1. (Credit Creation) Understanding bank balance sheet is useful since it also helps our understanding of the process called credit creation. This process shows that the Fed (central bank)s policy of increasing the money supply is enhanced by banks operations. Suppose an occurrence of the Feds open market purchase proceed as follows:

1. The Fed decided to purchase $100 millions of securities from Bank A.

2. Bank A holds 10% of its increase in liquidity as required reserves, 40% as excess reserves, and use 50% as loans to Borrower A.

3. Borrower A holds 50% of her liquidity as currency and 50% as deposits in Bank B.

4. Bank B holds 10% of its increase in liquidity as required reserves, 40% as excess reserves, and use 50% as loans to Borrower B.

5. Borrower B holds 50% of her liquidity as currency and 50% as deposits in Bank C.

6. Finally, Bank C holds all of its increase in liquidity as reserves (required re- serves plus excess reserves). Hence the deposit creation process stops here.

The following balance sheet records the changes in compositions of assets and liabilities for each market participants. Fill the numbers in a-i.

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Fed Assets Securities

Bank A Assets Securities Required reserves Excess reserves Loans

Liabilities Currency+Reserves +$

million

Borrower A Assets Currency Deposits

+$ c million +$ d million

Liabilities Borrowing

+$50 million

+$100 million

Liabilities

$100 million +$ a million +$ b million + $50 million

Bank B Assets Required reserves Excess reserves Loans

+$ e million +$ f million +$ g million

Liabilities Deposits

+$ d million

Borrower B Assets Currency Deposit

Liabilities +$ h million Borrowing +$ g million

+$ i million Liabilities

Bank C Assets Reserves

+$ i million Deposits +$ i million

2. (Bank Run) Answer the following question about a bank run.

1. (a) Explain what is a bank run.

2. (b) Explain why a special consideration is needed for preventing bank run. In particular, explain why bank run may occur when the bank is healthy enough to be solvent.

3. (c) Explain why deposit insurance is effective in preventing bank runs.

(d) Further Reading: The problem of bank run and its self-fulfilling character is analyzed in Diamond and Dybvig (1983). Also see the survey by Shin

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(2009). 3. (Credit Cycles) Consider a bank with the balance sheet given below.

Assets Reserves Securities Loans

$ 10 million $ 50 million $ 30 million

Liabilities Deposits Bank Capital

$ 80 million

Reference

Answer the following questions.

(a) Compute the bank capital.

2. (b) Assume that there was a default in mortgages loans by 10 million dollars worth. Draw the resulting bank balance sheet.

3. (c) Because of the decreased bank capital, the bank has to sell their assets by 10 million dollars. Suppose that it decides to sell securities. Since many other banks are in the same situation and they sold securities, too. Because of the surge of supply, the price of the securities had dropped and it caused the depreciation of banks securities by 5 million dollars worth. Draw the resulting bank balance sheet.