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_____ 10-year $1000 government bond.
_____ $50 pawnshop loan (iphone as collateral).
_____ 30-year mortgage loan on a $400,000 house.
_____ 24-month car loan.
_____ 30-day loan from a payday lender (borrower has to prove they have a job).
_____ Credit card with a $1000 limit.
_____ Equity credit line (based on ownership of a house) with a $25,000 limit.
3. A firm forecasts that a $20 million investment to build a new factory will allow the company to increase its production and that sales revenue will increase by $30 million one year from now. The firm forecast estimates that materials and labor cost at the new factory will be $9 million.
A. What is the expected rate of return on this investment? (Hint: Should the operating cost of factory be considered?)
B. Suppose the going interest rate is 6%. If the firm has to borrow the money for the investment, should the firm undertake the investment at this rate?
C. Now suppose that the company already has the money, from earlier profits, to make the investment and does not need to borrow. Should the company make this investment?
D. Suppose the interest rate falls falling to 4%. How would this affect the company’s decision?
E. Suppose the interest rate is 6%, but, because of a drop in operating costs, the new factory will only cost $8 million to run. What should the company do now?
4. Consider a small island country that uses shiny shells as currency – they are all the same and have equal value. The economy currently has 2000 shiny shells circulating as currency.
A. Currently, there are no banks on this island. What is the size of the M1 money supply and the M2 money supply in this economy?
B. A bank is created on the island. The islanders put all of their money in the bank and the bank fully loans out the money. Size of the money supply is the reserve requirement was 10%? What if it was 25%?
C. Suppose a fisherman finds a coral reef full of shiny shells. The fisherman collects 1000 shiny shells and brings back to the island. What effect will this have on the money supply if the reserve requirement was 10%? Use the quantity theory of money equation (MV = PQ) to explain why a commodity money could be dangerous to an economy. (Assume GDP is currently at potential and a constant velocity of money)
2. Rank the following seven loan in order based on the interest rates you would expect each one to have (1 for the lowest and 7 for the highest). Specify the factors that you considered in your ranking.
1. Consider how the following events will affect the market for loanable funds and which market graph to the right shows the effect on the market.
More people enter the work force and incomes rise.
More people retire and incomes fall.
Foreigners save money in this economy’s banks.
Government borrows money to pay for the building of a new highway.
The economy suffers a deep recession an many people lose their jobs.
5. Answer the following questions using the balance sheet information for the two banks shown to the right. Both banks operate in the same economy and have a reserve requirement of 10%. The economy is suffering a financial crisis and both banks currently facing crises of confidence in which depositors are trying to take their money out of the banks. The loan amount reflects the true value of the assets after they have been “written down”. A. Which bank is facing a liquidity problem and how should it be resolved? B. Which bank is facing an insolvency problem and how should it be resolved?
6. Consider the bank shown with the balance sheet shown to the right. The liability side is made up of deposits and capital from investors in the bank. The asset side has outstanding loans and reserves. This bank has a 10% reserve requirement. Suppose, due to an economic downturn, the “mark to market” value of the loans falls by $5.A. Is this bank still solvent? Why?
B. How has investor capital served as a “cushion”?
C. After the financial crisis, some people have advocated for banks to have higher “capital requirements”. What is the benefit and cost of higher capital requirements on banks?
Infographic - "Heads or Tails" - Story of a Penny that gets at the role of money in society and how one coin is in the money supply. (click to enlarge)
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