the future? The answer to this question depends on alternative investments you could make. Basically present value asks, how much money could you deposit in the bank today to generate the same return as this alternative asset. 24/36

25 Present Value: An example So let s consider a bond that costs $100 and pays 5% interest at the end of year 1 and year 2. The market interest rate is 2%. How much could you put in the bank today to generate the same return as this bond? If you put X in the bank after year 1 you will have (1.02) X. If you put Y in the bank for 2 years you will have (1.02) 2 Y. We want 1.02 X = 5 and Y = 105. This gives X=4.90 and Y= X+Y= /36

26 Present Value: An example Note that the present value formula is just: P V = C C + M = = This is the exact same thing that we calculated above! The present value is just the amount you could put in the bank today to give the same return as the bond and is therefore the price you would be willing to pay for the bond. 26/36

27 Question 6-7 This table presents information on the demand for money at a given interest rate and for a given level of real GDP. r M d (Y=$10bn) M d (Y=$20bn) /36

28 Question 6 The quantity of money is $3 billion. Initially, real GDP is $20 billion. If the interest rate is less than 4 percent a year (a) people sell bonds, the price of a bond falls, and the interest rate rises. (b) people buy bonds, the price of a bond rises, and the interest rate rises (c) people sell bonds, the price of a bond falls, and the interest rate falls (d) people buy bonds, the price of a bond rises, and the interest rate falls (e) the demand for money increases 28/36

29 Question 6 Answer In this case there is excess demand for money. Money demand exceeds $3 billion but the supply is $3 billion. When there is excess demand households will sell bonds for cash to increase money holdings. The supply of bonds will then increase and the price will fall. If the price falls then it becomes less attractive to deposit money in the bank and so the interest rate rises. 29/36

30 Question 6 The quantity of money is $3 billion. Initially, real GDP is $20 billion. If the interest rate is less than 4 percent a year (a) people sell bonds, the price of a bond falls, and the interest rate rises (b) people buy bonds, the price of a bond rises, and the interest rate rises (c) people sell bonds, the price of a bond falls, and the interest rate falls (d) people buy bonds, the price of a bond rises, and the interest rate falls (e) the demand for money increases 30/36

31 Question 7 The quantity of money is $3 billion. Initially, real GDP is $20 billion. If the interest rate is greater than 4 percent a year (a) people buy bonds, the price of a bond rises, and the interest rate rises (b) people buy bonds, the price of a bond rises, and the interest rate falls (c) people sell bonds, the price of a bond falls, and the interest rate rises (d) people sell bonds, the price of a bond falls, and the interest rate falls (e) the demand for money decreases 31/36

32 Question 7 Answer In this case there is an excess supply of money. Money demand is less than $3 billion but the supply is $3 billion. When there is excess supply households will buy bonds to reduce their money holdings. The supply of bonds will then fall and the price will rise. If the price rises then it becomes more attractive to deposit money in the bank and so the interest rate falls. 32/36

33 Question 7 The quantity of money is $3 billion. Initially, real GDP is $20 billion. If the interest rate is greater than 4 percent a year (a) people buy bonds, the price of a bond rises, and the interest rate rises (b) people buy bonds, the price of a bond rises, and the interest rate falls (c) people sell bonds, the price of a bond falls, and the interest rate rises (d) people sell bonds, the price of a bond falls, and the interest rate falls (e) the demand for money decreases 33/36

34 Question 8 The money multiplier can also be calculated as, where a is the cash drain ratio and b is the desired reserve ratio. (a) (a + b) (1 + b) (b) a (a + b) (c) (1 + a) (a + b) (d) (a + b) (1 + a) (e) (1 + b) (a + b) 34/36

35 Answer The previous cash drain example provides the answer to this question and shows how the cash drain affects the money multiplier. 35/36

36 Question 8 The money multiplier can also be calculated as, where a is the cash drain ratio and b is the desired reserve ratio. (a) (a + b) (1 + b) (b) a (a + b) (c) (1 + a) (a + b) - Answer (d) (a + b) (1 + a) (e) (1 + b) (a + b) 36/36