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EC 223
Economics of the Canadian Banking and Financial System
Instructor: Sharif F. Khan
Department of Economics
Wilfrid Laurier University
Fall 2011

Suggested Solutions to Assignment 5 (Optional)

Total Marks: 120

Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.

B1. [5 marks]

Some economists think that the central banks should try to prick bubbles in the stock
market before they get out of hand and cause later damage when they bust. How can
monetary policy be used to prick a bubble? Explain how it can do this using the Gordon
growth model.

A stock market bubble can occur if market participants either believe that dividends will have
rapid growth or if they substantially lower the required return on their equity investments, thus
lowering the denominator in the Gordon model and thereby causing stock prices to climb. By
raising interest rates the central bank can cause the required rate of return on equity to rise,
thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the
expected growth rate of the economy and hence of dividends, thus also keeping stock prices from

B2. [5 marks]

Whenever it is snowing when Joe commuter gets up in the morning, he misjudges how
long it will take him to drive to work. Otherwise, his expectations of the driving time are
perfectly accurate. Considering that it snows only once every ten years where Joe lives,
Joes expectations are almost perfectly accurate. Are Joes expectations rational? Why or
why not?

Although Joes expectations are typically quite accurate, they could still be improved by his
taking account of a snowfall in his forecasts. Since his expectations could be improved, they are
not optimal and hence are not rational expectations.

B3. [5 marks]

If I read in the Globe and Mail: Report on Business that the smart money on Bay Street
expects stock prices to fall, should I follow that lead and sell all my stocks?

No, because this is publicly available information and is already reflected in stock prices. The
optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from
selling your stocks.

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B4. [5 marks]

If most participants in the stock market do not follow what is happening to the monetary
aggregates, prices of common stocks will not fully reflect information about them. Is this
statement true, false, or uncertain? Explain your answer.

False. All that is required for the market to be efficient so that prices reflect information on the
monetary aggregates is that some market participants eliminate unexploited profit opportunities.
Not everyone in a market has to be knowledgeable for the market to be efficient.

B5. [5 marks]

If higher money growth is associated with higher future inflation and if announced money
growth turns out to be extremely high but is still less than the market expected, what do you
think would happen to long-term bond prices?

Because inflation is less than expected, expectations of future short-term interest rates would be
Lowered. As a result, according to the Expectations, Liquidity Premium and Preferred Habitat
theories of the term structure of interest rates, long-term interest rates would fall. The decline in
long-term interest rates implies that long-term bond prices would rise.

B6. [5 marks]

Can we expect the value of the dollar to rise by 2% next week if our expectations are

No, because this expected change in the value of the dollar would imply that there is a huge
unexploited profit opportunity (over a 100% expected return at an annual rate). Since rational
expectations rules out unexploited profit opportunities, such a big expected change in the
exchange rate could not exist.

B7. [5 marks]

If the public expects a corporation to lose $5 a share this quarter and it actually loses $4,
which is still the largest loss in the history of the company, what does the efficient market
hypothesis say will happen to the price of the stock when the $4 loss is announced?

The stock price will rise. Even though the company is suffering a loss, the price of the stock
reflects an even larger expected loss. When the loss is less than expected, efficient markets theory
then indicates that the stock price will rise.

B8. [5 marks]

Why has the development of overnight loan market made it more likely that banks will hold
fewer reserves?

Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan
markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling
off loans. The presence of overnight loan markets thus reduces the costs associated with deposit
outflows, so banks will hold fewer excess reserves.

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B9. [5 marks]

If the bank you own has no excess reserves and a sound customer comes in asking for a
loan, should you automatically turn the customer down, explaining that you dont have any
excess reserves to lend out? Why or why not? What options are available for you to provide
the funds your customer needs?

No. When you turn a customer down, you may lose that customers business forever, which is
extremely costly. Instead, you might go out and borrow from other banks, corporations, or the
Bank of Canada to obtain funds so that you can make the customer loans. Alternatively, you
might sell negotiable CDs or some of your securities to acquire the necessary funds.

B10. [5 marks]

Using the T-accounts of the First Bank and the Second Bank, describe what happens when
Jane Brown writes a $50 cheque on her account at the First Bank to pay her friend Joe
Green, who in turn deposits the cheque in his account at the Second Bank.

The T-accounts for the two banks are as follows:

First Bank

Assets Liabilities
Reserves -$50 Deposits -$50

Second Bank

Assets Liabilities
Reserves +$50 Deposits +$50

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B11. [5 marks]

What happens to reserves at the First Bank if one person withdraws $1000 of cash and
another person deposits $500 of cash? Use T-accounts to explain your answer.

Reserves drop by $500. The T-account for the First Bank is as follows:

First Bank

Assets Liabilities
Reserves -$500 Deposits -$500

B12. [5 marks]

(a) The bank you own has the following balance sheet:

Assets Liabilities
Reserves $75 million Deposits $500 million
Loans $525 million Bank Capital $100 million

If the bank suffers a deposit outflow of $50 million and has a desired reserve ratio
on deposits of 10%, what actions must you take to keep your bank from failing?

The $50 million deposit outflow means that reserves fall by $50 million to $25 million. Since
required reserves are $45 million (10 percent of the $450 million of deposits), your bank needs to
acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off
$20 million of loans, by borrowing $20 million in loans from the Bank of Canada, by borrowing
$20 million from other banks or corporations, by selling $20 million of securities, or by some
combination of all of these.

(b) If a deposit outflow of $50 million occurs, which balance sheet would a bank rather
have initially, the balance sheet of your bank in part (a) of Problem B15 or the
following balance sheet? Why?

Assets Liabilities
Reserves $100 million Deposits $500 million
Loans $500 million Bank Capital $100 million

The bank would rather have the balance sheet shown in this problem, because after it loses $50
million due to deposit outflow, the bank would still have excess reserves of $5 million: $50
million in reserves minus required reserves of $45 million (10% of the $450 million of deposits).
Thus the bank would not have to alter its balance sheet further and would not incur any costs as a
result of the deposit outflow. By contrast, with the balance sheet in part (a) of Problem B15, the
bank would have a shortfall of reserves of $20 million ($25 million in reserves minus the required
reserves of $45 million). In this case, the bank will incur costs when it raises the necessary
reserves through the methods described in the text.

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B13. [5 marks]

During the Great Depression years 1930-1933, the desired reserves ratio r rose
dramatically. What do you think happened to the money supply? Why?

The rise in banks holdings of reserves relative to chequable deposits meant that the banking
system in effect had fewer reserves to support chequable deposits. Thus the money multiplier fell
and this led to a decline in the money supply.

B14. [5 marks]

If the Bank of Canada paid interest on bank reserves what would happen to r?

The Bank of Canada does pay some interest on bank settlement balances (the bank rate less 50
basis points). If that interest rate were to increase, excess reserves would be more attractive to

B15. [5 marks]

If the Bank of Canada sells $1 million of bonds and banks reduce their borrowing from the
bank Canada by $1 million, using economic analysis predict what will happen to the money

The Bank of Canadas sell of $1 million of bonds shrinks the monetary base by $1 million, and
the reduction of advances also lowers the monetary base by another $1 million. The resulting $2
million decline in the monetary base leads to a decline in the money supply.

B16. [5 marks]

Using economic analysis predict what will happen to the money supply if there is a sharp
rise in the currency ratio.

The money supply falls. The rise in c means that there has been a shift from deposits which
undergo multiple deposit expansion to currency which does not. Thus, the overall level of
multiple expansion declines, and the money multiplier and money supply fall.

B17. [5 marks]

Using economic analysis predict what would happen to the money supply if expected
inflation suddenly increased?

A rise in expected inflation would increase interest rates (through the Fisher effect), which would
in turn cause r to fall and the volume of advances to rise. The fall in r increases the amount of
excess reserves available to support chequable deposits so that deposits and the money multiplier
will rise. The rise in advances causes the monetary base to rise. The resulting increase in the
money multiplier and the monetary base leads to an increase in the money supply.

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B18. [5 marks]

If the Bank of Canada sells $2 million of bonds to the first bank, what happens to reserves
and the monetary base? Use T-accounts to explain your answer.

Reserves and the monetary base fall by $2 million, as the following T-accounts indicate:

First Bank

Assets Liabilities
Reserves -$2 million
Securities +$2 million

Bank of Canada

Assets Liabilities
Securities -$2 million Reserves -$2 million

Unless otherwise noted, the following assumptions are made in Problem B19 and B20: the
desired reserve ratio on chequable deposits is 10%, banks do not hold on to excess reserves, and
the publics holdings of currency do not change.

B19. [5 marks]

If a bank sells $10 million of bonds back to the Bank of Canada in order to pay back $10
million on the advances it owes, what will be the effect on the level of chequable deposits?

None. The reduction of $10 million in advances and increase of $10 million of bonds held by the
Bank of Canada leaves the level of reserves unchanged so that chequable deposits remain

B20. [5 marks]

If you decide to hold $100 less cash than usual and therefore deposit $100 in cash in the
bank, what effect will this have on chequable deposits in the banking system if the rest of
the public keeps its holdings of currency constant?

The deposit of $100 in the bank increases its reserves by $100. This starts the process of multiple
deposit expansion, leading to an increase in the money supply

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B21. [5 marks]

If the Bank of Canada did not administer the operating band what do you predict would
happen to the money supply if the bank rate were several percentage points below the
overnight rate?

The monetary base and the money supply would increase indefinitely. Banks could borrow at the
lower bank rate and then lend the proceeds at a higher interest rate. Hence banks would make a
profit on every dollar borrowed from the Bank of Canada, so they would continue to borrow
indefinitely --- which would in turn increase the monetary base indefinitely.

B22. [5 marks]

Discuss how the operating band affects interest rates and the money supply in the economy.

A rise in the operating band increases short-term interest rates in the economy. This reduces the
monetary base and the money supply. On the other hand, a fall in the operating band decreases
short-term interest rates and increases the monetary base and the money supply.

B23. [5 marks]

You often read in the newspaper that the Bank of Canada has just lowered the target
overnight rate. Does this signal that the Bank is moving to a more expansionary monetary
policy? Why or why not?

Usually yes, a decrease in the target overnight rate implies a decline in the bank rate. As the bank
rate falls, all other short-term interest rates in the economy decline as well. A decrease in the bank
rate increases the monetary base and the money supply.

B24. [5 marks]

Explain how repos (also known as SPRAs) and reverse repos (also known as SRAs) affect
the overnight rate.

In a repo, the Bank of Canada buys government of Canada securities from participants with an
agreement to resell them on the next business day. The Bank pays for the repos by crediting the
participants account at the Bank, thereby increasing settlement balances. This increase in
settlement balances puts downward pressure on the overnight interest rate, as banks would have
to borrow less to meet their settlement requirements.

In a reverse repo, the Bank of Canada sells government of Canada securities with an agreement to
buy them back on the next day. When the bank of Canada sells these securities, it debits the
participants account at the Bank, thereby reducing settlement balances. The reduction in
settlement balances puts upward pressure on the overnight rate, as banks would have to borrow
more to meet their settlement requirements.