Chapter 10: Money and Banks
Explains process of money creation by banks -- also concept of balance sheets and double entry bookkeeping
Final Exam Questions:
1. Explain and interpret the yield curve of Pakistan, given in the lecture -- that is, what do the points on the curve mean? What does this curve show about public expectations? Is the public expecting interest rates to go further up or do they expect interest rates to come down?
2. Explain what a bond is -- what is the coupon value, the price of the bond and the yield on the bond.Explain why a decrease in market interest rates will lead to an increase in the price of bonds and vice versa.
3. According to standard textbook theories of money, the Central Bank is in control of the money supply (exogenous money). By setting the narrow money supply at some level M0, the total money supply is determined via the multiplier to be some fixed amount m x M0. Explain why this theory is wrong, and how the private sector can create as much money as they want. This is called the endogenous money theory. Then the money supply in an economy is determined by the demand for loans.
A1: Yield curve shows the yield of the bonds in sequential order from shortest maturity to longest maturity. Yield curve of Pakistan shows that yields are lower for short term bonds and higher for long term bonds. The slope of the yield curve tells us about the expectations of the bond market. If there is increasing slope, interest rate is expected to increase and vice versa. In case of Pakistan interest rate are expected to increase as there is increasing yield curve. correct
A2 Bond is a formal contract between borrower and lender for repayment of loan at fixed intervals with interest.
Coupon is the interest rate, that is paid on the face value of the bond. coupon value is written on the bond.
Price of the bond is the issue price that is the face value of the bond at first time but later it may be traded at premium or discount.
Yield on the bond is equal to the coupon rate at the time of issue. But later as it trades yield may differ as the price changes. Yield is actually the true interest rate that the bond gives. Yield is coupon value divided by the price of the bond
Yield = coupon value / price
If price of the bond decreases yield on the bond increases.
Market interest rates decrease due to slowdown in economic activity. There is a loss of purchasing power because of the reduced interest rate so the risk on the bonds will decrease which would lead to increase in the prices of the bonds.
Last sentence is not correct. Market interest rate is what you can get by putting your money into banks or other uses for money. If this increases than whatever the rate the bond is offering become LESS attractive and the price of bond decreases. If market interest rate decreases, then whatever the bond is paying become MORE attractive in comparison with the market interest, and so the price of bonds increases. There are explicity formula given in the text which should be used in the answer.
A3: Money is created by the process of lending. Amount of money that is created depends on the demand for loans. Money is created at zero cost so there is no supply curve. Any bank can create any amount of money. As banks don’t have any cash as demand comes in, bank borrows reserve from the central bank that is kept to meet the reserve requirements. Or may take loan from other banks.This is more or less correct. A little bit more detail would be useful