Question 1
BEEM119: Problem Set 3—Indicative Answers
Consider the following balance sheets of companies X and Y in 2011. In 2012, company X could roll over its debt, while company Y failed to do so and defaulted. Explain a plausible cause of this difference.
Company X
Assets
Liabilities
cash
bank deposits receivables
inventory
buildings and equipment
$15,000 $55,000 $10,000 $10,000 $30,000
Loan $60,000 Equity $60,000
Company Y
Assets
Liabilities
cash
bank deposits receivables
inventory
buildings and equipment
$10,000 $10,000 $30,000 $20,000 $50,000
Loan $55,000 Equity $65,000
To repay loans, one needs cash. X’s assets include more cash and cash equivalents and hence are more liquid than Y’s.
Question 2
Explain ‘expansionary monetary policy’ using the following words: central bank, money, interest rate, firm, investment, commercial bank, bank rate, lend, open market, government bond. (80-100 words in total)
With expansionary monetary policy, the central bank tries to induce interest rates to drop to encourage firms to increase investment and households to consume so that economic activity picks up. The central bank achieves this goal indirectly by making commercial banks more willing to lend money to firms and households. It sets the bank rate low so that commercial banks will increase borrowing from the central bank; or it conducts an open market operation by purchasing government bonds and other securities from commercial banks for money.
Question 3
1. In Brazil, a country that underwent a rapid inflation before 1994, many transactions were conducted in dollars rather than in “real” (the domestic currency). Why? The value of a dollar was stable and so the money used in transactions was actually a storage of value–something the real could not provide.
2. Rank the following assets from most liquid to least liquid: checking account deposit, houses, currency, automobile, savings deposits, and common stock. Currency, check- ing deposits, saving deposits, common stock, automobiles, houses.
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3. Name three examples of commodity money. For each of them, mention advantages and disadvantages compared to the others that you mentioned. (For instance, silver is better than wine because it is more standardized). Apples, sheep, gold. Apples are a worse storage of value than gold or sheep as they go bad (faster than sheep die). Gold is a better medium of exchange than sheep as it can be carried around more easily than sheep.
4. Who can hold accounts with the central bank? What are these accounts used for?
Only banks and the government can hold accounts in the central bank. Those accounts are used for settlements between banks and the government. There is some reserve requirement and small interest may be paid by the central bank for excess reserves. However, banks hold reserves mainly because it is convenient for settlement.
Question 4
1. Which of the following are reported as liabilities on a bank’s balance sheet?
(a) Deposits (b) Reserves
(c) U.S. Treasury securities (d) Loans
2. When a new depositor opens a checking account at the First National Bank, the bank’s assets and its liabilities .
(a) increase; increase (b) increase; decrease (c) decrease; increase (d) decrease; decrease
3. Which of the following statements regarding expansive monetary policies is true?
(a) The central bank directly sets the bank rate, the rate at which commercial banks lend money to firms and households.
(b) The central bank increases its lending to firms and households.
(c) In quantitative easing, the central bank buys bonds, hoping that it will also create demand for a variety of other bonds issued by firms and households.
(d) Quantitative easing leads the asset demand curve to shift to the left. 2
(e) The central bank sells bonds to the government so it can increase its expenditure for stimulus policies.
4. Which of the following statements regarding creation of money is true?
(a) Bank deposits become additional money when cash is deposited and that cash remains in the bank as a reserve.
(b) Bank time deposit with 10-year maturity counts as money more than what regular bank deposit does.
(c) If Tom stops keeping $10,000 cash in his drawer and deposits it to a bank but that bank lends out that money to Mary, then the two effects will offset each other and the amount of money circulating in the economy will not change.
(d) None of the above.
Answers
1. a. 2. a. 3. c. 4. d.
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