Macroeconomics I

EC1002 Introduction to economics

Block 15 Answers
Activity SG15.1
Based on Maths 18.1, use the following information to calculate the money multiplier, the bank
deposit multiplier, and the money supply (broad money).
Deposits = £1000
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3% of deposits
Answer: Money multiplier = 12.875; bank deposit multiplier = 51.5; money supply = £1,030.

Activity SG15.2
Based on the model above, use the following information to calculate the money multiplier, the bank
deposit multiplier, and the money supply (broad money).
Cash held by the public = £600
Banks reserves = £900
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3.333% of deposits
Answer: Money multiplier =12.4; bank deposit multiplier =20.667; money supply = £18,600.

Activity SG15.3
Figure 18.2 and Table 18.3 in the textbook provide a good summary of the various factors behind the
demand for money. Draw the MB and MC curves for the demand for money in an economy, and use
these to answer the following question:
What will happen to the demand for money in the following cases, assuming all other factors remain
constant?
Real incomes fall (say, because of a recession)
There is a general rise in prices
Interest rates fall

Answer:
Macroeconomics I

EC1002 Introduction to economics

Sample examination questions

1) All of the following are examples of financial intermediaries except:
a) commercial banks
b) stock exchanges
c) pension funds
d) insurance companies.
Answer: (b)
Explanation: The stock exchange is not an intermediary, it is the platform where the exchanges
happen.

2) A credit crunch reduces aggregate demand by:

a) increasing the exchange rate
b) increasing interest rates
c) reducing consumption and investment spending
d) reducing the money supply.
Answer: (c)
Explanation: A credit crunch is a decrease in lending to consumers and firms. It reduces the
aggregate demand because, with less lending, there is less consumption and investment.
3) To the extent that mortgage defaults contributed to the financial crisis of 2008–2009, blame for
these actions lies with:
a) homebuyers who borrowed more than they could afford to repay.
b) mortgage brokers who encouraged households to borrow excessively.
c) financial intermediaries who held large positions in mortgage-related assets
d) all of the above.
Answer: (d)
Explanation: Until 2008 homebuyers borrowed massively. Sometimes even more than 100 per
cent of the value of their collateral (price of the house).
Mortgage brokers encouraged this kind of lending, as they were able to make good profits.
As this type of lending was profitable, financial intermediaries held large positions in mortgage
related assets.
When house prices fell, the value of collateral dropped. Many households were not able to repay
their debts. Mortgage brokers and financial intermediaries had to write-down their assets,
causing fears of insolvency.
Macroeconomics I

EC1002 Introduction to economics

4) A bank with assets worth less than liabilities is said to be _____, while a bank without adequate
funds immediately available to make promised payments is said to be _____.
a) inflated; inverted
b) inverted; inflated
c) insolvent; illiquid
d) illiquid; insolvent.
Answer: (c)
Explanation: A bank is insolvent when the value of its assets is lower than the value of its
liabilities. If instead the value of assets is equal to liabilities, but some of the assets are not in
liquid form and therefore the bank is not able to satisfy some of the required payments, then the
bank is called illiquid.

5) An increase in the demand for money could be caused by

a) an increase in the general level of prices
b) an increase in incomes
c) an increase in interest rates
d) an increase in synchronisation between payments and receipts.
Answer: (b)
Explanation: An increase in real incomes increases both the transactions motive and the
precautionary motive for holding money. Part (a) would have no effect and parts (c) and (d)
would lead to a decrease in the demand for money.

6) Given a fixed money supply, more competition in banking could lead to

a) An increase in the interest rate paid on bonds
b) A decrease in the interest rate paid on bonds
c) No change in the interest rate paid on bonds
d) A decrease in the interest rate paid on bank deposits
Answer: (a)
Explanation: Increased competition between banks increases the interest rate paid on bank
deposits, leading to an upwards shift in the LL curve, with more money demanded at each
interest rate (on bonds). Given a fixed money supply, the interest rate paid on bonds must
increase to maintain equilibrium in the money market.

Long response question

A farmer’s harvest will be worth £ 00 if she can borrow £100 worth of fertiliser. The fertiliser needs
to be applied now and harvest will take place in six months’ time. There are N savers in the
economy, each endowed with £1. Each agent faces a p% chance that there will be an emergency
such as they will absolutely need their £1 three months from now.

a) Explain why a financial intermediary is needed in this situation

Answer: On the one hand, the farmer needs to borrow in order to finance its investment: the
cost of the fertiliser has to be paid now but the investment will pay out in six months’ time. As
the farmer does not have any endowment, the only way to finance the investment is through
borrowing.

On the other hand, savers have an endowment that they need in the future only with a
probability p%.
Macroeconomics I

EC1002 Introduction to economics

A financial intermediary can:

collect money from the savers, providing an interest rate
finance the farmer’s investment, making a profit (the difference between the
interest rate received by the farmer and the interest rate paid to savers).

b) What is the minimum value of N such that a financial intermediary can solve the problem of
getting money from savers to borrowers? (Hint: it depends on p)

Answer: The financial intermediary has to hold some liquid assets, so as to be able to cover the
needs of the agents that will face an emergency (occurring with probability p). As this
emergency occurs with probability p, the financial intermediary has to hold p*N*1 in liquid
assets. It also needs to finance 100$ to the farmer. This means it must receive at least

N*1=100+p*N*1 solving N=100/(1-p)

c) On the basis of this example, can you see what economists mean when they say banks are
engaged in maturity transformation?

Answer: Maturity transformation means that the bank receives short-term debt (from savers)
and transform it into long-term asset (loan to the farmer).

d) Now for something a bit harder. Instead of p being a fixed number, suppose that p can turn
out to be small (with 90% probability) or large (with 10% probability).Can you see a bank
run developing in this case?

Answer: In the case p is subject to uncertainty, the bank holds liquid the fraction of resource
that on average is sufficient to cover the withdrawal needs of the savers.

Here is the problem: if after hree months the realised p is p_high, savers will ask to the bank an
amount of money equal to= p_high*N*1$. However, the bank held liquid only the quantity
0.9*p_small*N*1$+0.1*p_high*N*1$, which is lower than p_high*N*1$.

In this case the bank is not able to cover the liquidity needs of all its savers. There is a bank run,
as savers run to the bank hoping to the able to be among the few who are given money the
bank has.

e) What could the role of a central bank be in this case?

Answer: The role of the central bank is to prevent a bank run to happen. In case the bank’s
liquidity is insufficient, the central bank can intervene, lending to the suffering bank the
necessary liquidity in order to satisfy savers liquidity needs. When the central bank steps in,
there is no reason for a bank run, as savers realise there won’t be any liquidity shortage.