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Money Banking and Financial Markets 2nd edition Laurence M. Ball - Solutions

What are the current interest rates on 1-year certificates of deposit at a commercial bank and a credit union located near you? Is one institution’s rate higher than the other’s? What might explain the difference?
Suppose that Melvin’s Bank purchases Gertrude’s Bank, making Gertrude a subsidiary of Melvin. Does this acquisition benefit the stockholders of Melvin’s Bank? Does the answer depend on the motives for the purchase? Explain.
Securitization has spread from mortgages to student loans and credit card debt. However, few loans to businesses have been securitized. Explain why.
Suppose that loan sharks propose legislation to promote their industry. They want a legal right to break the kneecaps of loan defaulters.a. Suppose you were hired as a lobbyist for the loan sharks. What arguments could you make to support their proposal?b. How would you respond to these arguments
Consider the example in Chapter 7 of two firms that want to issue bonds. Assume as before that a firm makes the promised payment on a bond only if its project succeeds.a. Suppose the government guarantees the firms’ bonds: it makes the promised payment if either firm defaults. Can both firms sell
Discuss several reasons why the government guarantees student loans but not auto loans.
The text Web site provides data on 82 countries from a 2002 study on government bank ownership. For each country, the data include (a) the percentage of bank assets at government-owned banks in 1970, (b) the average growth rate of bank loans as a percentage of GDP from 1960 to 1995, and (c) the
The Web site of the Community Financial Services Association, the payday lenders’ organization, has a page on “Myths and Realities" about payday lending. Do you agree with the CFSA about what’s a myth and what’s reality? Do some research to answer this question, starting with the CFSA site
Suppose Melvin's Bank starts with the balance sheet in Table 9.4A and the income statement in Table 9.2. Show how the balance sheet and income statement change in each of the following scenarios. Also calculate the new ROA, ROE, and rate- sensitivity gap.a. The bank issues $20 of new stock and uses
Do some research on adjustable rate mortgages. One source is Freddie Mac’s Annual ARM Survey (the text Web site links to Freddie Mac’s site, which contains the survey). Since 2009, when ARMs were 3 percent of prime mortgages, has this percentage remained low or risen? What explains the answer?
Do some research on the Consumer Financial Protection Bureau, established in 2010 (the text Web site links to the Bureau’s site). What regulations on credit cards has the Bureau created? Is it considering additional regulations on credit cards? How do existing and proposed regulations affect the
Suppose again that Melvin's Bank starts with the balance sheet in Table. Then the bank sells $10 of loans for $10 of cash.a. What is the immediate effect on the balance sheet?b. After the loan sale, what additional transactions is the bank likely to make? What will the balance sheet look like after
Suppose Ashley’s Finance Company raises most of its funds by issuing long-term bonds. It uses these funds for floating-rate loans.a. How does the company’s rate-sensitivity gap differ from those of most banks?b. What deal could Ashley and Melvin make to reduce risk for both of their
Canada does not have an institution like Fannie Mae that securitizes mortgages. How do you think this fact affects the types of mortgages offered by Canadian banks? (Hint: Think about interest-rate risk.)
Robert Shiller of Yale University has suggested a variation on ARMs in which mort-gage interest rates are tied to inflation, not to short-term interest rates. Discuss the pros and cons of this idea for banks and for borrowers.
Suppose the Federal Reserve raises short-term interest rates, an action that is likely to reduce aggregate output temporarily. Describe the various effects on the profits of commercial banks.
How does each of the following developments affect banks’ desired equity ratios? Explain.a. An increase in OBS activities.b. A shift from C&I lending to real estate lending.c. A shift from fixed-rate to floating-rate loans.d. An increase in securitization.
As noted in Section 9.4, the Credit CARD Act of 2009 has made it more difficult for people under 21 to obtain credit cards. Do you think this policy helps or hurts young adults? Explain your view.
How could a system be designed to allow a choice of operating systems from which to boot? What would the bootstrap program need to do?
Suppose you are a depositor at Melvin's Bank, which has the balance sheet shown in Table 10.1A. Deposit insurance does not exist. You originally deposited your money in Melvin's Bank because its branch locations are more convenient than those of other banks.a. Suppose you know that Melvin's other
The text Web site has a link to a paper by Christine Blair, an economist at the FDIC, called “The Mixing of Banking and Commerce." Read this paper and briefly summarize the arguments for and against the “mixing" in the title. Which side do you agree with?
Suppose an economy has a high level of loans from one bank to another. How might this fact affect the likelihood of a bank panic?
Some economists suggest that banks should be charged premiums for deposit insurance based on their levels of capital. Premiums should be higher if capital is lower. What is the rationale for this proposal? Are there any drawbacks to the idea?
Suppose Walmart is allowed to open a bank that accepts deposits and makes loans at its U.S. stores.a. How might this affect existing banks, especially community banks?b. In general, who might gain and who might lose if Walmart opens a bank?
Consider an analogy (the type on the SATs): “A bank regulator is to a bank as a bank is to a borrower." In what ways is this analogy true? for a review of the bank-borrower relationship.)
Suppose Melvin’s Bank can make a bet on derivatives that has a 2/3 probability of earning $20 and a 1/3 probability of losing $40.a. Assume Melvin’s has $20 in capital. What are the possible costs and benefits of the bet for Melvin and the deposit insurance fund? Is Melvin likely to make the
Let's change the example of capital requirements in Table 10.3. Assume that Melvin's Bank holds $40 in Treasury bonds (rather than $10) and $30 in loans to other banks (rather than $10). Otherwise, Melvin's assets are the same as in the table.a. Calculate the level of capital that Melvin's must
Consider two possibilities: (i) a bank is forced to close even though there is no good reason for it to close; (ii) a bank remains open even though there are good reasons for it to close.a. Explain why (i) and (ii) are possible, and what regulations affect the likelihood of these outcomes.b. Can
Link through the text Web site to the site of the Office of the Comptroller of the Currency and look up “Enforcement Actions." Find an example of a specific enforcement action against a bank. Explain what the OCC did and what problem it was trying to rectify.
Continue the story of The Friendly Bank for a few more days. Show the bank’s balance sheet, the monetary base, and the money supply for Friday and the following Monday, Tuesday, and Wednesday. Continue to assume the currency- deposit ratio and reserve-deposit ratio are 0.25.
In the text, we ignored traveler’s checks in deriving the money multiplier. Suppose we are more careful and include traveler’s checks in the money supply. Let T be the level of traveler’s checks, so T/D is the ratio of traveler’s checks to checking deposits. Derive the money multiplier in
Suppose the Fed wants to reduce the money supply by $100. Should it buy or sell government bonds? How much should it buy or sell?
Assume the monetary base is $100, the currency-deposit ratio is 0.5, and the reserve-deposit ratio is 0.1.a. Calculate the money multiplier and the money supply.b. Suppose the currency-deposit ratio rises to 1.0. If the Fed holds the monetary base constant, what happens to the money multiplier and
The Fed bought an unusually large quantity of Treasury bonds at the end of December 1999. What explains this behavior? (Hint: Search online for “Y2K.”)
Which is more stable from day to day, the discount rate or the federal funds rate? Explain.
Start with the Wednesday balance sheet for The Friendly Bank on page 320. Suppose that, at the end of Wednesday, the Fed buys $100 in government bonds from a dealer with an account at the bank. Otherwise, everyone behaves the same way as in the text. Show the bank’s balance sheet, the monetary
Let’s change the story of The Friendly Bank by introducing savings deposits. Assume that when people put money into the bank, half of it goes to checking deposits (D) and half to savings deposits (S). The ratio of currency to total deposits, C/(D + S), is 0.25. The ratio of reserves to checking
Suppose someone keeps $100 in cash under her pillow. One day, she takes it out and deposits it in a checking account.a. Does this action directly affect the monetary base or the money supply? Explain why or why not.b. Does the action eventually lead to a change in the monetary base or the money
Suppose that foreigners start holding more U.S. currency. For a given interest rate, Americans don’t change their holdings of either currency or checking deposits. Assume the Fed keeps the monetary base constant. Describe what happens to (a) the money supply, (b) the money-demand curve, and (c)
Redo Problem 5, but do not assume the monetary base is constant. Instead, answer each part of the question assuming the Fed targets the money supply. Then answer each part assuming the Fed targets the interest rate. What happens to the monetary base in each of these cases?
How did the Federal Reserve’s actions over 2008-2009 in response to the financial crisis.
Suppose the discount rate is below the federal funds rate, and banks can borrow as much as they want from the Fed. How could a bank earn easy profits? Would the federal funds rate stay above the discount rate? Explain.
Milton Friedman believed the Fed should control the money supply precisely. In the 1960s, he proposed that the required reserve ratio be raised to 100 percent. How would this policy improve control of the money supply? What are the drawbacks to the policy?
Suppose potential output grows 2 percent per year and the natural rate of unemployment is constant at 6 percent. In 2020, the unemployment rate is 7 percent.a. Assuming Okun’s law, what is the output gap in 2020?b. If output grows 5 percent from 2020 to 2021, what is the unemployment rate in 2021?
The United States was on a gold standard from 1879 to 1914. During that period, the average inflation rate was about zero. Inflation was sometimes positive and sometimes negative, and there was no relation between inflation in one year and the next. Each year inflation was equally likely to be
The data in Figure 12.14 suggest an unemployment coefficient of approximately -1.0 in the Phillips curve. That is, the Phillips curve is n- n(-1) = -(1.0)(U - U*) . Assume the natural rate, U*, is 5 percent. Actual unemployment is 5 percent in 2020, 7 percent in 2021, 6 percent in 2022, and 5
The text Web site has U.S. data on output, unemployment, and inflation from 1960 through 2010, along with estimates of potential output and the natural rate of un-employment. Focus on the data for the year 2010.a. Do the data for 2010 fit Okun’s law? b. Do the data for 2010 fit the unemployment
From the text Web site, link to the site of the Federal Reserve Bank of St. Louis; also, see the “Guide to St. Louis Fed Data." Get annual data on the inflation rate, the interest rate on 3-month Treasury bills, and the unemployment rate.a. According to the AE curve and Okun’s law, what is the
Interview a few people who are not economists but are old enough to remember the 1970s. Ask them what caused the high inflation of the 1970s and the deep recession of the early 1980s. Also ask about the 1990s: Why was there a recession at the start of the decade and a roaring economy at the end? Do
Suppose the growth rate of potential output rises. The behavior of the output gap (the fluctuations of output around potential) does not change. Do NBER recessions become more or less common? Explain.
Suppose a country bans trade with other countries, so net exports are always zero. How would this affect the slope of the AE curve? Explain.
Suppose the Fed raises the real interest rate and consumer confidence falls around the same time (as occurred in 1990). Show with a graph what happens to the AE curve and to output.
Suppose the economy starts with output at potential. Then a supply shock occurs: oil prices rise sharply. The Fed is partly accommodative: it raises the real interest rate, but not by enough to keep inflation from rising. Show with graphs what happens to the AE and Phillips curves and to output and
Suppose oil prices jump up and the Fed is completely accommodative: it keeps the real interest rate constant. How must the Fed adjust the nominal interest rate? How must it adjust the money supply? Explain.
Suppose again that oil prices increase. This has two effects: (a) firms’ costs jump up and (b) since more of consumers’ income goes to pay for oil imports, there is less to spend on U.S. goods. Assume the Fed holds the real interest rate constant. Show what happens to the AE and Phillips curves
Suppose the economy starts with output at potential and constant inflation. In 2020, oil prices jump up. Initially, the Fed is accommodative. In 2023, a new Fed chair is appointed and resolves to return inflation to the level before 2020. Show with graphs what happens over time to the real interest
Suppose that expected inflation is the average of inflation over the two previous years:n = (1/2)[n(-1) + n(-2)]a. Write the equation for the Phillips curve in this case.b. Redo the disinflation example in Figure 12.21. Assume the path of the real interest rate is the same as before. Is the path of
Suppose the federal funds rate is 3 percent. Bond traders expect it to remain at that level for 3 months and then rise to 3.5 percent for 9 months. However, the FOMC raises the rate to 3.5 percent immediately. After this action, traders expect the funds rate to stay at 3.5 percent for a year. How
Link from the text Web site to the online Economic Report of the President and get annual data on real GDP and real investment. Calculate the growth rates of the two variables for each year since 1960. (A variable’s growth rate in a given year is the percentage change from the previous year.)
Suppose that bond traders expect an increase in the federal funds rate, but the FOMC surprises them by keeping it constant. What happens to longer-term rates? Explain.
Describe all the ways that a rise in stock prices affects aggregate expenditure. Do the same for a rise in housing prices. Do stock prices have some effects that housing prices don’t, or vice-versa?
The riskiness of banks’ assets fluctuates over time. For example, default risk on loans rises and falls.a. How are banks likely to adjust their equity ratios (their ratios of capital to assets) when the riskiness of assets changes? Explain.b. How do the adjustments in part (a) affect the sizes of
Economists have found that recent earnings have larger effects on investment for small firms than for large firms. What might explain this fact?
Figure 13.12 shows what happens if the AE curve shifts out temporarily and the central bank raises the real interest rate. Now suppose the same shock occurs but the central bank keeps the interest rate constant. Assuming lags in the AE and Phillips curves, show over time what happens to output and
Consider the expenditure shock in Figure 13.12: the AE curve shifts to the right in 2020 and returns to its initial position in 2021. Suppose the central bank anticipates the shock: in 2019, it knows what will happen in the following two years. Assuming lags in the AE and Phillips curves, can the
Consider the AE/PC model with time lags. Suppose the economy starts in 2019 with output at potential and constant inflation. In 2020, an adverse supply shock occurs, shifting the Phillips curve up.a. Show the paths of output and inflation over time if the central bank keeps the real interest rate
From the text Web site, get Bernanke and Kuttner’s data on expected and unexpected changes in the federal funds rate by the FOMC..Choose one day when the expected change in the funds rate was large and the unexpected change was small, and one day when the opposite was true. Then link to the site
Suppose that country A and country B have the same rate of money growth, and velocity is constant in both. Output growth is higher in country A. Which country has higher inflation? Explain.
“Inflation is always and everywhere a monetary phenomenon, but deflation is not." Comment.
How does each of the following events affect the risk of a liquidity trap?a. The central bank decides to push long-run inflation to zero.b. The neutral real interest rate rises.c. The government introduces a tax on people’s holdings of currency. Other assets are not taxed.
Link from the text Web site to the St. Louis Fed site for data on (1) nominal GDP and (2) interest rates on 3-month Treasury bills. Link to www.sweepmeasures.com for data on M1 adjusted for sweep accounts (use the series labeled M1RS).a. Using these data, compute the velocity of money for each year
Link from the text Web site to the site of the International Labour Organization, whose LABORSTA database reports consumer price indices for most of the world’s countries. For a recent year, identify the country with the highest inflation rate (that is, the largest percentage change in its price
From the St. Louis Fed Web site, get annual data on U.S. inflation from 1960 to the present.a. For each decade from the 1960s through the 2000s, calculate the mean and variance of inflation over the decade. For example, calculate the mean and variance for the 10 years from 1960 through 1969.b. Make
In Figure 14.1, the relation between money growth and inflation is less perfect among countries with inflation below 10 percent than it is among countries with higher inflation. What might explain this difference?
Should the United States return to the gold standard? What might be the advantages and disadvantages?
Assume that a central bank’s nominal seigniorage revenue equals the change in the money supply, denoted AM. Real seigniorage revenue is AM/P. Assume the inflation rate equals the growth rate of the money supply, which is AM/Ma. What is the rationale for these assumptions? Are they realistic?b.
Suppose all firms in an economy adjust prices once per year. Half the firms adjust prices in January, and half adjust in July. Suppose inflation rises from 0 to 10 percent per year. What is the likely effect on the variability of relative prices? Explain.
Consider the market for loan able funds, which determines the real interest rate in the long run. a. As usual, draw the supply and demand for loans as functions of the pretax real interest rate, r. b. Suppose savers are taxed on their nominal interest income. If inflation rises, what happens to
Suppose the pretax real interest rate (r) is 2 percent, the tax rate (^) is 0.4, and the inflation rate (n) is 8 percent. Calculate the after-tax real interest rate (r).
What inflation rate would make the after-tax real interest rate equal the pretax real rate (that is, what inflation rate implies (r) = r)? Explain.
Explain the difference between deflation and disinflation.
Suppose the neutral real interest rate is 3 percent in Country A and 1 percent in Country B. a. What might explain this difference? b. If the central banks of the two countries choose the same inflation target, which country is at greater risk of a liquidity trap? Explain. c. Should the two
Suppose an economist has a bright idea: a central bank should lean against the wind when output falls, but not when it rises. That is, policymakers should lower the interest rate below the neutral level when a recession occurs but not raise it in a boom. a. Why might this plan appear attractive? b.
We have assumed that the coefficients in the Taylor rule, ay and an, are both positive. Under this assumption, the rule guides the economy back to long-run equilibrium after a shock. The output gap Y eventually returns to zero and inflation returns to its long-run level nT. a. Suppose the inflation
Suppose the central bank measures the output gap accurately, but mismeasures the neutral real interest rate. It believes the neutral rate is 1 percent, but the true neutral rate is 3 percent. If the central bank follows a Taylor rule, how does its mistake affect the interest rates it sets and the
In Figure 15.6, the central bank responds to an expenditure shock. Suppose policymakers know the true slope of the AE curve but mismeasure the shock: they think the curve shifts to the right by 2A, twice the actual shift. How will the central bank adjust the interest rate if it wants to keep output
Consider a variation on the Taylor rule: r = (0.25)rTAYLOR + (0.75)r(-1), where r is the real interest rate in a quarter, rTAYLOR is the interest rate implied by the Taylor rule, and r(-1) is the interest rate in the previous quarter. Call this rule TR-S.a. Compare the behavior of the interest rate
Suppose the Fed had a policy of responding to asset-price bubbles. Under this policy, it would have set higher interest rates than it actually did during the stock market boom of the late 1990s and the housing bubble of the 2000s. a. For the period 1990-2007, draw a graph showing roughly what
Suppose the economy is in long-run equilibrium in 2019. In 2020, a(n) (temporary) adverse expenditure shock reduces output by 2 percent.a. Assume the central bank uses TR-I in Table 15.2. Using the equations for the AE and Phillips curves in the online appendix, derive the paths of output,
Suppose a parent paid your college tuition this year. He or she wants you to get a summer job so you can contribute next year. You would prefer to spend your time with friends at the beach. Your parent says, “There’s no way I’ll pay for everything next year. If you don’t get a job, you’ll
In 2006, Ben Bernanke said the goals of strong output growth and low inflation “are almost always consistent with each other." Alan Greenspan once called the tradeoff between output and inflation “ephemeral." a. Are these statements accurate? Explain. b. Why do you think the chairmen made these
The text Web site has data from the Ball-Sheridan study on inflation targeting. One variable is the standard deviation of output growth, which measures the instability of output. a. In theory, how might inflation targeting affect output stability? b. What do the Ball-Sheridan data say about this
The text Web site links to “Inflation Targeting for the United States?," a 2005 article by economist Marvin Goodfriend, and to a comment on the article by Donald Kohn, then the vice-chair of the Fed. Goodfriend supports inflation targeting and Kohn opposes it. Write a brief essay saying which
Suppose the Phillips curve becomes steeper: a given change in output has a larger effect on inflation. How does this affect the time-consistency problem facing the central bank and the likelihood of high inflation?
In the Kydland-Prescott theory, it is desirable for central bank officials to hate inflation passionately. Is it also desirable for them to hate unemployment passionately? Explain why or why not.
Governors of the Federal Reserve serve overlapping terms in office. When one governor is appointed, the others are at various points in their terms. Suppose a new law mandates that all governors are appointed at the same time for concurrent terms. Would this increase or decrease the risks of
Consider the relationship between inflation targeting and Taylor rules.a. The adjustment of interest rates under inflation targeting is similar to a Taylor rule. Explain why. b. If a central bank shifts from flexible inflation targeting to strict targeting, does the equivalent Taylor rule become
In 2005, when President Bush announced Ben Bernanke’s appointment as Fed chair, the Dow Jones stock index jumped by more than 1 percent in a few minutes. a. Why do you think that happened? b. If the United States adopted inflation targeting, how might that affect the reaction of the stock market
Figure 12.23 on p. 377 shows the effects of an adverse supply shock in the AE/PC model. The figure assumes adaptive inflation expectations: n = n(-1) and shows how the economy evolves if the central bank accommodates the supply shock and if it doesn’t. Now suppose the central bank adopts an
Consider a policy of “output and inflation targeting": the central bank announces numerical targets for both inflation and real GDP. What are the pros and cons of such a policy? No central bank has seriously considered this approach; why not?

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