Question

Explain whether the following statements are TRUE or FALSE. State your stance clearly.

a) A positive term spread is indicative of economic recession. (5 marks)

b) By reducing the required reserve ratio, the central bank can increase the monetary base and thus the money supply.

Answer 1

a.

Answer: False

Term spread:

This is the difference of coupon rate between two bonds having different maturities, like short-term and long-term. If the long-term rate is higher than short-term rate, the term spread becomes positive and it is normal. If long-term rate is smaller than short-term rate, the term spread becomes negative and it indicates a recession in coming future. Therefore, recession is indicative if there is a negative spread and this happens out of fears and uncertainties of investors.

b.

Answer: True

An example could be taken for understanding. Suppose the demand deposit is $1,000 and the required reserve is 10%; therefore,

Money supply = Demand deposit / required reserve

                        = 1,000 / 0.10

                        = $10,000

Now, the required serve is reduced down to 8%,

Money supply = Demand deposit / required reserve

                        = 1,000 / 0.08

                        = $12,500

Therefore, these increase by reducing the required reserve ratio.