Buy Existing Paper - Why do financial intermediaries exist

Description

 

Why do financial intermediaries exist?  What services do they provide to the public?  Are all financial institutions financial intermediaries?

 

Financial intermediaries exist to link up SSUs and DSUs and to help minimize the transactions costs associated with borrowing and lending.   Financial services provided by financial intermediaries include appraising and diversifying risk, offering a menu of financial claims that are relatively safe and liquid, and pooling funds from individual SSUs.  Not all financial institutions are financial intermediaries.  Financial intermediaries are a type of financial institution that issue claims on themselves.  Other financial institutions, such as stock and bond brokers merely link up SSUs and DSUs for a fee and do not issue claims on themselves.

Why do financial intermediaries exist

2. What are the pros and cons of lending to my next door neighbor rather than putting my surplus funds in a bank? 

 

Lending money to a friend can be very risky.  For the most part, you have no assurance that your friend will pay you back.  With a bank, deposits were insured for up to $100,000, now increased to $250,000.  Also, by lending to your friend (assuming you are not charging interest), you forgo the interest the bank would have paid you for the use of your money.  On the other hand, maybe you can develop an even closer relationship with your friend by lending him/her money.  For some people, a close friendship is more important than having a bank pay them interest or the security of an insured deposit.

 

3. The difference between SSUs and DSUs can best be described by the following:

a. DSUs spend less on consumption and investment goods than their current income while SSUs spend more on consumption and investment goods than their current income.

b. DSUs spend more on consumption and investment than their current income while SSUs spend less on consumption and investment than their current income.

c. SSUs need to borrow (or spend savings).

d. DSUs need to lend (or accumulate savings).

Why do financial intermediaries exist

4. If John receives $2000 monthly in net wages and spends $700 in rent, $500 on a car payment, $250 on entertainment, and $200 on groceries he is a(n)

a. deficit spending unit                   b. negative cash disbursement

c. surplus spending unit              d. accrued wage unit

 

5. An example of direct finance would be

a. your professor deposits his or her salary in a checking account.

b. you purchase stock in IBM from a stock broker.

c. you use your ATM card to get cash on the weekend.

d. your employer makes a contribution to your pension fund.

 

Chapter 2

1. What are the functions of money?  Which function do you think is most important?

 

The functions of money are to serve as a means of payment (medium of exchange), a unit of account, and a store of value.  The most important function of money is to serve as a means of payment.  Thus, it is critical that money is generally accepted to make payments.  Without a generally accepted means of payment, exchange is very costly.  For an exchange to occur, there would have to be a double coincidence of wants where the person you wished to buy from wanted what you were offering in exchange.

 

2. How does the Fed calculate M1, M2, M3 and DNFD?  Are these aggregates all money?  Why or why not?  Which contains the most liquid assets?  Which is smallest?  Which is largest?

Why do financial intermediaries exist

To calculate M1, M2, M3 and DNFD, we merely add up the items included in the aggregate as follows:

 

M1= currency…

M2=

M3=

DNFD=

 

All of these aggregates except DNFD are a measure of money.  M1 is the narrowest measure of money and the smallest aggregate.  M1 is generally used for transactions and contains the most liquid assets—assets that are money per se.  M2 and M3 are progressively broader measures of money that include M1 and other near money assets.  For example, M2 contains everything in M1 plus other less liquid near money substitutes.  DNFD is the largest aggregate but many of the items in DNFD are not money or near monies.  DNFD is the broadest measure of non-financial credit in the domestic economy.

 

3. Zoto is a remote island that has experienced rapid development.  In contrast, Zaha is an island where growth has been sluggish and the level of economic activity remains low.  How could the existence of money have affected these two outcomes?

 

 

Since money facilitates economic development, one would suspect that Zoto has a sophisticated and advanced “money”, while Zaha relies mainly on barter. The existence of money could explain the differing growth rates.

Why do financial intermediaries exist

4. Which of the following is NOT an important characteristic of something that functions as money?

a. it is generally accepted to make payments

b. it is durable and scarce

c. it is only issued by the government

d. it is a unit of account and a store of value

 

5. M1 includes all of the following except

a. currency.                                                   b. checkable deposits

c. money market deposit accounts       d. travelers’ checks

 

6. Briefly define the interest rate, reserves, the required reserve ratio, the inflation rate, and nominal GDP.

 

Interest rate: the cost to borrowers of obtaining money and the return (or yield) of money to lenders

Reserves: assets that are held by depository institutions as either vault cash or reserve deposit accounts with the Fed

Required reserve ratio: depository institutions must have reserve assets equal to a certain percentage of deposit liabilities; the required reserve ratio is that percentage

Inflation rate: the rate of change of a price index, such as the consumer price index

Nominal GDP: the quantity of final goods and services produced in an economy during a given time period and valued at today’s prices

 

7. Chris and Harold Yoshida are a young couple with a growing income.  What will happen to their demand for money over time?

 

Since income is directly (positively) related to the demand for money, as the Yoshida’s income grows over time, their demand for money will also grow.

 

8. How does real GDP differ from nominal GDP?

Why do financial intermediaries exist

Real GDP is the inflation adjusted quantity of final goods and services produced in an economy in a given timer period.  Nominal GDP is the quantity of final goods and services produced in an economy during a given timer period and valued at today’s prices.

 

9. Show on a graph how the interest rate and the quantity demanded of money are related.  Do the same for the quantity supplied of money.  When is the market in equilibrium?

 

See page 38, Figure 2-9 in your textbook.

 

10. What happens to interest rates, prices, and output when the demand for money increases?  What happens to the same variables when the demand for money decreases?

 

When the demand for money increases, the demand curve shifts rightward, and interest rates rise.  The rise in interest rates chokes off some spending and reduces aggregate demand.  The fall in aggregate demand may decrease output and put downward pressure on prices.  The reverse happens when the demand for money decreases.  Namely, interest rates fall, aggregate demand picks up, and there is upward pressure on prices.

 

11. Graphically, an increase in income would tend to

a. shift the demand curve for money to the left.

b. shift the demand curve for money to the right.

c. have no effect on the demand curve for money.

d. cause a movement along the demand curve for money.

Why do financial intermediaries exist

12. If a commercial bank has checkable deposit liabilities of $50,000 and the required reserve ratio is set at 12%, the commercial bank must hold how much in reserves?

a. None.  It is not mandatory to hold reserves.    b. $3,000

c. $6,000                                                                    d. $44,000

 

13. If the interest rate is below the equilibrium rate, there is an

a. excess supply of money and rising interest rates.

b. excess quantity demanded of money and rising interest rates.

c. excess demand of money and falling interest rates.

d. excess quantity demanded of money and falling interest rates.

 

14. If there is a rightward shift in the demand curve for money

a. the money supply will increase.

b. the money supply will decrease.

c. quantity demanded of money will stay the same.

d. quantity demanded of money will decrease.

 

15. As the interest rate falls, the demand for money

a. remains the same.

b. increases.

c. decreases.

d. increases causing the quantity supplied of money to increase.

Why do financial intermediaries exist

Chapter 3

1. Discuss each of the four main functions of the Fed.

 

The primary responsibility of the Fed is the formulation and implementation of the nation’s monetary policy. The conduct of monetary policy has two objectives. First, to ensure that sufficient money and credit are available to allow the economy to expand along its long‑run potential growth trend under conditions of relatively little or no inflation. Second, in the short run, to minimize the fluctuations¾recessions or inflationary booms¾around the long‑term trend.

Along with other government agencies, the Fed is responsible for the supervision and regulation of the financial system. In general, supervisory activities are directed at promoting the safety and soundness of depository institutions by making sure that banks are operated prudently and according to standing statutes and regulations.

The third main responsibility of the Fed is to help maintain an easy‑running payments mechanism. The Fed’s main activities in this area involve the provision of currency and coin and the clearing of checks.

The final main responsibility of the Fed is to serve as the fiscal agent for the government. The Fed furnishes banking services to the government in a manner similar to the way private banks furnish banking services to their customers. The Fed also clears Treasury checks, issues and redeems government securities, and provides other financial services.

 

2. List the major responsibilities of each of the following:

a. the Board of Governors

b. the 12 Reserve Banks

c. the Federal Open Market Committee

 

a. The Fed’s Board of Governors’ responsibilities are the following:

   1. Sets reserve requirements and approves discount rates as part of monetary policy

   2. Supervises and regulates member banks and bank holding companies

   3. Establishes and administers protective regulations in consumer finance

   4. Oversees Federal Reserve Banks

b. The following are the Federal Reserve Banks’ responsibilities:

   1. Propose discount rates

   2. Lend funds to depository institutions (discount policy)

   3. Furnish currency

   4. Collect and clear checks, and transfer funds for depository institutions

   5. Handle U.S. government debt and cash balances

c. The Federal Open Market Committee directs open market operations (buying and selling of U.S. government securities), which are the primary instrument of monetary policy.

 

3. Discuss the major policy tools that the Fed can use to promote the overall health of the economy.  What is the most widely used tool?

 

To promote the overall health of the economy, the Fed can utilize open market operations, changes in the primary credit (discount) and secondary credit rates, and/or changes in the required reserve ratio.

Open market operations are the most widely used tool by the Fed. These operations, which are executed by the Federal Reserve Bank of New York, involve the buying or selling of U.S. Government securities by the Fed.  They affect the amount of cash assets available for reserves in the banking system.  When the Fed wants to speed up the economy, reserves are pumped into the system and vice versa.

The primary credit (discount) and secondary rates are the interest rates the Fed charges depository institutions that borrow reserves directly from the Fed. The financially healthiest institutions are charged the primary credit rate while less healthy institutions are charged the secondary credit rate.  When the rate is lowered, depository institutions are encouraged to make more loans, because if they are caught short of reserves, it will not cost them as much to borrow reserves from the Fed.  Likewise when the rate is increased, depository institutions are discouraged from lending because, if caught short of reserves, borrowing reserves from the Fed would be more costly.

  

The Fed requires depository institutions to hold required reserves assets equal to a proportion of checkable deposit liabilities.  This proportion is the required reserve ratio. This is not a widely used tool.  However, lowering of the required reserve ratio would free up additional reserves so that depository institutions could make more loans and extend credit.

 

4. What is a primary dealer?  Can anyone become a primary dealer?  How do you become a primary dealer?

 

Primary dealers are banks and securities brokerages that trade in U.S. Government securities with the Federal Reserve System; specifically, the Federal Reserve Bank of New York.

 

The Federal Reserve selects the primary dealers.  A firm wishing to become a primary dealer must notify the FRBNY in writing.  The Bank then consults with the applicant’s principal regulator to verify that the firm complies with relevant capital standards. 

Why do financial intermediaries exist

Applicants must be either commercial banking organizations that are subject to official supervision by federal bank supervisors or broker-dealers registered with the SEC.  They may be foreign-owned.

 

Bank-related primary dealers must have at least $100 million in Tier I capital.  Registered broker-dealers must have at least $50 million in regulatory capital and must not be in violation of the regulatory “warning levels” for capital set by the SEC and the Treasury.

 

5. What is a “Policy Directive”?  What purpose(s) does it serve?

 

Statement of the FOMC that states its policy consensus and sets forth operating instructions to New York Fed regarding monetary policy.

 

6. What are some arguments for maintaining the independence of the Fed?  What are some arguments for decreasing the independence of the Fed?

 

Proponents of continuing the Fed’s independence argue that politicians are interested in getting elected and reelected, and this means they are short‑run maximizers. They (politicians) do not take the long view, which could be disastrous if the long‑run impacts of policy are different from the short‑run impacts. For instance, to please the electorate, politicians might pursue a stimulative monetary policy resulting in an expansion of economic activity, even though the more long‑run impact of the policy might accelerate inflation.  In other words, incumbent politicians may have an incentive to use monetary policy to stimulate the economy before an election even though it would lead to inflation and tightening of policy after the election. 

Proponents for increasing the accountability of the Fed argue that the Reserve Bank presidents represent the interests of the banking community since they are elected by the Reserve Bank directors, two‑thirds of whom, in turn, are elected by the member banks. Proponents for more accountability of the Fed also argue that the General Accounting Office should be able to audit all aspects of the Fed.

 

7. Ceteris paribus, increases in the discount rate,

a. decrease the cost of borrowing reserves from the Fed.

b. increase the cost of borrowing reserves from the Fed.

c. have no effect on the cost of borrowing, but decrease reserves and the money supply.

d. increase the cost of borrowing, increase reserves, and increase the money supply.

Why do financial intermediaries exist

8. In order to enact an expansionary monetary policy, the Fed could

a. raise the discount rate, increase the required reserve ratio, or sell securities through open market operations.

b. lower the discount rate, decrease the required reserve ratio, or sell securities through open market operations.

c. raise the discount rate, increase the required reserve ratio, or buy securities through open market operations.

d. lower the discount rate, decrease the required reserve ratio, or buy securities through open market operations.

 

Chapter 4

1. Distinguish between primary and secondary markets and between money and capital markets.

 

Primary markets are markets where new securities, issued to finance current deficits, are bought and sold.

Secondary markets are markets where outstanding (previously issued) securities are bought and sold.

The money market is the market where securities with original maturities of one year or less are traded.

The capital market is the market where securities with original maturities of more than one year are traded.

 

2. How does trading activity in the secondary market of an instrument affect the trading activity in that instrument’s primary market? 

 

The more active the secondary market for a particular security, the more active the primary market for that security will be. Well organized, smoothly functioning, high­ quality secondary markets facilitate the trading of outstanding securities at relatively low cost and little inconvenience. This, in turn, facilitates the financing of planned deficits in primary markets.

 

3. Define commercial paper, negotiable CDs, federal funds, and Eurodollars.  In what ways are they similar?

 

Commercial paper: Short‑term debt instruments issued by domestic and foreign corporations.

Why do financial intermediaries exist

Negotiable certificates of deposit (CDs): Short-term debt instruments with typical maturities of 1 to 12 months that are sold by depository institutions and that make interest payments and repay the principal at maturity; certificates of deposit have a minimum denomination of $100,000 and can be traded in secondary markets.

Federal funds: Loans of reserves between depository institutions, typically overnight.

Eurodollars: Originally considered to be deposits denominated in dollars in a foreign bank. Today, the term Eurodollar has come to mean any deposit in a foreign (host) country where the deposit is denominated in the currency of the country from which it came rather than that of the host country.

The terms defined in this question are all money market instruments with original maturities of less than one year. They differ with regard to who issues the claim, whether it is a bank, a corporation, or government.  They differ with regard to who the usual participants are in the market.  For example, depository institutions are the borrowers and lenders in the fed funds market.

 

4. Which of the following are long-term debt instruments of the U.S. government with typical maturities of two to ten years?

a. Treasury Bills                                           b. general revenue bonds

c. Treasury Notes                                      d. repurchase agreements

 

5. Overnight loans among depository institutions of their deposits at the Fed are called

a. discount loans                                         b. federal funds transactions

c. agency securities                                     d. general obligation bonds

 

6. Long-term debt instruments issued by corporations are called

a. revenue bonds                                         b. corporate stocks

c. corporate bonds                                                d. commercial paper

Why do financial intermediaries exist

7. The capital market includes those markets that trade securities with original maturities of ___________.

a. 1 month or less                                        b. 6 months or less

c. 12 months or less                                    d. more than 1 year

 

8. The spot market is where

a. future trading of financial instruments takes place.

b. future trading of options takes place.

c. instantaneous trading of financial instruments takes place.

d. All of the above.

 

9. The earnings from municipal bonds are which of the following?

a. exempt from federal taxes and generally exempt from state taxes in the issuing state

b. exempt from state taxes

c. exempt from local taxes

d. exempt from federal taxes only

 

10. Which of the following are not capital market instruments?

a. stocks                                                         b. corporate bonds

c. eurodollars                                              d. mortgages

 

 

Chapter 5

1. Define the concepts of compounding and discounting.  Use future values and present values to explain how these concepts are related.

 

Compounding is a method used to find out the future value of a present sum-‑­that is, what is the future value of money lent (or borrowed) today.

Unlike compounding, which is forward looking, discounting is in effect backward looking. Discounting is the method used to figure out what the present value of money is to be received (or paid) in the future.

Why do financial intermediaries exist

2. Under what conditions will a bond sell at a premium above par?  At a discount from par?

 

If the interest rate increases, a bond will sell at a discount from par. If the interest rate increases, the present value of the future stream of income from the bond falls and therefore its price falls. 

If the interest rate decreases, a bond will sell at a premium above par. If the interest rate decreases, the present value of the future stream of income from the bond rises and therefore its price rises. 

 

3. During the Great Depression of the 1930s, nominal interest rates were close to zero.  Explain how real interest rates could be very high even though nominal interest rates were very low.

 

The nominal interest rate is composed of the real interest rate plus an inflation premium. The real interest rate is therefore the nominal interest rate minus the inflation premium. During the Great Depression, if prices were going down instead of up, the inflation premium was actually negative. In this case, to find the real rate, we subtract a negative inflation rate from a low nominal rate.  Thus, the more negative the inflation rate is, the higher the real interest rate will be for any nominal interest rate.

 

4. What factors affect the demand for loanable funds?  The supply of loanable funds?

 

The demand for loananble funds comes from household, business, government and foreign net borrowers.  As spending plans of these units increase, the demand for loanable funds increases and vice versa. Changes in the demand for loanable funds are positively or directly related to changes in GDP. When GDP increases, the demand for loanable funds increases and vice versa. When interest rates increase, quantity demanded decreases and vice versa. 

 

The supply of loanable funds comes from household, business, government and foreign net lenders.  In addition, the supply of loanable funds is affected by the actions of the Fed (monetary policy) in speeding up or slowing down the provision of reserves to the banking system. When monetary policy is expansionary, the supply of loanable funds increases.  When monetary policy is contractionary, the supply of loanable funds decreases. When interest rates increase, quantity supplied increases and vice versa. 

 

5. In general, discuss the movement of interest rates, the money supply, and prices over the business cycle.

 

In expansions, GDP increases causing interest rates generally to rise because of increased demand, and inflation to pick up speed.  Likewise, to prevent overheating of the economy, the Fed is generally reducing the money supply and further increasing interest rates. 

 

In recessions, GDP is falling, the interest rate is falling due to reduced demand and expansionary Fed policy may be causing the money supply to increase and interest rates to further fall.  At the same time, upward price pressures are reduced.

 

Thus, but not always, interest rates and inflation fluctuate pro-cyclically.

 

6. Graph the demand and supply for loanable funds.  If there is an increase in income, ceteris paribus, show what happens to the interest rate, the demand for loanable funds, and the quantity supplied of loanable funds.

 

loanable funds

          

 

If there is an increase in income, the demand curve for the loanable funds shifts from D to D1. At the new equilibrium point (where S and D1 intersect), interest rate, demand for loanable funds, and quantity supplied of loanable funds increase.

 

7.  If the Fed orchestrates a decrease in the money supply growth rate, ceteris paribus, show what happens to the interest rate, the supply of loanable funds, and the quantity demanded of loanable funds.

 

                                 loanable funds

If the Fed orchestrates a decrease in the money supply growth rate, the supply curve will shift from S to S1. At the new equilibrium point (where D and S1 intersect), the interest rate increases. At the new equilibrium point, the supply of loanable funds and the quantity demanded of loanable funds decrease.

Why do financial intermediaries exist

8. Use graphical analysis to show that if Y and M both increase, the interest rate may increase, decrease, or stay the same.  In each case, what happens to the equilibrium quantity demanded and supplied.

 

 

If Y and M increase, both the demand and the supply curves will shift to the right. Graph I shows that at the new equilibrium point (where the D1 and S1 curves intersect), the interest rate is lower than at the original equilibrium point (where the D and S curves intersect).

 

Graph II shows that at the new equilibrium point (where the D1 and S1 curves intersect), the interest rate is higher than at the original equilibrium point (where the D and S curves intersect).

 

As both graphs illustrate, the change in interest rate will depend on the magnitude of the shifts of the supply and demand curves.

 

In both graphs, the quantity demanded and quantity supplied change in accordance to the magnitude of the shifts of the supply and demand curves.

 

9. A bond sells at ______ because interest rates have increased since the bond was originally issued.

a. an inflation premium                               b. par value

c. a premium above par                              d. a discount from par

 

10. Periodic interest payments over the term to maturity of bonds are called

a. coupon payments.                                b. present values.

c. pay values.                                                d. discountings.

 

11. In general, if bond prices are rising, then interest rates are

a. rising.                                                         b. falling.

c. unchanging.                                             d. rising slightly, then stabilizing.

Why do financial intermediaries exist

12. Reacting to nominal values rather than to real values is which of the following?

a. Myopia                                                       b. money illusion

c. rational expectations                               d. elasticity

 

13. In general, the direction of the change in interest rates will

a. not be affected by the direction of the change in inflationary expectations.

b. go the opposite direction of the change in inflationary expectations.

c. follow the direction of the change in inflationary expectations.

d. either go in the opposite direction of the change in inflationary expectations or remain the same.

 

14. If the nominal interest rate is 7% and the real interest rate is 3%, then the expected rate of inflation must be

a. 6%                                                              b. 4%

c. -4%                                                             d. 5%

 

 

 

15. Which of the following could have generated the phenomena diagrammed above?

a. a decrease in income

b. a decrease in the money supply

c. an increase in the money supply

d. an increase in income

 

16.  Which of the following best describes the diagram above?

a. The demand for loanable funds increased.  This, in turn, increased the interest rate and the supply of loanable funds.

b. The demand for loanable funds increased.  This, in turn, increased the interest rate and the quantity supplied of loanable funds.

c. The supply of loanable funds increased.  In turn, interest rates increased.

d. Interest rates increased, causing the demand of loanable funds to increase.