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Main Point - Money is an economic tool that facilitates economic activity.
Main Point - Banks reduce the transactions cost for savers to lend money to investors in order to channel resources toward economic growth.
Main Point - Banks are a unique type of economic organization that can be destroyed simply by a crisis of confidence, which means a central bank is necessary to protect the banking system.
Part # 1 - Money
Reading - Money - click here
Part # 2 - Banking
Reading - Banking - click here
Practice Problem - Market for Loanable Funds - 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. (Answer)
A. More people enter the work force and incomes rise.
B. More people retire and incomes fall.
C. Foreigners save money in this economy’s banks.
D. Government borrows money to pay for the building of a new highway.
E. The economy suffers a deep recession an many people lose their jobs.
Practice Problem - Money Supply - 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. (Answer)
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 20%?
C. When the reserve requirement is 10% the economy has price stability. The economy has a money velocity of 5. Based on this, what is the GDP of the island economy measured in shiny shells?
D. What would happen to the money supply and economy if the reserve requirement was moved to 20% (assume that money velocity is still 5)?
E. Suppose a fisherman finds a coral reef full of shiny shells. The fisherman collects 100 shiny shells and brings back to the island. What effect will this have on the money supply if the reserve requirement was 10% and money velocity is 5? Based on this example, how could a commodity money (like one based on gold) be dangerous to an economy?
Part # 3 - Banking Crises
Reading - Banking Crises - click here
Practice Problem - Banking Crisis - 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?
Practice Problem - Value of Capital - 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 2008 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?
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