*Asset management

Balance sheet

*Capital adequacy
management
*Compensating balance

*Credit rationing

*Credit risk
*Deposit outflows
Discount loans
*Discount rate
*Duration analysis
*Equity multiplier (EM)

- when the bank manager must pursue an acceptably low level of

risk by aquiring assets that have a low rate of default and by
diversifying asset holdings
- a list of banks assets and liabilities
- a list of its bank funds (liab) and uses to which fund are put
(assets)
- when the manager must decide the amount of capital the bank
should maintain and then aquire the needed capital
- one particular form of collateral required when a bank makes
commercial loans
- a firm receiving a loan must keep a required minimum amount of
funds in a checking acc. At the bank
- a way in which financial institutions deal with adverse selection
and moral hazard
- refusing to make loans even though borrowers are wiiling to pay
the stated interest rate or even a higher rate
- the risk arising because borrowers may default
- when deposits are lost because depositors make withdrawals and
demand payment
- borrowings from Fed ; advances
- the cost associated with discount loans is the interest rate that
must be paid to the Fed
- examines the sensitivity of the market value of the banks total
assets and liabilities to changes in interest rates
- the amount of assets per dollar of equity capital
EM =

Excess reserves

*Gap analysis

*Interest- rate risk

*Liability management
*Liquidity management
*Loan commitment

*Loan sale

assets
equity capital

- determines the relationship between the return on assets ( which

measures how efficiently the bank is run ) and the return on equity
( which measures how well the owners are doing on their
investment )
- additional reserves kept by the bank, because they are the most
liquid of all bank assets
- the bank can use them to meed its obligations when funds are
withdrawn, either directly by a depositor or indirectly when a
check is written on an acc.
- used to measure more directly the sensitivity of bank profits to
changes in interest rates
- in which the amount of rate-sensitive liabilities is substracted
from the amount of rate-sensitive assets
- the riskiness of earnings and returns on bank assets that results
from interest-rate changes
- aquiring funds at low cost
- the aquisition of sufficiently liquid assets to meet the banks
obligations to depositors
- is a bank comitment ( for a specified future period of time ) to
provide a firm with loans up to a given amount at an interest rate
that is tied to some market interest rate
- = secondary loan participation involves a contract that sells all
or part of the cash stream from a specific loan and thereby
removes the loan so that it no longer is an asset on the banks
balance sheet

*Money center banks

*Off balance sheet

activities
Required reserve ratio
Required reserves

Reserve requirements
Reserves

*Return on assets (ROA)

- large banks which in 1960, in key financial centers such as New

York, began to explore ways in which the liabilities on their balance
sheet could provide them with reserves and liquidity
- trading financial instruments and generating income from fees
and loan sales, activities that affect bank profits but do not appear
on bank balance sheets.
- the fraction of every dollar that must be kept as reserves
- reserves that the Fed requires banks to hold because of reserve
requirements
- earn low interest rates
-the regulation that for every dollar of checkable deposits at a
bank, a certain fraction must be kept as reserves
- are the deposits the banks aquire and hold in an acc. at the Fed
+ currency that is physically held by banks (called vault cach
because it is stored in bank vaults overnight)
- a basic measure of bank profitability
- the net profit after taxes per dollar of assets :
ROA =

*Return on equity (ROE)

- shows how much the bank is earning on their equity investment

- the net profit after taxes per dollar of equity (bank) capital :
ROE =

Secondary reserves
T-account

Vault cash
13. Board of Governors
of the Federal Reserve
System
Dual mandate

Federal Open Market

Comittee (FOMC)
Federal Reserve bank
Goal independence
Hierachical mandates
Instrument
independence
Natural rate of
unemployment
Nominal anchor
Open market operations

Political business cycle

net profit after taxes

assets

net profit after taxes

equity capital

- short-term U.S. goverment securities

- is a simplified balance sheet, with lines in the form of a T, that
lists only the changes that occur in balance sheet items starting
from some initial balance sheet position
- currency physically storred in bank vault overnight
- 7 members, including the chairman, appointed by the oresident
of U.S and confirmend by the Senate
- a statement in practice that says long-term interest rates will be
very high if there is high inflation used to achieve 2 co-equal
objectives : price stability and maximum employment
- 7 members of board of Governors plus presidents of FRB of New
York and 4 other FRBs
-each has 9 directors who appoint president and other officers of
the FRB (12 FRBs)
- the ability of the central bank to set the goals of monetary policy
- mandates which put the goal of price stability first and then say
that as long as it is achieved other goals can be pursued
- the ability of the central bank to set monetary policy instruments
- a level above zero consistent with full employment at which the
demand for labor equals the supply of labor
- a nominal variable such as inflatin rate or the money supply,
which ties down the price level to achieve price stability
- the purchase and sale of government securities that affect both
interest rates and the amount of reserves in the banking system
through which the Federal Reserve exercises control over the
monetary base (next to its extensions of discount loans to banks)
- in which just before an election, expansionary policies are

Price stability
Time inconsistency
problem
14. Borrowed reserves

Discount rate
Excess reserves
Float

High-powered money
Monetary base

Money multiplier

Multiple deposit creation

Nonborrowed monetary
base
Open market purchase
Open market sale
Simple deposit
multiplier
17. Appreciation
Capital mobility
Depreciation
Effective exchange rate
index
Exchange rate
Exchange rate
overshooting
Foreign exchange
market
Forward exchange rate
Forward transaction
Interest parity condition

pursued to lower the unemployment and interest rates

- which central bankers define as low and stable inflation, is
increasingly viewed as the most important goal of monetary policy
- in which monetary policy conducted on a discretionary, day-by-da
basis leads to poor long-run outcomes
- the nonborrowed monetary base is formally defined as the
mmonetary base minus banksborrowings from the Fed ( discount
loans )
MBn = MB - BR
- the interest rate charged to banks for the discount loans
- any additional reserves the banks choose to hold
the resulting temporary net increase in the total amount of
reserves in the banking system occurring from the Feds checkclearing process
- another name for monetary base equals currency in circulation
C plus the total reserves in banking system R
MB = C + R
- the sum of the Feds monetary liabilities (currency in circulation
and reserves) and the U.S. Treasurys monetary liabilities (Treasury
currency in circulation, primarily coins)
- (m) tells us how mmuch the money supply changes for a given
change in the monetary base
- the process in which deposits increase of this amount when the
Fed supplies the banking system with 1$ of additional reserves
- the remainder of the base that is created by discount loans from
the Fed and is under the Feds control because it results primarily
from open market operations
- a purchase of bonds by the Fed
- a sale of bonds by the Fed
- the multiple increase in deposits generated from an increase in
the bankink systems reserves
D = 1/r x R
- when a currency increases in value
- foreigners can easily purchase American assest and Americans
can easily purchase fooreign assets
- when a currency falls in value and is worth fewer U.S. dollars
- plots measures of real and nominal interest rates and the value
of the dollar in terms of a basket of foreign currencies ???
- the price of one currency in terms of another
- the process in which the exchange rate falls by more in the short
run than it does in the long run when the money supply increases
- the financial market where exchange rates are determined
- the exchange rate for the forward transaction
- involve the exchange of bank deposits at some specified future
date
the equation that states that the domestic interest rate equals the
foreign interest rate minus the expected appreciation of the
domestic currency

i
Law of one price

iF

E ct +1Et
Et

- if 2 countries produce an identical good and transportation costs

and trade bariers are very low, the price of the good should be the
same throughout the world no matter which country produces it

Montary neutrality

Quotas
Real exchange rate
Spot exchange rate
Spot transaction
Tariffs
Theory of purchasing
power parity (PPP)

- basic proposition in monetary theory that states that in the long

ru, a one-time percentage rise in the money supply is matched by
the same one-time percentage rise in the price level, leaving
unchanged the real money supply and all other economic variables
such as interest rates
- restrictions on the quntity of foreign goods that can be imported
- the rate at which domestic goods can be exchanged for foreign
goods
- is the exchange rate for the spot transactions
- involve the immediate (two-day) exchange of bank deposits
- taxes on imported goods
- states that exchange rates between any two currencies will
adjust to reflect changes in the price levels of the 2 countries
- one of the most proeminent theories of how exchange rates are
determined

net profit after taxes

assets

ROA =

net profit after taxes

equity capital

ROE =

ROE = ROA x EM

assets
equity capital

EM =

Mn = MB BR

1
r

D =

x R

MBn = nonborrowed monetary base

MB = monetary base
BR = borrowed reserves from the Fed

D = change in total checkable deposits in the banking system

r = required reserve ratio

R = change in reserves for the banking system

M = m x MB

M = money supply
m = money multiplier
MB = monetary base

c=

C
D

c = currency ratio

C = currency
D = deposits

e=

ER
D

e = excess reserves ratio

ER = excess reserves
D = deposits

m=

1+ c
r+ e+ c

15) Using T-accounts show what happens to reserves at Security National Bank if one
individual deposits $1000 in cash into her checking account and another individual withdraws
$750 in cash from her checking account.
Answer: Security National Bank
Assets
Liabilities
Reserves +$250
Checkable deposits
+$250
35) Your bank has the following balance sheet:
Assets
Liabilities
Reserves $ 50 million
Checkable deposits $200 million
Securities 50 million
Loans 150 million
Bank capital 50 million
If the required reserve ratio is 10%, what actions should the bank manager take if there is an unexpected deposit
outflow of $50 million?
Answer: After the deposit outflow, the bank will have a reserve shortfall of $15 million. The bank
manager could try to borrow in the Federal Funds market, take out a discount loan from
the Federal Reserve, sell $15 million of the securities the bank owns, sell off $15 million of
the loans the bank owns , or lastly call-in $15 million of loans. All of the actions will be
costly to the bank. The bank manager should try to acquire the funds with the least
costly method.

18) Your bank has the following balance sheet

Assets
Liabilities
Rate-sensitive $100 million

Rate-sensitive $75 million

Fixed-rate 100 million

Fixed-rate 125 million

What would happen to bank profits if the interest rates in the economy go down? Is there anything that you could
do to keep your bank from being so vulnerable to interest rate movements?
Answer: The banks profits would go down because it has more interest-rate sensitive assets than
liabilities. In order to reduce interest-rate sensitivity, the bank manager could use
financial derivatives such as interest-rate swaps, options, or futures. The bank manager
could also try to adjust the balance sheet so that the banks profits are not vulnerable to
the movement of the interest rate.
15) Explain the time-inconsistency problem. What is the likely outcome of discretionary policy? What are the
solutions to the time-inconsistency problem?
Answer: With policy discretion, policymakers have an incentive to attempt to increase output by
pursuing expansionary policies once expectations are set. The problem is that this policy
results not in higher output, but in higher actual and expected inflation. The solution is to
adopt a rule to constrain discretion. Nominal anchors can provide the necessary
constraint on discretionary behavior.

51) Assume that no banks hold excess reserves, and the public holds no currency. If a bank
sells a $100 security to the Fed, explain what happens to this bank and two additional steps in
the deposit expansion process, assuming a 10% reserve requirement. How much do deposits
and loans increase for the banking system when the process is completed?
Answer: Bank A first changes a security for reserves, and then lends the reserves, creating
loans. It
receives $100 in reserves from the sale of securities. Since all of these reserve will be
excess reserves (there was no change in checkable deposits), the bank will loan out all
$100. The $100 will then be deposited into Bank B. This bank now has a change in
reserves of $100, of which $90 is excess reserves. Bank B will loan out this $90, which will
be deposited into Bank C. Bank C now has an increase in reserves of $90, $81 of which is
excess reserves. Bank C will loan out this $81 dollars and the process will continue until
there are no more excess reserves in the banking system.

Bank A : 100$ securities becomes 100$ reserves => they can give loans
Bank B : deposits 100$ with 10% required ratio => can give loan of 90$ = excess reserve
Bank C : deposits 90$ (increases in reserves) with 10% required ratio => 81$ excess reserves
can give loans
Bank D, etc...
For the banking system, both loans and deposits increase by $1000. ( the increase is tenfold,
the reciprocal of the 10% reserve requirement )
28) Explain the law of one price and the theory of purchasing power parity. Why doesnt
purchasing power parity explain all exchange rate movements? What factors determine longrun exchange rates?
Answer: With no trade barriers and low transport costs, the law of one price states that the
price of
traded goods should be the same in all countries. The purchasing power parity theory
extends the law of one price to total economies. PPP states that exchange rates should
adjust to reflect changes in the price levels between two countries. PPP may fail to fully
explain exchange rates because goods are not identical, and price levels include traded
and nontraded goods and services. Long-run exchange rates are determined by domestic
price levels relative to foreign price levels, trade barriers, import and export demand, and
productivity.
49) Explain and show graphically the effect of an increase in the expected future exchange rate on the equilibrium
exchange rate, everything else held constant.
Answer: See figure below.

When the expected future exchange rate increases, the relative expected return on the
domestic assets increases. This will cause the demand for domestic assets to increase and
the current value of the exchange rate will appreciate.
50) Explain and show graphically the effect of an increase in the expected inflation rate on the equilibrium
exchange rate, everything else held constant.
Answer: See figure below.

When the expected inflation rate increases, the relative expected return on domestic
assets is affected two ways. First, through the Fisher effect, the domestic nominal interest
rate will increase the expected return on domestic assets. Second, through purchasing
power parity, the future value of the domestic exchange rate will decline which will

decrease the expected return on domestic assets. Since it is generally believed that the
effect of the change in the expected future value of the domestic exchange rate is larger
than the Fisher effect, the net effect is a lower expected return on domestic assets. This
will decrease the demand for domestic assets, which will cause the current value of the
domestic exchange rate to depreciate.