General economic questions and concepts

Economics of Banking

General Economic Questions

Write a one sentence description for each of the following financial instruments. Then fill in the following table in terms of type of claim (debt/equity), maturity (money market/capital market), risk (low/high/highest), and liquidity (low/medium/high). Identify a type of financial institution or other participant in the financial market (individuals, government, and business) that are most likely to borrow using these instruments, and a type of institution or other participant that are most likely to lend using these instruments.

A a) Commercial Paper: An instrument issued by commercial companies (banks, insurance and corporations) which offers fixed, generally low short-term rates for loans to the issuer for periods of one night ('overnights') to several months. It is generally used to fund working capital.

A b) Consumer Loans (Credit Card): Non-secured loans to consumers, generally with an indeterminate end date and minimum payments which are mostly interest.

Residential Mortgages: Secured loans to consumers using their primary or secondary residences as the main collateral. Generally backed by FHA if below certain threshold amounts, which change regularly.

A d) Municipal Bonds: Debt obligations issued by cities and counties, generally tax-free at the state level.

A e) Repurchase Agreements: Financial instruments issued in the money markets in which the seller provides securities to the buyer; the seller agrees to repurchase those securities for a greater sum at a later date.

A f) Junk Bonds: Bonds issued by debtors whose credit rating is below "investment grade," generally less than B. rating. These generally carry higher risk, but higher interest rates, than investment-grade bonds.

Type of claim

Maturity

Risk

Liquidity

Commercial paper

Debt

Consumer loans

Debt

Indeterminate

Residential mortgages

Debt

5-30 years

Municipal bonds

Debt

1-30 years

Repurchase agreements

Debt/Equity kicker

Usually

Junk bonds

Debt

1-30 years

Likely to borrow

Likely to lend

Commercial Paper

Corporations

Banks, Money Market funds

Residential Mortgages

Consumers

Banks, Mutual funds

Municipal Bonds

Cities, Counties

Banks, consumers

Junk Bonds

Corporations

Consumers, Mutual funds

Type Maturity Risk Liquidity Borrower Lender Commercial Paper Credit Cards Banker's Acceptances Residential Mortgages Municipal Bonds Repurchase Agreement Junk Bonds

2) Each of the following will make a poor medium of exchange except one. Why is each a poor medium of exchange?

Which one is lacking the problems that make it a poor medium of exchange?

A a) Pizza: perishable, differences in quality (i.e. no standardization) b) Diamonds: good medium of exchange

Peaches: perishable, differences in quality (i.e. no standardization) d) Grade a Honey: differences in quality (i.e. no standardization), difficult to transport e) Ice in a warm climate: perishable, difficult to store a. Over the long run, what is the primary determinant of the price level? Supply and demand, with price acting as an equilibrator b. Over the long run, what is the primary determinant of inflation?

The supply of money as compared to changes in productivity.

c. How is inflation related to the nominal interest rate?

Expectations of future inflation are one of the key factors in determining the nominal interest rate, the other being the 'core' interest rate, or the inflation-free level at which one is willing to lend money (which differs according to the issuer and associated risk premium).

4. Describe each of the following financial institutions. If it is a financial intermediary, describe what type of liabilities it issues and who holds these liabilities, as well as what kinds of assets it holds and who issued these assets.

If it is not a financial intermediary, describe the role of the institution in the financial system. Read through chapter 13.