Economics of Financial Institutions
Exam Answer Key
Course Introduction
This course explores the fundamental economic principles underlying financial institutions, including banks, insurance companies, investment firms, and non-bank financial intermediaries. Students will examine how these institutions operate, their roles in the wider economy, and the regulatory frameworks that govern them. Topics include risk management, financial intermediation, asset-liability management, the impact of monetary policy, and the responses of financial institutions to global financial crises. The course also analyzes current challenges facing the sector, such as technological innovation, market competition, and evolving regulations, providing a comprehensive understanding of the economic forces shaping modern financial institutions.
Recommended Textbook
Economics of Money Banking and Financial Markets 12th Edition by Frederic S. Mishkin
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Chapter 1: Why Study Money, banking, and Financial Markets
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Sample Questions
Q1) During a recession,output declines result in
A)lower unemployment in the economy.
B)higher unemployment in the economy.
C)no impact on the unemployment in the economy.
D)higher wages for the workers.
Answer: B
Q2) Budgets deficits can be a concern because they might
A)ultimately lead to higher inflation.
B)lead to lower interest rates.
C)lead to a slower rate of money growth.
D)lead to higher bond prices.
Answer: A
Q3) What crucial role do financial intermediaries perform in an economy?
Answer: Financial intermediaries borrow funds from people who have saved and make loans to other individuals and businesses and thus improve the efficiency of the economy.
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Chapter 2: An Overview of the Financial System
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Sample Questions
Q1) The purpose of the disclosure requirements of the Securities and Exchange Commission is to
A)increase the information available to investors.
B)prevent bank panics.
C)improve monetary control.
D)protect investors against financial losses.
Answer: A
Q2) An investment intermediary that lends funds to consumers is
A)a finance company.
B)an investment bank.
C)a finance fund.
D)a consumer company.
Answer: A
Q3) How do regulators help to ensure the soundness of financial intermediaries?
Answer: Regulators restrict who can set up a financial intermediary,conduct regular examinations,restrict assets,and provide insurance to help ensure the soundness of financial intermediaries.
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Page 4
Chapter 3: What Is Money
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Sample Questions
Q1) ________ is the narrowest monetary aggregate that the Fed reports.
A)M0
B)M1
C)M2
D)M3
Answer: B
Q2) Which of the following is NOT included in the monetary aggregate M2?
A)currency
B)savings bonds
C)traveler's checks
D)checking deposits
Answer: B
Q3) Why are most of the U.S. dollars held outside of the United States?
Answer: Concern about high inflation eroding the value of their own currency causes many people in foreign countries to hold U.S. dollars as a hedge against inflation risk.
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Chapter 4: The Meaning of Interest Rates
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Sample Questions
Q1) The sum of the current yield and the rate of capital gain is called the A)rate of return.
B)discount yield.
C)perpetuity yield.
D)par value.
Q2) A coupon bond that has no maturity date and no repayment of principal is called a A)consol.
B)cabinet.
C)Treasury bill.
D)Treasury note.
Q3) A credit market instrument that requires the borrower to make the same payment every period until the maturity date is known as a A)simple loan.
B)fixed-payment loan.
C)coupon bond.
D)discount bond.
Q4) Your favorite uncle advises you to purchase long-term bonds because their interest rate is 10%. Should you follow his advice?
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Chapter 5: The Behavior of Interest Rates
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Sample Questions
Q1) You would be less willing to purchase U.S. Treasury bonds,other things equal,if
A)you inherit $1 million from your Uncle Harry.
B)you expect interest rates to fall.
C)gold becomes more liquid.
D)stock prices are expected to fall.
Q2) Everything else held constant,if the expected return on RST stock declines from 12 to 9 percent and the expected return on XYZ stock declines from 8 to 7 percent,then the expected return of holding RST stock ________ relative to XYZ stock and demand for XYZ stock ________.
A)rises;rises
B)rises;falls
C)falls;rises
D)falls;falls
Q3) The riskiness of an asset that is unique to the particular asset is
A)systematic risk.
B)portfolio risk.
C)investment risk.
D)nonsystematic risk.
Q4) Using the liquidity preference framework,what will happen to interest rates if the Fed increases the money supply?
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Chapter 6: The Risk and Term Structure of Interest Rates
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Q1) A particularly attractive feature of the ________ is that it tells you what the market is predicting about future short-term interest rates by just looking at the slope of the yield curve.
A)segmented markets theory
B)expectations theory
C)liquidity premium theory
D)separable markets theory
Q2) The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to
A)rise in the near-term and fall later on.
B)fall sharply in the near-term and rise later on.
C)fall moderately in the near-term and rise later on.
D)remain unchanged in the near-term and rise later on.
Q3) During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults,we would expect the risk premium for ________ bonds to be very high.
A)U)S. Treasury
B)corporate Aaa
C)municipal
D)corporate Baa
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Chapter 7: The Stock Market, the Theory of Rational
Expectations,
and the Efficient Market Hypothesis
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Sample Questions
Q1) Which of the following types of information most likely allows the exploitation of a profit opportunity?
A)financial analysts' published recommendations
B)technical analysis
C)hot tips from a stockbroker
D)insider information
Q2) The view that expectations change relatively slowly over time in response to new information is known in economics as
A)rational expectations.
B)irrational expectations.
C)slow-response expectations.
D)adaptive expectations.
Q3) Mean reversion refers to the fact that
A)small firms have higher than average returns.
B)stocks that have had low returns in the past are more likely to do well in the future.
C)stock returns are high during the month of January.
D)stock prices fluctuate more than is justified by fundamentals.
Q4) What rights does ownership interest give stockholders?
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Chapter 8: An Economic Analysis of Financial Structure
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Sample Questions
Q1) Which of the following is NOT a benefit to an individual purchasing a mutual fund?
A)reduced risk
B)lower transactions costs
C)free-riding
D)diversification
Q2) Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE?
A)Issuing marketable securities is the primary way that they finance their activities.
B)Bonds are the least important source of external funds to finance their activities.
C)Stocks are a relatively unimportant source of finance for their activities.
D)Selling bonds directly to the American household is a major source of funding for American businesses.
Q3) How does a mutual fund lower transactions costs through economies of scale?
Q4) Explain the principal-agent problem as it pertains to equity contracts.
Q5) How does collateral help to reduce the adverse selection problem in credit market?
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Chapter 9: Banking and the Management of Financial Institutions
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Sample Questions
Q1) Assume a bank has $200 million of assets with a duration of 2.5,and $190 million of liabilities with a duration of 1.05. If interest rates increase from 5 percent to 6 percent,the net worth of the bank falls by
A)$1 million.
B)$2.4 million.
C)$3.6 million.
D)$4.8 million.
Q2) A deposit outflow results in equal reductions in A)loans and reserves.
B)assets and liabilities.
C)reserves and capital.
D)assets and capital.
Q3) Banks face the problem of ________ in loan markets because bad credit risks are the ones most likely to seek bank loans.
A)adverse selection
B)moral hazard
C)moral suasion
D)intentional fraud
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Chapter 10: Economic Analysis of Financial Regulation
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Sample Questions
Q1) When comparing the banking crisis in the United States to the crises in Latin America,cost to the taxpayers of the government bailouts was
A)higher in Latin American than in the United States.
B)higher in the United States than in Latin America.
C)about the same in both Latin America and the United States.
D)positive in Latin America but negative in the United States.
Q2) As in the United States,an important factor in the banking crises in Latin America was the
A)financial liberalization that occurred in the 1980s.
B)decline in real interest rates that occurred in the 1980s.
C)high inflation that occurred in the 1980s.
D)sluggish economic growth that occurred in the 1980s.
Q3) Regulations designed to provide information to the marketplace so that investors can make informed decisions are called
A)disclosure requirements.
B)efficient market requirements.
C)asset restrictions.
D)capital requirements.
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Page 12
Chapter 11: Banking Industry: Structure and Competition
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Sample Questions
Q1) One factor contributing to the decline in cost advantages that banks once had is the
A)decline in the importance of checkable deposits from over 60 percent of banks' liabilities to 11 percent today.
B)decline in the importance of savings deposits from over 60 percent of banks' liabilities to under 15 percent today.
C)decline in the importance of checkable deposits from over 40 percent of banks' liabilities to 15 percent today.
D)decline in the importance of savings deposits from over 40 percent of banks' liabilities to under 20 percent today.
Q2) The main center of the Eurodollar market is A)London.
B)Basel.
C)Paris.
D)New York.
Q3) Discuss three ways in which U.S. banks can become involved in international banking.
Q4) Why did the interest rate volatility of the 1970s spur financial innovation?
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Chapter 12: Financial Crises
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Sample Questions
Q1) Firms that are designated as systemically important financial institutions (SIFIs)are subject to all of the following additional Federal Reserve regulations EXCEPT
A)higher capital standards.
B)stricter liquidity requirements.
C)providing a plan for orderly liquidation if necessary.
D)interest rate ceilings on time deposits.
Q2) When financial intermediaries deleverage,firms cannot fund investment opportunities resulting in
A)a contraction of economic activity.
B)an economic boom.
C)an increased opportunity for growth.
D)a call for government regulation.
Q3) The originate-to-distribute business model has a serious ________ problem since the mortgage broker has little incentive to make sure that the mortgagee is a good credit risk.
A)principal-agent
B)debt deflation
C)democratization of credit
D)collateralized debt
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Page 14
Chapter 13: Central Banks and the Federal Reserve System
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Sample Questions
Q1) Explain two concepts of central bank independence. Is the Fed politically independent? Why do economists think central bank independence is important?
Q2) Each Fed bank president attends FOMC meetings;although only ________ Fed bank presidents vote on policy,all ________ provide input.
A)three;ten B)five;ten
C)three;twelve D)five;twelve
Q3) Under the European System of Central Banks,the National Central Banks have the same role as the ________ of the Federal Reserve System.
A)Board of Governors
B)Federal Open Market Committee
C)Federal Reserve Banks
D)Federal Advisory Council
Q4) Why does the Federal Reserve Bank of New York play a special role within the Federal Reserve System?
Q5) Explain the similarities and differences between the European System of Central Banks and the Federal Reserve System.
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Chapter 14: The Money Supply Process
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Sample Questions
Q1) If the required reserve ratio is equal to 10 percent,a single bank can increase its loans up to a maximum amount equal to
A)its excess reserves.
B)10 times its excess reserves.
C)10 percent of its excess reserves.
D)its total reserves.
Q2) The M2 money multiplier is
A)negatively related to high-powered money.
B)positively related to the time deposit ratio.
C)positively related to the required reserve ratio.
D)positively related to the excess reserves ratio.
Q3) Everything else held constant,an increase in the excess reserve ratio will mean ________ in the M2 money multiplier and ________ in the M2 money supply.
A)an increase;an increase
B)an increase;a decrease
C)a decrease;an increase
D)a decrease;a decrease
Q4) Explain why the simple deposit multiplier overstates the true deposit multiplier.
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Chapter 15: Tools of Monetary Policy
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Sample Questions
Q1) Which of the following statements is an example of the Fed's conditional commitment policy?
A)"In these circumstances,the Committee believes that policy accommodation can be maintained for a considerable period."
B)"The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
C)"Policy accommodation can be removed at a pace that is likely to be measured."
D)"The exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent,and inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal."
Q2) Everything else held constant,in the market for reserves,when the federal funds rate equals the discount rate,lowering the discount rate
A)increases the federal funds rate.
B)lowers the federal funds rate.
C)has no effect on the federal funds rate.
D)has an indeterminate effect of the federal funds rate.
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Page 17
Chapter 16: The Conduct of Monetary Policy: Strategy and Tactics
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Sample Questions
Q1) The mandate for the monetary policy goals that has been given to the Federal Reserve System is an example of a ________ mandate.
A)primary
B)dual
C)secondary
D)hierarchical
Q2) A credit-driven bubble arises when ________ in lending causes ________ in asset prices which can cause ________ in lending.
A)a decrease;a decrease;an increase
B)a decrease;an increase;an increase
C)an increase;an increase;a further increase
D)a decrease;a decrease;a further decrease
Q3) If the Taylor Principle is not followed and nominal interest rates are increased by less than the increase in the inflation rate,then real interest rates will ________ and monetary policy will be too ________.
A)rise;tight
B)rise;loose
C)fall;tight
D)fall;loose
18
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Chapter 17: The Foreign Exchange Market
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Sample Questions
Q1) When domestic real interest rates rise,the domestic currency ________.
A)appreciates
B)depreciates
C)appreciates or depreciates depending on the change in nominal interest rates
D)does not change
Q2) The immediate (two-day)exchange of one currency for another is a
A)forward transaction.
B)spot transaction.
C)money transaction.
D)exchange transaction.
Q3) The Brexit vote in June 2016 resulted in higher expected trade barriers . Therefore,the expected value of the pound would be ________ in the future. The result was the sharp ________ in the equilibrium exchange rate for the British pound.
A)lower;fall
B)higher;fall
C)lower;rise
D)higher;rise
Q4) Explain and show graphically the effect of an increase in the expected inflation rate on the equilibrium exchange rate,everything else held constant.
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Chapter 18: The International Financial System
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Sample Questions
Q1) If a central bank does not want to see its currency rise in value,it may pursue ________ monetary policy to ________ the domestic interest rate,thereby weakening its currency.
A)expansionary;raise
B)contractionary;raise C)expansionary;lower D)contractionary;lower
Q2) When a country forgoes its own currency and starts using another country's currency as its own,we say that this country has
A)created a currency board.
B)undergone dollarization.
C)adopted a managed exchange system.
D)adopted an exchange rate monetary system.
Q3) If a central bank does not want to see its currency ________ in value,it may pursue expansionary monetary policy to lower the domestic interest rate,thereby ________ its currency.
A)fall;strengthening B)fall;weakening
C)rise;strengthening D)rise;weakening
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Chapter 19: Quantity Theory, inflation and the Demand for Money
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Q1) In the late 1990s,M2 velocity ________,suggesting a ________ normal relationship between M2 and macroeconomic variables.
A)stabilized;less
B)stabilized;more
C)slowed;less
D)slowed;more
Q2) Because Keynes assumed that the expected return on money was zero,he argued that people would
A)never hold money.
B)never hold money as a store of wealth.
C)hold money as a store of wealth when the expected return on bonds was negative.
D)hold money as a store of wealth only when forced to by government policy.
Q3) The speculative motive for holding money is closely tied to what function of money?
A)store of wealth
B)unit of account
C)medium of exchange
D)standard of deferred payment
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Page 21
Chapter 20: The Is Curve
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Sample Questions
Q1) When the level of unplanned inventory investment is equal to zero,the economy is A)in disequilibrium.
B)in a recession.
C)in equilibrium.
D)overheating.
Q2) If the consumption function is expressed as C = a + mpc × YD,then "a" represents
A)autonomous consumer expenditure.
B)the marginal propensity to consume.
C)the expenditure multiplier.
D)disposable income.
Q3) In the Keynesian model of income determination,consumer expenditure includes spending by
A)consumers on personal computers.
B)businesses on personal computers.
C)governments on personal computers.
D)foreigners on domestic personal computers.
Q4) The Federal Reserve increases interest rates when it wants to reduce aggregate demand to fight inflation. How do increases in the interest rate reduce aggregate demand?
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Chapter 21: The Monetary Policy and Aggregate Demand
Curves
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Q1) The aggregate demand curve is downward sloping because a higher inflation rate leads the central bank to raise ________ interest rates,thereby ________ the level of equilibrium aggregate output. ,everything else held constant.
A)real;lowering
B)real;raising
C)nominal;lowering
D)nominal;raising
Q2) When the financial crisis started in August 2007,inflation was rising and the Fed began an aggressive easing lowering of the federal funds rate,which indicated that
A)the Fed pursued an autonomous monetary policy tightening.
B)the Fed pursued an autonomous monetary policy easing.
C)the Fed had an automatic negative response to inflation based on the Taylor rule.
D)the Fed had an automatic positive response to inflation based on the Taylor rule.
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Chapter 22: Aggregate Demand and Supply Analysis
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Q1) A positive supply shock causes ________ to ________.
A)aggregate demand;increase
B)aggregate demand;decrease
C)short-run aggregate supply;decrease
D)short-run aggregate supply;increase
Q2) Positive spending shocks lead to ________ output ________.
A)higher;in both the short and long runs
B)higher;in the short run but not in the long run
C)lower;in both the short and long runs
D)lower;in the short run but not in the long run
Q3) As of 2009,China's economy had recovered from the global recession that began in 2008. Use aggregate demand and aggregate supply analysis to explain why,and to explain the likely consequences for China of an increase in the growth rate of the global economy.
Q4) Everything else held constant,a decrease in government spending ________ aggregate ________.
A)increases;demand
B)decreases;demand
C)decreases;supply
D)increases;supply
Page 24
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Chapter 23: Monetary Policy Theory
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Q1) When the economy suffers a permanent negative supply shock and the central bank responds by changing the autonomous component of monetary policy to keep inflation at the target inflation rate,then
A)aggregate demand curve shifts leftward.
B)output will be unchanged.
C)output will be at its potential.
D)all of the above.
E)both A and C.
Q2) The real interest rate for investments reflects not only the short-term real interest rate set by the central bank,but also the financial frictions. When the policy rate has hit the floor of zero,to stimulate the economy at given inflation rates,policymakers can A)lower the financial frictions.
B)lower the short-term real interest rate.
C)lower both the short-term real interest rate and the financial frictions. D)lower the policy rate.
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Chapter 24: The Role of Expectations in Monetary Policy
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Q1) The argument that econometric policy evaluation is likely to be misleading if policymakers assume stable economic relationships is known as
A)the monetarist revolution.
B)the Lucas critique.
C)public choice theory.
D)new Keynesian theory.
Q2) Potential weaknesses of nominal GDP targeting include
A)it requires accurate estimates of potential GDP growth,which are not easy to achieve.
B)it implies that the central bank will respond to slowdowns in the real economy even if inflation is not falling.
C)real GDP growth that is below potential or inflation that is below the inflation objective will encourage more expansionary monetary policy.
D)it focuses not only on controlling inflation but also explicitly on stabilizing real GDP.
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Chapter 25: Transmission Mechanisms of Monetary Policy
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Q1) According to Tobin's q theory,when equity prices are high the market price of existing capital is ________ relative to new capital,so expenditure on fixed investment is
A)cheap;low
B)dear;low
C)cheap;high
D)dear;high
Q2) ________ examines whether one variable affects another by using data to build a model that explains the channels through which this variable affects the other.
A)Indirect-model evidence
B)Organizational-model evidence
C)Reduced-form evidence
D)Structural-model evidence
Q3) A contractionary monetary policy raises the real interest rate,causing the domestic currency to ________,thereby ________ net exports.
A)appreciate;raising
B)appreciate;lowering
C)depreciate;raising
D)depreciate;lowering
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Chapter 26: Financial Crises in Emerging Market Economies
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Sample Questions
Q1) The mismanagement of financial liberalization in emerging market countries can be understood as a severe
A)principal/agent problem.
B)asymmetric information problem.
C)lemons problem.
D)free-rider problem.
Q2) Before the South Korean financial crisis,sales by the top five chaebols (family-owned conglomerates)were
A)nearly 50% of GDP.
B)about 10% of GDP.
C)almost 90% of GDP.
D)nearly 25% of GDP.
Q3) At the time of the South Korean financial crisis,the merchant banks were
A)almost virtually unregulated.
B)subject to heavy government regulation.
C)engaged in long-term lending to the corporate sector.
D)restricted to long-term foreign borrowing.
Q4) What two key factors trigger speculative attacks leading to currency cries in emerging market countries?
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Chapter 27: The ISLM Model
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Q1) In the long-run the ISLM model predicts that ________ can change real output.
A)only monetary policy
B)only fiscal policy
C)both monetary and fiscal policy
D)neither monetary nor fiscal policy
Q2) The long-run neutrality of money refers to the fact that in the long run,monetary policy
A)changes only real output.
B)changes only the real interest rate.
C)changes both real output and the real interest rate.
D)has no effect on either real output or the real interest rate.
Q3) The situation in which expansionary fiscal policy does not lead to a rise in aggregate output is referred to as
A)fiscal neutrality.
B)a recession.
C)complete crowding out.
D)inflation.
Q4) Using the ISLM model,explain the effects of a monetary expansion combined with a fiscal contraction. How do the equilibrium level of output and interest rate change?
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