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2. Read the required chapter(s) of the textbook and any additional recommended resources. Some answers may require you to do additional research on the Internet or in other reference sources. Choose your sources carefully.
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1. Between the early 1960s and late 2000s, bankers sought to raise and lend out more deposit funds. Today, however, a number of banks have stopped trying to attract more deposits. A few are even actively discouraging deposits by charging customers fees if they deposit “too many” funds. Why have bankers’ views about the desirability of increased deposits shifted so dramatically in recent years?
Low Returns on Lending
One key reason that banks have soured on deposits is that earnings they can anticipate from lending deposit funds are now very low. In today’s dampened U.S. economy, many fewer households and firms are seeking credit than in years past. As a consequence, banks have been competing with one another for a dwindling set of borrowers, and they have bid market interest rates on bank loans downward.
Thus, existing deposits are now yielding lower returns for banks. This fact gives them less incentive to seek out more deposits from current or new customers.
Higher Deposit Insurance Premium
Even as banks’ returns from lending deposit funds have dropped, the costs they must pay for deposits have increased. Since 2006, the premium rate that banks must pay the Federal Deposit Insurance Corporation has jumped from close to zero to more than $0.30 per $100 of insured deposits—the highest rate since the FDIC’s establishment in 1933.
The net result? Some banks have begun actively discouraging customers from substantially increasing their deposits. Recently, for instance, the Bank of New York Mellon began charging large depositors for the privilege of holding federally insured deposits. The bank now charges an annual interest fee of 0.13 percent to customers with deposit accounts of $50 million or more. Unless market loan rates rise and deposit insurance premiums fall, it appears likely that other banks will follow suit. Some banking experts speculate that eventually banks might begin charging interest fees to customers with small deposits.
a. Why do you suppose that the market clearing interest rates on bank savings and time deposits have fallen as the interest rates on bank loans have dropped?
b. If interest rates earned by banks on their assets fell close to zero, why might all bank customers have to pay interest fees on deposits they hold with banks?
To take a look at the latest statistics on the status and performance of U.S. commercial banks, go to www.econtoday.com/chap15.
For a look at historical U.S. commercial banking data, go to www.econtoday.com/chap15A.
2. During the late 1970s, prices quoted in terms of the Israeli currency, the shekel, rose so fast that grocery stores listed their prices in terms of the U.S. dollar and provided customers with dollar shekel conversion tables that they updated daily. Although people continued to buy goods and services and make loans using shekels, many Israeli citizens converted shekels to dollars to avoid a reduction in their wealth due to inflation. In what way did the U.S. dollar function as money in Israel during this period?
3. Let’s denote the price of a nonmaturing bond (called a consol) as Pb. The equation that indicates this price is Pb = I/r, where I is the annual net income the bond generates and r is the nominal market interest rate.
a. Suppose that a bond promises the holder $500 per year forever. If the nominal market interest rate is 5 percent, what is the bond’s current price?
b. What happens to the bond’s price if the market interest rate rises to 10 percent?
c. Imagine that initially the market interest rate is 5 percent and at this interest rate you have decided to hold half of your financial wealth as bonds and half as holdings of non-interest-bearing money. You notice that the market interest rate is starting to rise, however, and you become convinced that it will ultimately rise to 10 percent.
d. In what direction do you expect the value of your bond holdings to go when the interest rate rises?
e. If you wish to prevent the value of your financial wealth from declining in the future, how should you adjust the way you split your wealth between bonds and money? What does this imply about the demand for money?
4. Consider the following data: The money supply is $1 trillion, the price level equals 2, and real GDP is $5 trillion in base-year dollars. What is the income velocity of money? Suppose that the money supply increases by $100 billion and real GDP and the income velocity remain unchanged.
a. According to the quantity theory of money and prices, what is the new equilibrium price level after full adjustment to the increase in the money supply?
b. What is the percentage increase in the money supply?
c. What is the percentage change in the price level?
d. How do the percentage changes in the money supply and price level compare?