1. (10 pts.)

Explain the distinction between direct and indirect finance. Explanation: Direct finance is a method of financing in which borrowers (spenders) and lenders (savers) meet directly and exchange funds without a third party involvement. A very good illustration of direct financing is individual lending money to his friends who would repay the individual later with or without an interest rate. There is no other party involved in this fund transfer. Debts markets, securities traded on stock exchanges are examples of direct financing. Indirect finance is a method of financing in which financial intermediaries such as banks, insurance companies are involved in the funds transfer between borrower and lender. In indirect financing, a lender deposits money with a financial intermediary which in turn loans out that money to a borrower. A very good example of indirect financing is Mutual Funds. The main distinction between direct and indirect finance is the involvement of a financial intermediary. Direct financing requires lenders and borrowers to find each other on their own whereas indirect financing establishes the relationship between lender and borrower via a middle man called ‘Financial Intermediary’. The time and money spent in carrying out financial transactions (Transaction costs) is one of the burdens faced by people. Indirect financing helps in eliminating this burden by channeling funds between spenders and savers. Financial intermediaries help the system with the advantage economies of scale due to their large size and developed expertise. This is not possible with direct financing. In indirect financing, a financial intermediary will take the ownership of the activities and help facilitate trade by clearing and settling payments between the parties. Financial intermediaries eliminate risks and uncertainties about returns on investor assets. In direct financing, the borrower and lender share the responsibility of ensuring funds availability, payment and settlements. Direct Financing enables both lender and borrower to share each other’s information transparently. In indirect financing, the financial intermediary maintains information on lenders and borrowers but the transparency of the information is limited. In direct finance, only the lender can choose the person to whom he wants to lend the money but in indirect finance, the financial intermediary decides on how to invest (lending) the money that it has been deposited with. Indirect financing allows diversified investments through financial intermediaries whereas diversified investments are limited in direct financing. Due to their size and low transactional costs, financial intermediaries allow higher liquidity services to both borrowers and lenders.

2. (10 pts.)

Discuss the reasons for the decline we have witnessed over the past 30 years in the number of U.S. banks. Explanation: Following the Great Depression of 1930s, many bank regulations came into effect. Regulation Q (1933), Glass-Steagall (1933 & 1935) and McFadden Act (1927) act are few regulations that came into effect in US as a result of the crisis. However, these bank regulations failed to control the growth of number of banks leading to overcapacity. This overgrowth imposed risk to the financial stability. With no cap on interest rates for savings deposits, banks lured customers with higher interests for deposits. To prevent another financial disaster, few steps were taken in the US banking sector in 1980s. Between 1978 and 1986, Regulation Q was repealed in phases. This act repeal enforced ceiling on interest rate for savings deposits. This imposed cap on savings deposit interest rates also encouraged customers to find other options to banks. Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 abolished all prohibitions on interstate banking. This enabled banking between states and movement of money in diversified way.These relaxed laws allowed the emergence of alternatives to banks such as mutual funds etc.., and merger of banks soon took place. Due to large economies of scale and economies of scope, bigger banks provide increased financial stability. As customers started to explore other alternatives to channel their funds during the 80s and 90s, loans were made available in different ways triggering loan diversification. Also, large banks were able to better services compared to smaller banks and this resulted in merger of small banks into larger banks and the increased competition bigger banks brought in better services to the customer.

3. (35 pts.)

Suppose the total amount of reserves in the economy is $5 billion, and the public does not directly hold any cash. Also, suppose all banks hold excess reserves equal to 4% of deposits and the required reserve ratio is 5%. (Please round numerical answers to two decimal places.)

a. (2 pts.)

Calculate the money multiplier.

Solution: Total Reserves: $5 Billion Public Holding Cash: $0 Excess Reserve (E): 4% = 0.04 Required Reserve Ratio (R): 5% = 0.05 Money Multiplier (M) = 1/(R+E) = 1/ (0.05+0.04) = 1/0.09 = 100/9 = 11.11
|Money Multiplier = 11.11 |

b. (5 pts.)

What is the total money supply (or money stock)?

Solution:

Money Multiplier= 1/(R+E) = 1/ (0.05+0.04) = 11.11 Total Deposit = Initial Deposit * Money Multiplier Total Deposit = 5*11.11 = 55.55 Billion Cash held by Public = $0 Total Money Supply = Total Deposits + Cash held by Public Hence, Total Money Supply = Total Deposits + $0 = $55.55 B +0 = $55.55B

|Total Money Supply = $55.55 Billion |

c. (8 pts.)

Bank of America (BOA) has $300 million in deposits, $10 million in bank capital (net worth), $203 million in loans, and $80 million in other assets.

Draw a balance sheet for BOA, showing all categories, including the amount of reserves the bank must be holding.

Solution:

|Assets |Liabilities |
|Reserves : “say X” |Checking Deposits : $300 M |
|Loans: $203 M | |
|Others: $80 M | |
| |Net Worth: Assets – Liabilities |
| |(Bank Capital) |
| | |
| |10 = (X+ 203 +80) – 300 (in Million) |

X = 10+300 – 283 X = 310-283 X = $ 27 Billion

|Reserves: $ 27 Million |

Final Balance Sheet:

|Assets |Liabilities |
|Reserves: $27 M |Checking Deposits : $300 M |
|Loans: $203 M | |
|Others: $80 M | |
| |Net Worth: Assets – Liabilities |
| |(Bank Capital) : $10 M |

Now suppose that all banks in the economy decide to reduce excess reserves to just 1%.

d. (5 pts.)

Explain in general why banks might want to keep some excess reserves. Also explain why banks want to keep excess reserves as low as possible.

Explanation:

Banks require some additional reserve amounts to cover their liabilities and unexpected expenses. These additional reserves, called excess reserves, are bank reserves that are in excess of required reserves. All throughout the history, the world has been hit with financial crises from time to time. In order to ensure bank survival during difficult times such as wars, financial crises etc.., banks maintain excess reserves in addition to required reserves set by a central bank; however, these excess reserves are maintained at a very low level because excess reserves do not generate any profits to the banks. These excess reserves are idle money that is available on standby for the banks. If banks use these excess reserves for funding firms and households, those funds can generate interests for the banks however banks face risk in terms of low liquidity in their reserves. Hence banks prefer to maintain excesses but only at a minimum level.

e. (15 pts.)

Calculate the new equilibrium money supply, assuming the banks make new loans with all the funds they were formerly holding as reserves but no longer wish to hold.

Solution: As per problem statement, Total Reserves: $5 Billion Public Holding Cash: $0 Required Reserve Ratio (R): 5% = 0.05 Excess Reserve (E): 1% = 0.01 Money Multiplier= 1/(R+E) = 1/ (0.05+0.01) = 16.67 Total Deposit = $5B *16.67 = $83.35B

New Equilibrium Money Supply: = Total Deposits +Cash Held by Public = $83.35B +0
| New Equilibrium Money Supply = $83.35B |

4. (20 pts.)

Assume the public in Sylvania holds $4 billion in cash. All commercial banks are required to hold 20% of their checking deposits as reserves. All banks in Sylvania are identical, and have the following identical balance sheets:

|ASSETS |LIABILITIES & BANK CAPITAL |
| Reserves $ 50M | Checking Deposits ? |
| Loans $ 300M | BANK CAPITAL $ 150M |

Assume that this balance sheet is complete, i.e., lists all assets and capital of these banks, and that the only liability of the banks is checking deposits.

a. (5 pts.)

Find the dollar amount of checking deposits each of these banks has on its balance sheet. Show your work.

Solution:

Net Worth = $150 M Assets = Reserves + Loans = $50M +$300M = $350M Liabilities = Checking Deposits (Say X) Net Worth (NW: Bank Capital) = Assets – Liabilities 150 = 350 – X X = 350-150 = $200 M

| Checking Deposits: $200 M |

b. (5 pts.)

What percentage of checking deposits is each of these banks holding as excess reserves? Show your work.

Solution:

Required Ratio (R) = 20% = 0.2 Checking Deposits = $200M Required Reserves = $200 *0.2 = $40 M Actual Reserves with the banks = $50 M Excess Reserves = $50 M - $40 M = $10 M Excess Reserve (in percentage of checking deposits) = 10/200 = 1/20 = 0.05 = 5%

| Excess Reserve = 5% of checking deposits |

c. (10 pts.)

If the total money stock (supply) is $10B, find the total amount of reserves held by banks in the economy.

Solution:

Given that, Money Supply: $10 B Cash held by Public: $4 B Required Reserve Ratio: 20% or 0.2 We found excess reserve as 5% or 0.05 (deduced the value in question 4b) Money Supply = Total Deposit + Cash held by Public $10 B = T.D + $4 B Total Deposit = 10 – 4 = $6B Total Deposit = Initial Deposit * MM $6 B = ID*1/(0.2+0.05) = ID*1/0.25 = ID*4 Initial Deposit = $6 B/4 = $1.5 B

|Initial Deposit = $1.5 B |

5. (25 pts.)

Bank A is the only bank in the country of Sunny-weather. The total amount of cash held by the public in Sunny-weather is $4,000.

Initially, Bank A’s balance sheet is below. (There are no other holdings of assets or liabilities than those listed):

|Assets |Liabilities |
|Reserves |Checking Deposits |
|$2,500 |$6,000 |
|Loans | |
|$5,500 |Bank Capital |
| |? |
|Total ? |Total ? |

a. (5 pts.)

Complete Bank A’s balance sheet. Solution: Assets Total = Reserves + Loans = $2500+5500 = $8000 Liabilities = $6000 Net Worth (Bank Capital) = Assets- Liabilities= $8000-$6000 = $2000

|Assets |Liabilities |
|Reserves $2,500 |Checking Deposits $6,000 |
|Loans | |
|$5,500 | |
| |Net Worth (Bank Capital) = Assets- Liabilities |
| |= $8000-$6000 = $2000 |

b. (5 pts.)

Compute the money supply in Sunny-weather. Solution:

Bank A is the only bank in the town. So Total Deposits with the bank is 6000 (as there are no other banks in the town, all money must have been deposited only with Bank A)

Total Deposit in Bank A = 6000 Money Supply = Total Deposits + Cash held by Public Money Supply = 6000+ 4000 = $10000

|Money Supply = $10000 |

c. (5 pts.)

How much is the reserve required ratio in Sunny-weather if Bank A holds only required reserves? Round your answer to two decimal places, and show your work. Solution:

Required Reserve Ratio: $2500/$6000 = 5/12 = 0.4167 = 41.67%

|Required Ratio = 41.67% |

d. (5 pts.)

Assume instead that the required reserve ratio (R) is 10%. What dollar amount does Bank A have to hold as required reserves? Is Bank A holding excess reserves? How much? Solution:

Required reserve ratio = 10% or 0.1

| Bank A should hold required reserve of = $6000*0.1 = $600 |
|Yes, if required reserve ratio is 10%, the bank is holding excess reserves |
|Excess reserve amount = $2500 - $600 = $1900 |
|(Excess Reserve Percentage = 1900/6000 = 31.67%). |
| |
|Excess Reserve = $1900 |

e. (5 pts.)

Based on total reserves of $2,500 (and checking deposits of $6,000), compute the money multiplier in Sunny-weather. Solution:

Required Ratio = $2500/$6000 = 41.67% or 0.4167

Money multiplier = 1/(R+E) =1/0.4167 = 2.40

|Money Multiplier = 2.40 |