Happy Bank's Capital and Deposits Analysis
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Sayeeda JahanHappy Bank's Capital and Deposits Analysis
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Sayeeda JahanEast West University
ECO 102 (4) | Spring’ 2022.
Assignment – III
Due on 27 April 2022
The Monetary System
1. Happy Bank starts with $200 in bank capital. It then accepts $800 in deposits. It keeps
12.5 percent (1/8th) of deposits in reserve. It uses the rest of its assets to make bank
loans.
a. Show the balance sheet of Happy Bank.
b. What is Happy Bank’s leverage ratio?
c. Suppose that 10 percent of the borrowers from Happy Bank default and these
bank loans become worthless. Show the bank’s new balance sheet.
d. By what percentage do the bank’s total assets decline? By what percentage does
the bank’s capital decline? Which change is larger? Why?
(8 marks)
2. Suppose you take $100 you had kept under your mattress and deposit it in the Happy
bank account. If this $100 stays in the banking system as reserves and if banks hold
reserves equal to 10 percent of deposits, by how much does the total amount of deposits
in the banking system increase? By how much does the money supply increase?
(4 marks)
Monetary Policy (15 marks)
3. Explain how each of the following would affect the quantity of money demanded. Does
the change cause a movement along the money demand curve or a shift of the money
demand curve?
a. Short-term interest rates rise from 5% to 10%.
b. In order to avoid paying a sharp increase in taxes, residents of Manalia (an
imaginary country) shift their assets into overseas bank accounts. These
accounts are harder for tax authorities to trace but also harder for their owners
to tap and convert funds into cash.
4. Imagine, in this EID shopping season, the retailers have temporarily slashed prices to
unexpectedly low levels. Will this increase the opportunity cost of holding cash? Reduce
it? Have no effect? Explain with graph.
5. Assume the central bank increases the quantity of money by 25%, even though the
economy is initially in both short-run and long run macroeconomic equilibrium.
Describe the effects in the short run and in the long run on the following:
i. Aggregate output
ii. Aggregate price level
iii. Interest rate
Page 1 of 2
Open Economy Macroeconomics: Basic Concepts
6. What is happening to the U.S. real exchange rate in each of the following situations?
Explain.
a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United
States than abroad.
b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than
in the United States.
c. The U.S. nominal exchange rate declines, and prices are unchanged in the United
States and abroad.
d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the
United States.
(12 marks)
7. A can of soda costs $1.25 in the United States and 25 pesos in Mexico. What is the peso–
dollar exchange rate (measured in pesos per dollar) if purchasing power parity holds?
If a monetary expansion caused all prices in Mexico to double, so that soda rose to 50
pesos, what would happen to the peso–dollar exchange rate?
(3 marks)
8. A case study in the chapter analyzed purchasing power parity for several countries using
the price of Big Macs. Here are data for a few more countries:
a. For each country, compute the predicted exchange rate of the local currency per
U.S. dollar. (Recall that the U.S. price of a Big Mac was $4.93.)
b. According to purchasing-power parity, what is the predicted exchange rate
between the Hungarian forint and the Canadian dollar? What is the actual
exchange rate?
c. How well does the theory of purchasing-power parity explain exchange rates?
(8 marks)
Best of luck!
Page 2 of 2
Common questions
Powered by AIIn the short run, a 25% increase in the money supply typically lowers interest rates, encourages borrowing, and boosts spending and aggregate output. Prices may start to rise as demand increases, causing a movement along the aggregate supply curve. In the long run, according to the classical dichotomy and monetary neutrality, aggregate output is unaffected (if we assume full employment is eventually restored), but the aggregate price level is higher as the increase in money supply fully translates into inflation. Interest rates may return to their long-term real levels, adjusted for inflation expectations .
Slashing prices reduces the overall cost of goods, which could lower the opportunity cost of holding cash if consumers perceive less need to hold onto money with the expectation of making future investments. In this context, it would likely result in higher immediate spending, potentially causing a decrease in money demand as consumers are more willing to part with their cash for cheaper goods. The demand curve might experience a movement reflecting this temporary surge in spending behavior .
If prices in Mexico double, moving from 25 pesos to 50 pesos for a can of soda, the purchasing power of the peso decreases. Assuming initial purchasing power parity, doubling prices in Mexico without a corresponding increase in U.S. prices means that more pesos are required to purchase the same amount of dollars. Therefore, the exchange rate would change to reflect this new price level, likely increasing the number of pesos per dollar to maintain parity, provided there are no other offsetting factors such as changes in the nominal exchange rate or dollar prices .
If the U.S. nominal exchange rate declines while foreign prices rise faster than U.S. prices, the real exchange rate could either appreciate or depreciate based on the relative magnitude of changes. However, since foreign prices are rising faster and the nominal rate adjustment makes U.S. goods relatively cheaper abroad, this could likely lead to a real depreciation of the U.S. exchange rate despite the nominal rate's decline. This scenario reflects increased competitiveness of U.S. goods owing to relative price adjustments favoring U.S. exports .
If U.S. prices rise faster than prices abroad while the nominal exchange rate remains unchanged, the U.S. real exchange rate appreciates. This is because the purchasing power of the U.S. dollar increases relative to foreign currencies, making U.S. goods more expensive compared to foreign goods. Consequently, the real exchange rate, which adjusts for price level differences, shows an appreciation in U.S. terms .
After 10% of borrowers default, Happy Bank's balance sheet will show a decrease in total assets equivalent to the value of the defaulted loans. If the bank's initial loans were $875 (i.e., $800 deposits minus 12.5% reserve), then the defaulting amount would be $87.5 (10% of $875). Consequently, total assets decline by this amount. For capital, if losses reduce assets directly without affecting liabilities (deposits remain constant), the capital is reduced by the same $87.5, assuming the bank absorbs the full loss. The percentage decline in total assets is calculated as ($87.5/$1075) * 100%, whereas the percentage decline in capital is ($87.5/$200) * 100%. The capital decline percentage will be larger because the initial capital is much smaller than total assets .
Purchasing power parity may fail in predicting real-world exchange rates due to several factors, including transportation costs, trade barriers, and different consumption patterns across countries. Market imperfections, such as monopolistic practices and varying fiscal policies, can also lead to persistent deviations from parity. Furthermore, asset prices and speculative activities in foreign exchange markets can create fluctuations that do not align with price levels of goods and services alone, limiting the practical application of PPP theory .
Purchasing power parity theory predicts that exchange rates will adjust so that identical goods have the same price in different countries when expressed in a common currency. Assuming the price of Big Macs in local currencies is known, the exchange rate between the Hungarian forint and the Canadian dollar can be calculated by determining the relative price of Big Macs in these two currencies. For instance, if a Big Mac is 1000 forints and 6 Canadian dollars, the expected exchange rate would be 1000/6 forints per Canadian dollar, unless transaction costs, tariffs, or market imperfections intervene .
Shifting assets to overseas bank accounts represents a shift in preference from local cash holdings to foreign assets, causing a leftward shift in the money demand curve in Manalia. This shift indicates a lower quantity of money demanded at any given interest rate, as preference for cash declines in response to seeking tax-evasion benefits and potential protection against local economic instability .
An increase in short-term interest rates from 5% to 10% would typically reduce the quantity of money demanded. This is because higher interest rates make holding money less attractive compared to interest-bearing assets, thus increasing the opportunity cost of holding cash. As a result, there is a movement along the money demand curve, reflecting a decrease in the demand for money at the new higher interest rate .