Question

1. Why do managers of financial institutions care so much about the activities of the Central Bank? ( 3 marks)

2. If I can buy a car today for $50,000 and it is worth $100,000 in extra income next year to me because it enables me to get a job as a travelling salesman, should I take a loan from Sharky Finance at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking this loan? Can you make a case for legalizing loan sharking? (4 marks)

3. If there is a decline in interest rates, would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest rate risk? (3 marks)

4. Using the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions). (4 marks)

5. If the bank you manage has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don’t have any excess reserves to loan out? Why or why not? What options are available for you to provide the funds your customer needs? (4 marks)

Answer 1

1) Managers of financial institutions care so much about the activities of the Federal Reserve System because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.