EC2300
UNIVERSITY OF WARWICK
Summer Examinations 2015/2016
Economics of Money and Banking
Time Allowed: 1.5 hours.
Answer
ALL questions in
Section A (40 marks). Answer the
COMPULSORY question in
Section
B (30 marks). Answer
ONE question in
Section C (30 marks).
Answer Section A questions in one booklet, Section B questions in a separate booklet; and Section C
questions in a separate booklet.
Time should be allocated to questions in proportion to the number of marks available.
Approved pocket calculators are permitted.
Read carefully the instructions on the answer book provided and make sure that the particulars required
are entered on each answer book. If you answer more questions than are required and do not indicate
which answers should be ignored, we will mark the requisite number of answers in the order in which
they appear in the answer book(s): answers beyond that number will not be considered.
Section A: Answer ALL Questions
1. Set out a simple balance sheet for a commercial bank:
(a)
Use this balance sheet to explain the main functions of the banking system.
(8 marks)
(b)
How would a fall in asset quality affect the balance sheet and threaten the solvency of the
bank?
(7 marks)
2. Explain how banks can use
market power to increase their profitability. What can regulators do to
prevent this from happening?
(10 marks)
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EC2300
3. Consider an economy with the following equations:
π¦π‘ = π΄ β πππ‘β1
(A1)
π
πΈ
π‘ = ππ‘ + πΌ(π¦π‘ β π¦π) (A2)
π¦π‘ β π¦π = βπΌπ½(ππ‘ β ππ)
(A3)
in which inflation expectations take the form:
ππΈπ‘ = πππ + (1 β π)ππ‘β1
with 0 ο£ ο£ ο£ 1.
At time t=0 the economy is at its long run equilibrium. At time t=1 a
positive inflation shock affects this economy.
(a) Explain the effects of this shock on output and unemployment and the adjustment of the
economy back to the medium run equilibrium when ο£ = 0.
(8 marks)
(b) How would your answer change if expectations of inflation were firmly anchored at ο°T?
Explain.
(7 marks)
Section B: Answer the COMPULSORY Question
4. The question has three parts (a), (b) and (c). Answer all three, using diagrams and real world
examples where possible.
(a) Explain how the mark-up of the
loan rate above the
policy rate may be accounted for by risk
aversion.
(10 marks)
(b) Some suggest that
monopoly profits in financial intermediaries could prevent them from
taking too much risk, as such banks will be βtoo big to gambleβ. Explain the argument; and
whether or not you find it convincing.
(10 marks)
(c) After the financial crisis, Quantitative Easing (QE) was adopted as a new tool of monetary
policy. However, some recommend a variant of QE, βPeopleβs QEβ (where the central bank
prints money and gives it to households), as a more effective alternative. How would this
differ from current QE? Why might it have a greater impact on output and inflation?
(10
marks)
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(continued)
EC2300
Section C: Answer ONE Question
5. Consider an economy described by the following 3-equation model
:
π₯π‘ = β(ππ‘ β 0.02 β πΜπ‘)
(C1)
π
πΈ
π‘ β ππ = (ππ‘ β ππ) + 0.5π₯π‘ + π’
Μπ‘
(C2)
π
πΈ
π‘ = 0.02 + 2(ππ‘ β ππ)
(C3)
with
xt=yt-ye the output gap;
rt real interest rate; ο°
t the inflation rate; ο°
E the expected inflation, ο°
T the inflation target; πΜ
2
π‘ the demand shock, {πΜπ‘}~πΌπΌπ·(0, ππΜ ) and π’
Μπ‘ the inflation shock,
{π’Μ
2
π‘}~πΌπΌπ·(0, ππ’Μ ).
(a) Represent equations (C1) and (C2) of this economy using appropriate diagrams. Derive the
long-run solutions for the nominal interest rate and the inflation rate and illustrate these
long-run equilibrium values in the diagram.
(5 marks)
(b) Use the method of undetermined coefficients with initial guesses π₯π‘ = πΏππΜπ‘ + πΏπ’π’Μπ‘ and
ππ‘ β ππ = π½ππΜπ‘ + π½π’π’Μπ‘ (where πΏπ, πΏπ’, π½π and π½π’ are the coefficients to be determined) to
find the solutions for
xt and ππ‘ β ππ.
(20 marks)
(c) Explain how the economy will adjust over time following a
positive demand shock (assume
the economy was at its long-run equilibrium before the shock).
(5 marks)
6. In February 2016, The Bank of England cut its forecast for the UKβs GDP growth from 2.5% to
2.2%. The Bank also forecasted that consumer price inflation will reach its 2% target only in
2018 while the current expected inflation for 2016 is 0.4%. The Monetary Policy Committee
(MPC) voted unanimously to maintain Bank Rate at record lows of 0.5% and to maintain the
stock of purchased assets financed by the issuance of central bank reserves at Β£375 billion. Use
the three equation macroeconomic model (IS-MP-PC) to explain the possible economic reasons
behind these policies.
(30 marks)
7. Before the financial crisis, the major UK commercial banks were tempted to diversify into
Investment Banking (IB).
(a) How does investment banking activity differ from the conventional functions of retail
banking; and why might it prove attractive to high street banks?
(7 marks)
(b) Explain, using graphs if needed, the demand for risky assets on the part of Investment Banks
(IBs). Why is it so elastic; and how are IBs able to reassure those they borrow from that
they are protected from risk?
(8 marks)
(c) It has been argued that the exaggerated response of IBs to changes in fundamentals (such as
the expected return or the downside risk of holding risky assets) can make banking system
dynamically unstable β like the Millennium Bridge on opening day, as Hyun Shin likes to
say. Explain the argument; and by what measures the banking system might be made more
stable.
(15 marks)
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