Exercises: The financial system and money creation

Explain what the financial system is and who its main participants are. What role does it play in the economy by connecting them with one another?

Distinguish between cash and bank money. When you pay by card, what type of money do you use and where does that money "exist"?

A bank receives $\$20\,000$ in deposits and, by law, is only required to keep $10\ \%$ in reserves.

1. a) How much does it keep in reserve and how much can it lend?
2. b) Explain why the bank does not keep all the money in reserve: what would it gain and what would it lose?

With a reserve ratio of $10\ \%$, an initial deposit of $\$40\,000$ can end up creating up to $\$400\,000$ of bank money.

1. a) Calculate the money multiplier ($1$ divided by the reserve ratio) and check the final figure.
2. b) Explain step by step how this multiplication occurs: who deposits, who lends, and who redeposits.

The figure shows the bank money creation chain: Ana deposits, the bank lends to Bruno, Bruno pays Carla, and Carla deposits again.

1. a) Identify at what point new money is "created" and who creates it.
2. b) What would happen to the chain if Carla kept the banknotes under her mattress? Justify your answer.

Explain what the European Central Bank is and how it differs from a local commercial bank. Mention at least two functions that only the central bank performs.

The commercial bank «Banco Sureste» presents the following simplified balance sheet:

• Assets: Liquid cash reserves and central bank deposits: 10 million pesos; Mortgage loans and corporate loans maturing in 15 years: 90 million pesos.

• Liabilities and Equity: Demand deposits of its clients: 85 million pesos; Equity capital contributed by shareholders: 15 million pesos.

1. a) Following a piece of fake news that goes viral on social media, clients arrive to withdraw 18 million pesos within 24 hours. Prove numerically whether the bank faces a liquidity problem, a solvency problem, or both at that moment.
2. b) A parliamentary group proposes: «To end bank runs forever, let us require banks by law to keep a 100 % reserve requirement, keeping all deposit money in a safe». Economically refute this proposal by analysing its impact on the creation of bank money, on credit available for productive investment, and on the account maintenance costs for households.
3. c) If the central bank decides to act as a «lender of last resort» to bail out this institution, under what prior balance sheet requirement must it do so and what «moral hazard» problem would be generated if it bailed out banks that are genuinely insolvent?

In an economy, mortgage credit granted by banks is growing at a rate of 14 % per year, housing prices are rising by 11 % year-on-year, and headline consumer inflation stands at 2.1 %, very close to the central bank's target.

1. a) Explain the procyclical feedback loop: how do rising property prices increase borrowers' collateral, what role does the creation of bank money play in this process, and why do financial institutions not curb lending on their own initiative?
2. b) Faced with this situation, the central bank hesitates between two measures:

1) Raising policy interest rates by 250 basis points (2.5 percentage points).

2) Keeping interest rates stable and imposing macroprudential measures on banks: capping the loan-to-value (LTV) ratio at a maximum of 70 % of the appraised value and requiring an additional countercyclical capital buffer of 2.5 %.

Predict and justify the asymmetric effects of both options on: households that already hold a variable-rate mortgage, young people seeking to access their first home, and non-real estate industrial companies.

The central bank carries out a liquidity injection of 500 million pesos through the purchase of government bonds from commercial banks. The minimum reserve requirement set by the monetary authority is 2 % (0,02). However, the economy is going through a recession with high uncertainty:

• Commercial banks decide to retain an additional 8 % of deposits as voluntary excess reserves as a precaution against potential defaults.

• Individuals and firms decide to hold the equivalent of 10 % of their bank deposits in cash.

1. a) Calculate the theoretical potential money multiplier (assuming there is no cash drain or voluntary reserves) and compare it with the effective multiplier that occurs under the actual behavior described.
2. b) An analyst states on television: «The central bank has injected 500 million; therefore, banks are going to flood households with credit and will multiply the money supply fiftyfold immediately». Technically refute this statement using the calculations from the previous section and distinguishing between the supply of credit and the creditworthy demand for it.
3. c) Predict what would happen to the money supply and inflation risk if the economy suddenly regains confidence and both banks and households reduce their excess reserves and cash holdings to a minimum.