Chapter 13. Liabilities and Net Worth Total Reserves $800,000 Demand Deposits $800,000

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1 Chapter When you deposit $1,000 in your bank, A) the bank holds a financial asset of $1,000 and you hold a financial liability of $1,000. B) the bank holds a financial liability of $1,000 and you hold a financial asset of $1,000. C) both you and the bank now have a financial asset of $1,000. D) both you and the bank now have a financial liability of $1, The main problem caused by deposit guarantees is that A) depositors do not believe that their money is safe, so they still panic when a bank is rumored to be in trouble. B) they destroy the incentive for individuals to worry about whether a financial institution is making good loans. C) depositors no longer withdraw their deposits during a banking crisis. D) banks will declare bankruptcy even though their assets are strong just to acquire the insured funds. Use the following to answer question 3: Assets Liabilities and Net Worth Total Reserves $800,000 Demand Deposits $800, The table above represents a bank's T-account. Suppose it is the only bank in town and individuals in town hold no cash. If the reserve ratio is 5 percent, what will the bank's demand deposits be at the end of the first round of the money creation process? A) $ 40,000. B) $760,000. C) $800,000. D) $1,560, Some economists believe that the financial sector does not channel all saving back into the spending stream. Financial assets that do not re-enter the spending stream are called A) money. B) bonds. C) stocks. D) loans. Page 1

2 5. The real sector is best defined as the market for the creation and exchange of A) money. B) goods and services. C) financial assets. D) all assets with a money price. 6. Financial assets traded in the money market have a maturity of A) less than one year. B) 1 to 3 years. C) 3 years or more. D) 10 years or more. 7. The formula for the approximate real-world money multiplier is A) 1/(r + c). B) 1/r. C) c/r. D) (r+c)/1. 8. The money multiplier is A) less than the approximate real-world multiplier because the public holds cash that is not deposited in the banking system. B) less than the approximate real-world multiplier because banks hold excess reserves. C) greater than the approximate real-world multiplier because banks hold excess reserves. D) greater than the approximate real-world multiplier because the public holds cash that is not deposited in the banking system. 9. Historically, financial panics have occurred for all of the following reasons except A) banks issued banknotes even though they had no deposits. B) loss of faith by depositors in banks. C) overly risky lending on the part of banks. D) banks lent short term and borrowed long term. 10. Using a credit card creates a financial A) liability for the holder and a financial asset for the issuer. B) asset for the holder and a financial liability for the issuer. C) liability for both the holder and issuer. D) asset for both the holder and issuer. Page 2

3 11. When the interest rate rises, people are A) less likely to borrow, that is, sell a financial asset. B) more likely to borrow, that is, sell a financial asset. C) less likely to borrow, that is, purchase a financial asset. D) more likely to borrow, that is, purchase a financial asset. 12. If the cash-to-deposit ratio is 0.25 and the reserve ratio is 0.15, then the amount of money created per dollar deposited in the banking system is approximately A) $2.50 B) $4. C) $5,125. D) $6, Secondary reserves are A) reserves invested in securities. B) cash banks keep on hand to meet daily withdrawals by depositors. C) available reserves over and above the level banks wish to maintain. D) reserves in the form of loans. 14. If the total reserves of the banking system are $400 billion, these reserves could support of checkable deposits if the reserve ratio is 0.20 and the banks are fully loaned out. A) $ 400 billion B) $1,200 billion C) $1,600 billion D) $2,000 billion 15. If the reserve ratio is 0.20 and individuals hold no cash, what is the maximum amount of deposits that can be created from an initial $5 million deposit in the banking system? A) $5 million. B) $20 million. C) $25 million. D) $50 million. Page 3

4 16. The higher the reserve ratio, the A) greater the money multiplier. B) more money will be created. C) smaller the money multiplier. D) lower the level of desired reserves. Use the following to answer question 17: Assets Liabilities and Net Worth Total Reserves $100,000 Demand Deposits $100, The table above represents a bank's T-account. Suppose it is the only bank in town and individuals in town hold no cash. Assuming the reserve ratio is 10 percent, what will be the bank's loans at the end of the money creation process? A) $90,000. B) $100,000. C) $900,000. D) $1,000, Government regulation of banks is necessary for all of the following reasons except A) banks may lend recklessly. B) banks may issue too many loans. C) banks may hold too few deposits in reserve. D) banks may issue too few loans. 19. In an advertisement for credit cards, the statement is made, "Think of a credit card as smart money." An economist's reaction to this would be that a credit card is A) not money. B) dumb money. C) simply money. D) actually better than money. 20. If the reserve ratio is 0.08, the deposit multiplier is A) 1. B) 8. C) D) Page 4

5 21. When people hold a percentage of their money as cash, A) the approximate real-world money multiplier is given by 1/(r + c). B) the approximate real-world money multiplier is given by 1/r. C) there is no money multiplier process. D) the money multiplier becomes infinite. 22. If the reserve ratio is 0.1 and the ratio of money people hold as cash relative to deposits is 0.2, the money multiplier will be A) B) C) D) Suppose consumers shift money out of chequing accounts and into personal savings accounts at chartered banks. This shift will affect A) M1. B) M2. C) M2+. D) M Modern bankers A) focus on asset management. B) focus on liability management. C) focus equally on asset management and liability management. D) are unconcerned with asset and liability management and instead are concerned with how to make money. 25. Which of the following transactions occurrs in the money market? A) Purchase of a Canadian treasury bill. B) Mortgage granted by a bank. C) City issues a municipal bond. D) Investment broker sells 100 shares of existing stock. Page 5

6 26. For every financial asset, there is a A) corresponding financial liability. B) corresponding financial liability if the financial asset is financed. C) real liability. D) corresponding real asset. 27. If an individual receives $100, holds $20 of it, and deposits the remainder, the ratio of cash held to money deposited is A) 1/5. B) 1/4. C) 4. D) Which of the following is a real asset? A) Machinery. B) A bond. C) A stock. D) An IOU. 29. In the balance sheet of a chartered bank, reserves enter as A) liabilities. B) net worth. C) assets. D) equal to liabilities minus net worth. 30. A stock represents A) corporate debt. B) partial ownership of a company. C) a short-term promissory note of a corporation. D) long-term debt. 31. An IOU of a government or firm that matures in more than one year is called A) a stock. B) a bond. C) commercial paper. D) a treasury bill. Page 6

7 32. Savings deposits are not included in A) M1. B) M2. C) M3. D) M Financial assets are created A) by government intervention. B) by real economic activity, such as construction of a house. C) whenever somebody takes on a financial liability. D) only with the assistance of financial intermediaries. 34. M2 includes which of the following? A) Corporate bonds. B) Government bonds. C) Personal savings deposits at chartered banks. D) Personal savings deposits at near banks. 35. A bank wants to maintain a reserve ratio of.08. If it has demand deposits of $200,000 and is holding $4,000 in reserves, A) all the bank's reserves are excess reserves. B) the bank is not meeting its desired reserve ratio. C) the bank is holding $2,000 in excess reserves. D) the bank could extend additional loans and still meet its desired reserve ratio. 36. A bond represents A) a debt that matures in less than one year. B) partial ownership of a company. C) a short-term promissory note of a corporation. D) a debt that matures in more than one year. 37. Given a reserve ratio of 20 percent for all banks and assuming individuals hold no cash, total bank reserves of $300 billion could support maximum deposits of A) $60 billion. B) $1,200 billion. C) $1,500 billion. D) $2,000 billion. Page 7

8 38. Which of the following is an example of a depository institution? A) A credit union. B) A life insurance company. C) A pension fund. D) A mutual fund. 39. Assuming that r =.05 and c =.25, the approximate real-world money multiplier is A) B) 3.5. C) 4. D) In a market economy, every real transaction has a corresponding A) financial transaction. B) financial liability. C) real liability. D) real asset. 41. If the ratio of currency to deposits is 20 percent and the reserve ratio is 10 percent, then a $100 addition to deposits will result in a A) $333 addition to the money supply. B) $400 addition to the money supply. C) $500 addition to the money supply. D) $1,000 addition to the money supply. Use the following to answer question 42: Assets Liabilities and Net Worth Total Reserves $100,000 Demand Deposits $100, The table above represents a bank's T-account. Suppose it is the only bank in town and individuals in town hold no cash. Assuming the reserve ratio is 10 percent, what will be the bank's deposits and reserves at the end of the money creation process? A) Deposits will equal $100,000 and reserves will equal $10,000 B) Both deposits and reserves will equal $100,000. C) Deposits will equal $1,000,000 and reserves will equal $100,000. D) Both deposits and reserves will equal $1,000,000. Page 8

9 43. If the reserves in Canadian banks totalled $10,000 and total deposits were $20,000, the banking system's reserve ratio would be A).05. B).20. C).50. D) Assuming individuals hold no cash, the reserve ratio is 20 percent, and banks keep no excess reserves, an initial inflow of $100 into the banking system will cause an increase in deposits by A) $20. B) $400. C) $100. D) $ Given a reserve ratio of 20 percent for all banks and assuming individuals hold no cash, total bank reserves of $300 billion could support a money supply of A) $60 billion. B) $1,200 billion. C) $1,500 billion. D) $2,000 billion. 46. Suppose the banking system has $100,000 in outstanding deposits and actual reserves of $35,000. If banks desire a reserve ratio of 20 percent and individuals hold no cash, the maximum amount the banking system can now add to deposits is: A) $ 15,000. B) $ 75,000. C) $175,000. D) $500, Asset management refers to A) a bank's handling of how much interest it pays on deposits. B) a bank's handling of loans and other assets. C) how a bank attracts deposits and what it pays for them. D) how a bank manages its accounts payable. Page 9

10 48. Credit cards A) reduce the value of holding money. B) create the need to hold highly liquid assets. C) create money. D) are financial assets. 49. The Estey Commission recommended A) the formation of the CDIC in B) that the CDIC increase its deposit insurance to $100,000. C) reforms to financial regulations which led to the creation of the Superintendent of Financial Institutions. D) eliminating deposit insurance as it has never been used. 50. Financial assets traded in the capital market have a maturity of A) greater than one year. B) 5-7 years. C) less than one year. D) 3-7 years. Page 10

11 Answer Key 1. B When you deposit $1,000 in a bank, the bank is obliged to repay you at some point in the future, so the bank holds a new liability and you hold a new asset. 2. B Guarantees make depositors less vigilant about the profitability of their bank because they are assured that they will get their funds back. 3. D Since the bank must hold 5 percent of demand deposits as reserves, it loans out 95 percent of $800,000, or $760,000. This amount is then redeposited, bringing total deposits (which equal total liabilities) to $1,560, A When held by individuals and not spent, money escapes the spending stream. 5. B See the definition of the real sector in the text. 6. A See the definition of money market in the text. 7. A See the formula for the approximate real-world money multiplier in the text. 8. D The approximate real-world money multiplier takes into account cash held by the public that is not deposited, and thus cannot be multiplied through the money creation process. 9. D Banks borrow short-term and lend long-term, not the reverse. 10. A One is borrowing money when one uses a credit card, thereby incurring a financial liability. 11. A Interest rates in the financial sector are like prices in the real sector. Following the law of demand, when the interest rate rises, people are less willing to borrow (demand financial liabilities or supply financial assets). 12. A Using the approximate formula 1/(r + c), the money multiplier is 1/0.4 = A See the definition in the textbook. 14. D Page 11

12 Multiply the deposit multiplier (1/r) by total deposits [(1/.2)*400 = 2000 billion]. 15. C Multiply the deposit multiplier (1/r) by new reserves [(1/.2)*5 = 25 million]. 16. C As the reserve ratio goes up, banks hold more reserves and extend fewer loans. This reduces both money creation and the money multiplier. 17. C At the end of the money creation process, demand deposits are $1,000,000 (1/r*100,000). Of this amount, the bank holds 10 percent as reserves (.1*1,000,000) and the rest ($900,000) in the form of loans. 18. D Banks have no incentive to limit the number of loans they make. Doing so would undermine their profits. 19. A A credit card is not money and thus A) would be the best answer. A credit card replaces money and increases velocity. It makes the same amount of money able to handle many more transactions. 20. D The deposit multiplier is 1/r. 21. A See the formula for the approximate real-world money multiplier in the text. 22. B The approximate real world money multiplier is equal to 1/(r+c), which equals 3.33 in this case. 23. A Only M1 will be affected because only M1 excludes personal savings accounts at chartered banks. 24. C Modern banks are concerned with both asset management and liability management. The second part of answer D is obviously true, but it's through management of assets and liabilities that they make money, so the first part is wrong. 25. A Money market instruments are financial assets having a maturity of less than one year. 26. A The very fact that it is a financial asset means that it had a financial liability, so the qualifier "if the financial asset is financed" is unnecessary. 27. B Page 12

13 The person holds 20% in cash, 80% in deposits, for a cash to deposit ratio of 20/80 = 1/ A A real asset is the product of real economic activity. Machinery is such an example. The others are financial assets. 29. C Reserves, since they are cash, are assets for a bank. 30. B See the definition of stocks in the text. 31. B See the definition of bonds in the text. 32. A M1 includes currency and chequing deposits at chartered banks. 33. C Financial assets are created anytime there is a promise to pay (i.e. whenever a financial liability is created). 34. C M2 equals M1 plus personal saving deposits, and non-personal notice deposits at chartered banks. 35. B Multiply deposits by the desired reserve ratio (200,000*.08=16,000) to find desired reserves. Its reserves are less than $16, D See the definition of bonds in the text. 37. C Since the reserve ratio is 20% and people hold no cash, the deposit multiplier is 5. Thus total back reserves of $300 billion will support deposits of ($300*5) $1500 billion. 38. A See list of depository institutions in Figure 13A A The approximate money multiplier is 1/(r+c). 40. A Real goods are bought and sold for money or other financial assets. 41. A The approximate real-world money multiplier is 1/(r + c) = 1/0.3 = To find the increase in the money supply, multiply this by the additional deposits. 42. C Page 13

14 At the end of the money creation process, demand deposits are $1,000,000 (1/r*100,000). Of this amount, the bank holds 10 percent as reserves (.1*1,000,000). 43. C The reserve ratio is the ratio of reserves to total deposits (10,000/20,000=.5) 44. D The deposit multiplier is 1/r = 1/.2 = 5, which gives an increase in total money of $ B Since the reserve ratio is 20% and people hold no cash, the money multiplier is 4 (5-1). Thus total back reserves of $300 billion will support deposits of ($300*4) $1200 billion. 46. B Excess reserves are $15,000 and the deposit multiplier is 5, so (15,000 x 5) = $75,000 can be added. 47. B See the definition of asset management in the text. 48. A Credit cards are prearranged loans. With such loans, people do not need to hold as much cash. 49. C The Estey Commission was established in the aftermath of the failure of several financial institutions. Its recommendations led to the creation of the Superintendent of Financial Institutions. 50. A See the definition of the capital market in the text. Page 14