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Causes of 2007-2009 Financial Crisis
• Bursting of the U.S. housing bubble and subprime
mortgage crisis
• Change in lending model: MBS
• Credit default swap
• Inaccurate credit ratings
• Government policies
• Global financial integration: crisis spreads to global
financial markets
Policy Response: U.S.
• Federal Reserve
– Lower Federal Funds rate from 5.25% to almost zero
– Provide short term loans to banks [A total of $1.6 trillion in
loans to banks were made for various types of collateral (gov.
securities, commercial papers, etc.) by November 2008]
– Help to rescue financial institutions
(e.g., Fed provided an emergency loan of $85 Billion to AIG)
– Nonconventional monetary policy:
o QE1 (Nov. 2008); QE2 (Nov. 2010); QE3 (Sep. 2012)
o Forward guidance
Policy Response: U.S.
• U.S. treasury
– Troubled Assets Relief Program (TARP, $700b, Oct. 3, 2008)
– On Feb. 13, 2009, Congress passed $787 billion economic
stimulus bill
• Financial regulation
– Pre-crisis, focus was microprudential supervision; Postcrisis, macroprudential supervision: focuses on safety and
soundness of the financial system as a whole, rather than
individual institutions
– Dodd-Frank Wall Street Reform and the Consumer
Protection Act of 2010
Functions of the Bank of Canada
• The functions of the Bank of Canada are:
– Monetary Policy
– Financial System
– Currency
– Funds Management
The Money Supply Process

Who control the money supply?

What cause it to change?
o Three players
o Monetary base: MB = C + R
o Reserves = desired reserves + excess reserves
o The Bank of Canada controls the monetary base
mainly through (1) open market operations and (2)
advances to banks
Open Market Purchase from a Bank
Banking System
Bank of Canada
• Open market operation: a purchase/sale of
government bonds by the Bank of Canada
• Bank of Canada purchases $100m of bonds from a
bank and pays them with a $100m cheque
• Net result is that reserves have increased by $100m
• No change in currency in circulation
• Monetary base has risen by $100m
The Formula for Multiple Deposit Creation
• Assumption: banks do not hold on to any excess
• Given a desired reserve ratio (rd), we obtain a simple
deposit multiplier (a simple model of deposit creation)
ΔD = × Δ𝑅
Money Supply and Money Multiplier
• Define money as currency plus chequable deposits: M1
(that is M = C + D)
• We can also link the money supply (M) to the monetary
base (MB) and let m be the money multiplier
M = m × MB
𝒓𝒅 + 𝒆 + 𝒄
• Assuming the banks do not hold excess reserve. When
the monetary base is equal to $200 billion, the desired
reserve ratio is 0.10 and the currency ratio is equal to
0.20, the money multiplier is equal to ________ and the
money supply is equal to ________.
A) 4; $800 billion
B) 3.67; $734 billion
C) 4; $734 billion
D) 3.67; $800 billion
The Bank of Canada
• Monetary policy:
– Goal
– Operational instrument: target for the overnight interest rate
– Monetary policy tools
o Conventional monetary policy
o Nonconventional monetary policy
Taylor Rule
• How should the overnight interest rate target be
• One suggested approach: Taylor rule
𝑜𝑣𝑒𝑟𝑛𝑖𝑔ℎ𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝒕𝒂𝒓𝒈𝒆𝒕
= 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 + 𝑒𝑞𝑢𝑖. 𝑟𝑒𝑎𝑙 𝑜𝑣𝑒𝑟𝑛𝑖𝑔ℎ𝑡 𝑟𝑎𝑡𝑒
𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑔𝑎𝑝 + (𝑜𝑢𝑡𝑝𝑢𝑡 𝑔𝑎𝑝)
– A useful guide, but …
Conventional Monetary Policy Tools
• Bank of Canada standing liquidity facilities
– BoC lending
– BoC taking deposits from LVTS participants
• Open market operations
– open market purchase/sales
– now, BoC uses SPRAs and SRAs
Conventional Monetary Policy Tools of the
Federal Reserve
• Reserve requirement
• Open Market Operations
• Discount rate (the interest rate charged for discount window lending)
• Interest on reserves
Nonconventional Monetary Policy Tools
• Liquidity provision
• Large-scale asset purchases
• Commitment to future monetary policy actions
Should Central Banks Try to Stop Asset-Price
• Asset-price bubble
– Pronounced increase in asset prices that depart from
fundamental values, which eventually burst
• Types of asset-price bubbles
– Credit-driven bubbles
– Bubbles driven by overly optimistic expectations
(dubbed “irrational exuberance” by Alan Greenspan)
• Debate: leaning against asset-price bubbles vs.
cleaning up after the bubble burst
Policies to Restrain Credit-Driven Bubbles
• What policies would be most effective?
• Macropudential policy
– Regulatory policy to affect what is happening in credit
markets in the aggregate
– Tools: e.g., loan-value ratio, capital requirement
• Monetary policy
– Low interest rates may increase the incentives for asset
managers to search for higher yields and take higher
– Monetary policy can be used to lean against credit booms
Transmission Mechanisms of Monetary Policy
• The mechanisms through which monetary policy
affects the economy
1. Traditional interest-rate channel
2. Asset price channel
3. Credit channel
Foreign Exchange
• All currencies other than the domestic currency of a
given country are called foreign exchange
• Exchange rate: is the price of one country’s currency
in terms of another country’s currency (e.g., USD/CAD)
Factors That Affect Exchange Rates in the
Long Run
• In general, if a factor increases the demand for
domestic goods relative to foreign goods, then the
domestic currency will appreciate
– Relative price levels: a rise in a country’s price level
(relative to the foreign price level) causes its currency
to depreciate
– Trade barriers: Higher tariffs causes a country’s
currency to appreciate
– Preferences for domestic versus foreign goods:
increased demand for a country’s exports causes its
currency to appreciate
– Productivity: higher productivity leads to appreciation
of the country’s currency
Explaining Changes in Exchange Rates in
the Short Run
Shifts in the demand for domestic assets
• Domestic interest rate
– Increased domestic interest rates increases the demand for
domestic assets and causes the domestic currency to
• Foreign interest rate
– Increased foreign interest rates decreases the demand for
domestic assets and causes the domestic currency to
• Expected future exchange rate
– Rise in expected future exchange rate increases the demand
for domestic assets and causes an appreciation of the
domestic currency (5 factors will affect the expectation)
Exchange Rate Regimes in the International
Financial System
• Fixed exchange rate regime
– Value of a currency is pegged relative to the value of
one other currency (anchor currency)
• Floating exchange rate regime
– Value of a currency is allowed to fluctuate against all
other currencies
• Managed float regime (dirty float)
– Attempt to influence exchange rates by buying and
selling currencies
The Policy Trilemma
Balance of Payments
• The current account (CA) shows transactions that
involve currently produced goods and services
– net exports of goods & services (NX), which is the trade balance
– net factor income from abroad (NFI), and
– net unilateral transfers abroad (NUT).
• The capital account (KA) show net receipts from
capital/financial transactions (e.g., bank loans, purchases of
stocks and bonds, FDI, etc.)
Balance of Payments
• A current account (CA) surplus must be matched by a
capital account (KA) deficit or capital outflow;
• A current account (CA) deficit must be matched by a
capital account (KA) surplus or capital inflow.
Current account + capital account = net change in
government international reserves
(1) Which of the following can be described as involving direct finance?
A) A corporation issues new shares of stock.
B) People buy shares in a mutual fund.
C) A pension fund manager buys a short-term corporate security in the secondary market.
D) An insurance company buys shares of common stock in the over-the-counter markets.
(2) In Canada, federally registered banks and insurers, as well as trust and loan companies are supervised
and regulated by _________.
A) Bank of Canada
B) Department of Finance
C) Canada Deposit Insurance Corporation
D) Office of the Superintendent of Financial Institutions
(3) Typically, borrowers have superior information relative to lenders about the potential returns and
risks associated with an investment project. The difference in information is called ________, and it
creates the ________ problem.
A) asymmetric information; risk sharing
B) asymmetric information; adverse selection
C) adverse selection; risk sharing
D) moral hazard; adverse selection
(4) The time to maturity of a security is two years. If it pays $110 next year and $121 the year after that,
what is its yield to maturity if it sells for $200 today?
A) 9 percent
B) 10 percent
C) 11 percent
D) 12 percent
(5) The originate-to-distribute business model in the mortgage market is when ________.
A) mortgage originators made sure that the mortgage was a good credit risk
B) mortgage originators distributed the mortgage to an investor as an underlying asset in a security
C) homeowners could refinance their houses with larger loans when their homes appreciated in value
D) mortgage originators were the credit rating agencies
(6) A major shift in the US system of financial regulation in the aftermath to the financial crisis is
A) an easing of monetary policy
B) a tightening of monetary policy
C) a shift from microprudential supervision to macroprudential supervision
D) a shift from macroprudential supervision to microprudential supervision
(7) Supporters of the current system of Bank of Canada independence believe that a less autonomous
Bank would ________.
A) adopt a short-run bias toward policymaking
B) pursue overly expansionary monetary policies
C) be more likely to create a political business cycle
D) do each of the above
(8) Suppose a person cashes his payroll cheque and holds all the funds in the form of currency. Everything
else held constant, total reserves in the banking system ________ and the monetary base ________.
A) remain unchanged; increases
B) decrease; increases
C) decrease; remains unchanged
D) decrease; decreases
(9) In the simple deposit expansion model, an expansion in chequable deposits of $1000 when the
desired reserve ratio is equal to 20 percent implies that the Bank of Canada ________.
A) sold $200 in government bonds
B) sold $500 in government bonds
C) purchased $200 in government bonds
D) purchased $500 in government bonds
(10) If a bank has excess reserves of $10,000 and demand deposit liabilities of $80,000, and if the
reserve requirement is 20 percent, then the bank has actual reserves of ________.
A) $16000
B) $20000
C) $26000
D) $36000
(11) Assuming the banks do not hold excess reserve. When the monetary base is equal to $300 billion,
the desired reserve ratio is 0.10 and the currency ratio is equal to 0.20, the money supply is equal to
A) $1000 billion
B) $1200 billion
C) $1500 billion
D) $3000 billion
(12) If the desired reserve ratio is ten percent, currency in circulation is $400 billion, chequable deposits
are $1000 billion, and excess reserves total $1 billion, then the money supply is ________.
A) $10000 billion
B) $4000 billion
C) $1400 billion
D) $10400 billion
(13) To keep inflation from falling below the target range, the Bank of Canada ________.
A) decreases the target for the overnight rate which causes the dollar to go down
B) decreases the target for the overnight rate which causes the dollar to go up
C) increases the target for the overnight rate which causes the dollar to go down
D) increases the target for the overnight rate which causes the dollar to go up
(14) If the Bank of Canada wants to alleviate undesired downward pressure on the overnight interest
rate, it will enter into a ________.
A) Special Purchase and Resale Agreement (i.e., Repos)
B) Repurchase Agreement
C) Swap
D) Sale and Repurchase Agreement (i.e., Reverse Repos)
(15) Because of the presence of asymmetric information problems in credit markets, an expansionary
monetary policy causes a ________ in net worth, which ________ the adverse selection problem,
thereby ________ increased lending to finance investment spending.
A) decline; increases; encouraging
B) rise; increases; discouraging
C) rise; reduces; encouraging
D) decline; reduces; discouraging
(16) If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then
the theory of purchasing power parity predicts that, during 2005, the value of the Canadian dollar in
terms of Mexican pesos will ________.
A) rise by 6 percent
B) rise by 2 percent
C) fall by 6 percent
D) fall by 2 percent
(17) Suppose the Bank of Canada releases a policy statement today which leads people to believe that
the Bank will be enacting expansionary monetary policy in the near future. Everything else held
constant, the release of this statement would immediately cause the demand for Canadian assets to
________ and the Canadian dollar to ________.
A) increase; appreciate
B) decrease; appreciate
C) increase; depreciate
D) decrease; depreciate
(18) Which of the following does not appear in the current account part of the balance of payments?
A) A loan of $1 million from Royal Bank of Canada (RBC) to Brazil
B) Foreign aid to El Salvador
C) An Air France ticket bought by a Canadian
D) Income earned by General Motors Company (GM) from its plants abroad
(19) Under a fixed exchange rate regime, if a country has an ________ domestic currency, then its
central bank’s attempt to keep its currency from depreciating will result in a ________ of international
A) undervalued; gain
B) undervalued; loss
C) overvalued; gain
D) overvalued; loss
(20) A central bank’s attempt to prevent an appreciation of its currency can stimulate domestic inflation
if the ________ of its currency leads to ________ international reserves, which ________ the monetary
A) sale; lower; decreases
B) sale; higher; increases
C) purchase; higher; increases
D) purchase; lower; decreases
(21) Suppose 1-year interest rates for the next three years are expected to be 1%, 2%, and 3%, respectively.
The liquidity premium for the 2-year bond is 0.5% and the liquidity premium for the 3-year bond is 1.0%.
According to the liquidity premium theory of the term structure, the 3-year bond rate will be ________.
A) 2.5 %
B) 3.0 %
C) 3.5 %
D) 4.0 %
(22) The three players in the money supply process include ________.
A) banks, depositors, and the Department of Finance
B) banks, depositors, and borrowers
C) banks, depositors, and the central bank
D) banks, borrowers, and the central bank
Part II: Quantitative questions and short answer questions. (28 points)
(1). You believe that a corporation’s dividends will grow 5 percent on average into the future. The
corporation just paid a dividend of $5 per share and its stock has a current price of $75. Using the
Gordon growth model,
(a) what is the implied required rate of return for the stock?
(2 points)
(b) what is the expected price of the stock in 1 year (after the dividend payment)?
(2 points)
(2). Describe the three forms of Efficient Market Hypothesis and in each form, discuss the usefulness of
technical analysis and fundamental analysis in portfolio choice.
(4 points)
(3). Suppose the Bank of Canada lends $1 million to the First National Bank.
(a) For the initial effect of the loans (i.e., immediately after the Bank of Canada lending), show what
happens to the Bank of Canada and the banking system using T-accounts.
(2 points)
(b) Suppose the commercial banks in the banking system do not hold excess reserve (i.e., all excess
reserves are loaned out). Through multiple deposit creation, eventually the increase in reserves of the
banking system will support $10 million in new loans and chequable deposits. Using T-accounts, show
the final effect of the Bank of Canada lending (i.e., after the multiple deposit creation) for the Bank of
Canada and the banking system.
(3 points)
(4). In an economy, the currency in circulation is $400 billion, the amount of chequable deposits is $1000
billion, excess reserves are $15 billion, and the desired reserve ratio rd is 10%.
(a) Calculate the money supply and money multiplier.
(2 points)
(b) Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of
$200 billion due to a sharp contraction in the economy. Suppose that banks choose to hold all of these
proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that
currency and deposits remain the same, calculate the money supply and money multiplier. (3 points)
(5). The Basel Accord requires banks to hold capital at a certain percentage of their total risk-weighed
assets. The assets are allocated into four categories, each with a different weight to reflect the degree of
credit risk (see the table below).
Risk weight
Asset categories
Reserves and government securities
Claims on banks (e.g., holdings of bonds issued by other banks)
Municipal bonds, residential mortgages
Loans to consumers and companies
Consider a bank with the following balance sheet:
Liabilities & Equity
Desired Reserves
$9.6 million Chequable Deposits
$120 million
Excess Reserves
$1.4 million
Treasury bills
$20 million Bank Capital
$ 6 million
Residential mortgages
$45 million
Commercial Loans
$50 million
(a) Calculate the bank’s risk-weighted capital ratio.
(3 points)
(b) Suppose that the bank regulator decides that the bank needs a risk-weighted capital ratio of 10%.
Based on the bank’s balance sheet, how much of an additional capital injection is required in order to
reach the 10% target?
(2 points)
(6). Discuss the mechanisms through which monetary policy affects the aggregate demand and the
overall economy. Please be specific about the channels/theories.
(5 points)
———————————————- END ————————————-
Formula Sheet
The following formulas may be used in answering the questions in the exam.

𝑃 =
+ ⋯+
𝑃 =
𝑀 = 𝑚 × 𝑀𝐵

Purchase answer to see full

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Monetary policy

University of Winnipeg

Commercial Loans

Treasury bills

econ 2301


Residential mortgages

weighted capital ratio

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