1. Final Revision
Money & Banking
Question 1: Define the following terms:
1- Banks:
Banks are financial institutions that accept
deposits and make loans.
2- Financial Markets:
Markets in which funds are transferred from
people who have an excess of available funds to
people who have a shortage.
3- Monetary theory:
The theory that relates the change in the
quantity of money to changes in aggregate
economic activity & the price level.
4- Inflation:
Is the continuous increase in the price level of
goods & services in an economy.
5- Interest rate:
Is the cost of borrowing (or the return from
lending.

2. 6- Current account:
A current account is an account in which money or
checks can be taken out or payments can be made
at any time.
7- Deposit accounts:
These earn an interest, since the customers are not
expected to make frequent withdrawals, and should
give notice in advance.
8- The balance sheet:
Is a statement of banks assets, liabilities , and net
worth at a given point in time.
9- Reserves
Are either bank deposits held at the central bank, or
currency that is physically held by banks
10- Required reserves : a certain fraction of deposits
must be held as reserves by law
11- Excess reserves: used by a bank to meet obligations
to depositors.

3. 12- Adverse selection
Is the problem created by asymmetric information
before the transaction occurs.
13- Moral hazard is a problem of asymmetric
information occurring after a loan is made.
Example:
Suppose that John Brown has heard that the first
National Bank provides excellent service, so he opens
a checking account with 100 $
He now has a 100$ checkable deposit at the bank,
which shows up as a 100$ liability on the bank’s
balance sheet
The bank now puts his 100$ into its vault so that the
bank’s assets rise by the 100$ increase in vault cash.
Assets
Reserves 100$
liabilities
checkable deposits 100$

4. If john had opened his account with a 100$ check
written on an account at another bank, say the second
National Bank, we would get the same result. The
initial effect on the T-account of the first National
Bank as follows
Assets
Liabilities
cash item in 100$
checkable deposits 100$
process of collection
The final balance sheet positions of two banks are as
follows:
First National Bank
Assets
Reserves
100$
Liabilities
checkable deposits
100$
second National Bank
Assets
Reserves - 100$
liabilities
checkable deposits -100

5. The process can be summarized as follows: when a
check written on an account at one bank is deposited
in another, the bank receiving the deposit gains
reserves equal to the amount of the check, while the
bank on which the check is written sees its reserves
fall by the same amount .
Example:
Suppose that the first National bank has the following balance
sheet position, and the required reserve ratio on deposits is 20%
Assets
Reserves
Liabilities
25 m
Loans
75
Securities
Deposits
100 m
Bank capital 10
10
1) If the bank suffers a deposit outflow of 6 million,
what will its balance sheet now look like?. Must
the bank make any adjustment in its balance
sheet? Why?
2) Suppose the bank now is hit by another 4 million
deposits outflow. What will its balance sheet
position look like now? Must the bank make any
adjustment in its balance sheet? Why?

6. 3) If the bank satisfies its reserve requirements by
selling of securities, how much will it have to
sell? Why?
4) After selling off the securities to meet its reserve
requirement , what will its balance sheet look
like?
5) If after selling off the securities the bank is now
hit by another 10 million withdrawals of deposits,
and it sells off all its securities to obtain reserves,
what will its balance sheet look like?
6) If the bank is now unable to call in or sell any of
its loans and no one is willing to lend funds to this
bank, then what will happen to the bank and why?
Answer:
1) Assets
Liabilities
Reserves
19 m
deposits
94 m
loans
75
Bank capital 10
securities
10

7. The answer is no because the bank still satisfy its reserve
requirement (94 * 20%)
2)
Assets
Liabilities
Reserves
15 m
loans
75
securities
deposits
90 m
10
Bank capital 10
The answer is yes because the bank must make an
adjustment to its balance sheet, because its required
reserve are 18 million. It has a reserve deficiency of 3
million
3)That bank will have to sell 3 million . As the bank
has a reserve shortfall of 3 million, which it can
acquire by selling the 3 million of securities
4)
Assets
Liabilities
Reserves
18m
loans
75
securities
7
deposits
90 m
Bank capital 10

8. 5)
Assets
Liabilities
Reserves
15m
loans
75
securities
0
6-
deposits
80m
Bank capital 10
The bank could fail. The required reserves for
the bank are 16 million (20% of 80 million) , but
it has 15 million of reserve.
Example:
Suppose that you are the manager of a bank that has the
following balance sheet; with a required reserve ratio of
10%.
Assets
Liabilities
Reserves 20 m
Deposits
100 m
Loans
80
Bank capital 10
Securities
10
1) If the bank suffers a deposit outflow of 10 m ,
what will its balance sheet? Why?

9. 2)
Let's assume that instead of initially holding
10m in excess reserves, the bank makes loans of
10m, so that it holds no excess reserves. What
will its balance sheet position look like now?
3)
Suppose the bank now is hit by another 10 m
deposit outflow. What will its balance sheet
position look like now? Must the bank make
any adjustment in its balance sheet? Why?
Answer:
1)
The required reserve = 10% * 100= 10m
The bank has excess reserves of 10m. when a
deposit outflow of 10m occurs, the bank's balance
sheet becomes.
Assets
Liabilities
Reserves 10 m
Deposits
90 m
Loans
80
Bank capital 10
Securities
10

10. The answer is no because the bank still satisfy its
reserve requirement
2)
The initial balance sheet would be:
Assets
Liabilities
Reserves 10 m
Loans
90
Bank capital 10
Securities
3)
Deposits
100 m
10
When the bank suffers the 10 m deposits outflow, its
balance sheet becomes:
Assets
Liabilities
Reserves 0 m
Loans
90
Securities
Deposits
90 m
Bank capital 10
10
To eliminate this shortfall, the bank has four basic
options:

11. a)the first option is to sell some of its securities.
Assets
Liabilities
Reserves 9 m
Deposits
90 m
Loans
90
Bank capital 10
Securities
1
a) The second option is borrowing from other banks or
borrowing from corporations
Assets
Reserves 9 m
Loans
90
Securities 10
Liabilities
Deposits
90 m
borrowing from
Other banks
9
Bank capital 10
c)the third option is borrowing from the central bank
Assets
Liabilities
Reserves 9 m
Loans
90
Securities 10
Deposits
90 m
discount loans
from the CB
9
Bank capital 10

12. d)Finally, reducing its loans by this amount
Assets
Liabilities
Reserves 9 m
Loans
81
Deposits
90 m
bank capital 10
Securities 10
When a deposit outflow occurs holding excess reserves
allows the bank to escape the costs of:
1)borrowing from other banks or corporations
2)borrowing from the CB
3) selling securities
4)calling in or selling off loans.
Because excess reserves have a cost, banks also take other
steps to protect themselves: for example, they might shift
the holding of assets to more liquid securities (secondary
Reserves)
Example:
Let ‘s consider two banks with identical balance sheets,
except that the High Capital Bank has a ratio of capital to
assets of 10%, while the Low Capital Bank has a ratio of
4%.

13. High capital Bank
Assets
Liabilities
Reserves
10m
deposits
90 m
loans
90
Bank capital 10
Low capital Bank:
Assets
Liabilities
Reserves
10m
loans
90
deposits
96m
Bank capital 4
- The high capital bank has 100 million of assets, and
10 million of capital, which gives it an equity
multiplier of 10 (100/10)
• The low capital bank has only 4 million of capital ,
so its equity multiplier is higher , equaling 25
(100/4)
• Suppose that these banks have been equally well run
so that they both have the same return on assets 1%

14. • The return on equity for the high capital bank equals
1% * 10= 10% while
• The return on equity for the low capital bank equals
1%*25= 25%
We now see why owners of a bank may not want it
to hold too much capital.
Question 3: Discuss
AThere are four players in the Money Supply
Process. Explain.
Answer:
(1) The central Bank:
The government agency that oversees the banking
system , and is responsible for the conduct of monetary
policy.
(2) Banks (Depository Institutions):
The financial Intermediaries that accept deposits from
individuals & institutions and make loans.
(3) Depositors:
Individuals and institutions that hold deposits in banks.

15. (4) Borrowers from banks:
Individuals and institutions that borrow from the
depository Institutions , and institutions that issue bonds
that are purchased by the Depository Institutions.
B- Examine the essential role of the central bank in
an economy.
Answer:
(1) Lender of the last Resort:
the central bank is the provider of reserves to financial
institutions. When no else would provide them in order
to prevent a financial crisis.
(2) Government Banker:
- It is responsible for implementing government
monetary policy , which aims at controlling the amount
of money in circulation (to control the inflation rate)
- It has the important job of controlling foreign
exchange
(3) A Banker’s Bank:
- The central bank holds deposits made by commercial
banks, which appear in its balance sheet in the liability
side( appear in the balance sheet of commercial banks
in the asset side)

16. - Control of credit and cash available to the public
CThe central bank interferes in the market
through specific tools. Elaborate
Answer:
Tools of Monetary Policy:
First: the three major tools of Monetary policy
(1)
Open market operations
(2)
Setting reserves requirements for commercial
banks and other depository institutions
(3)
Setting the level of the discount rate
(1) Open market operations:
• The central bank can directly affect the amount of
bank reserves by buying or selling government
securities ( stock, bonds) , in the open market where
these securities are traded. Such transactions are
called open market operations
• When the central bank conducts open market
purchases, it buys government bonds and puts
reserves into the banking system, causing an
expansion of demand deposits and other checkable
deposits, and hence an increase in the economy’s
money supply

17. • When the central bank conducts open market sales ,
it sells government bonds and takes reserves out of
the banking system, causing a contraction of
demand deposits and other checkable deposits, and
hence a decrease in the economy’s money supply
(2) Legal Reserves Requirements:
The central bank has the authority to set the
required reserve ratios within limits.
(A) Increase in the legal Reserves Requirement
• Suppose that the central bank wants to tighten up
the economy’s money supply, this means that the
central bank wants to force the banks in the banking
system to reduce their lending activity or their
holdings of other earnings.
(B) Decrease in the legal Reserves Requirement
• If the central bank wants to increase the money
supply, it can reduce the reserves requirement.
• In general, we can say that an increase in the
required reserve ratio will force a money supply
reduction. A decrease in the required reserve ratio
increase the amount of excess reserves, encouraging
banks to increase lending and deposit expansion,
thereby increasing the money supply.

18. (3) Setting the Discount Rate:
• The depository institutions make loans to the public,
and the central banks make loans to depository
institutions.
• Banks naturally find it attractive to borrow from the
central bank, whenever the interest rates they can
earn from making loans to business and consumers
or by purchasing securities, are greater than the
discount rate.
• On the other hand, when the discount rate is higher
than these interest rates, banks are discourage from
borrowing at the central bank.
• In general, we can say that if the central bank raises
the discount rate, bank borrowing is reduced, and
the amount of reserves in the banking system falls .
this tends to deposit contraction, and a reduction in
the size of the money supply
• If the central bank lowers the discount rate, bank
borrowing rises, causing an increase in reserves and
deposit expansion and hence an increase in the
money supply.
D-
Differentiate between stocks & Bonds

19. E- Explain briefly the functions of money.
Answer:
1- Medium of Exchange.
Money in the form of currency or checks is a
medium of exchange. It is used to pay for goods and
services.
If there were no money, goods would have to be
exchanged by barter.
• For a commodity to function effectively as money,
it as to meet several criteria:
1- it must be widely accepted
2- it must be divisible
3- it must be easy to carry

20. 4- it must not deteriorate quickly.
2- Measure of value
It is used to measure value in the economy. We
measure the value of goods and services in terms
of money.
Using money as a unit of account reduces
transaction costs in an economy by reducing the
number of prices that need to be considered.
3- store of value
People usually save in the form of money.
However, this function of money depends on its
stability of value. If money loses its stability of
value, people tend to save in the form of buying
assets.
4- Unit of Account
In both households and businesses, it is necessary to
look a head and calculate future income and
expenditure. Money, acting as a unit of account, can
serve these purposes.