Question

Part 1: A small regional bank, Bank of Cascadia, has deposits of $600 million. It holds reserves of $50 million, government bonds worth $40 million, and corporate bonds worth $30 million. It has made loans of $500 million.

· Set up a T-account balance sheet for the bank, with assets and liabilities, and calculate the bank’s net worth.

· Describe the asset-liability time mismatch that Bank of Cascadia and all banks face.

Part 2: Explain what happens to the bank’s net worth when the value of the corporate bonds falls from $30 million to $1 million.

Part 3: As new residents move to the region, they deposit $20 million in to the Bank of Cascadia.

a. Bank of Cascadia is required to hold 5% of its deposits but can loan out the rest. Draw a new T-account for Bank of Cascadia that shows the change in deposits, the change in reserves, and the change in loans, assuming that Bank of Cascadia holds only the required reserves of these new deposits. Make sure that in the end the value of assets and the value of liabilities are equal.

b. What is the maximum amount that the money supply can change in the economy with that original deposit of $20 million?

c. What assumptions are you making about the behaviors of borrowers and banks to find your answer to part b and how would your answer change if banks chose not to lend out all the excess reserves that they legally could?

Part 4: If the central bank was concerned about inflation, it would sell treasury bonds to banks.

· Discuss how this would change the T-account for Bank of Cascadia and ultimately bring downward pressure to prices. (HINT: the changes will be on the asset side).

· Explain how the Fed can incentivize member banks to purchase Treasury bills and bonds (i.e. How does any seller create an incentive to purchase an item?)

Answer 1

Here,

Part 1

Liabilities	Amount($ million)	Assets	Amount($ million)
Net Worth	20	Reserves	50
Deposits	600	Government Bonds	40
		Corporate Bonds	30
		Loans	500
Total	620		620

Since Assets = Liabilities

So Net Worth = Assets - Deposits = 620 - 600 = $20 million

Asset Liability Time mismatch:

The biggest asset liability time mismatch that most banks faces is the difference in the norms for loans and deposits. Deposits are demand deposits that is those can be withdrawn at demand but when it comes to loans the same doesnt apply and the person whom the loan is given gives it back according to predecided longer time duration. In case of corporate and government bonds some bit of liquidity is there as they can be sold in the secondary market. Reserves are there to take care of this situation with the assumption that only a certain of people will withdraw all money at a given point of time

Part 2

When Value of the corporate bonds falls from $30 million to $1 million the networth shrinks as indicated in the table below

Liabilities	Amount($ million)	Assets	Amount($ million)
Net Worth	-9	Reserves	50
Deposits	600	Government Bonds	40
		Corporate Bonds	1
		Loans	500
Total	591		591

Part 3:

a) New Deposit = $20 million

Reserve Ratio = 5%

So New T table

Liabilities	Amount($ million)	Assets	Amount($ million)
Net Worth	20	Reserves	51
Deposits	620	Government Bonds	40
		Corporate Bonds	30
		Loans	519
Total	640		640

Additional Reserves 5% of 20 = 1 million

b) Reserve Ratio =5%

So money multiplier = 1/5% = 20

So max change in money supply = 19*20 = $180 million

c) The loaners will utilise the money properly and hence will help in multiplication of money while banks will loan out entire excess reserves

If banks could not loan out entire excess reserves than the money supply will increase by lesser amount

d)

If FED Sells treasury bonds, than banks will have lesser amount to loan out and the updated table will have less of loans compensated by higher of government bonds. Thus loan given out will be lesser.

FED can incentivise banks to buy treasury bonds by offering better yields than currently available . Any seller can incentive buyer by giving him higher consumer surplus