Financial Institution - Chapter No. 8 - INVESTMENT COMPANIES AND EXCHANGE TRADED FUNDS

CHAPTER 8

INVESTMENT COMPANIES

AND EXCHANGE-TRADED FUNDS

TYPE OF INVESTMENT COMPANIES

Open-End Funds (Mutual Funds)

More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem shares at a price based on net asset value, which is total asset value less liabilities. Prices are quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. The net asset value (NAV) per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors.

There are several important characteristics of open-end or mutual fund. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager actively manages the portfolio. Third, the share price is the NAV. Fourth, the NAV is determined only once each day, at the close of the day.

In the case of a load fund the offer price will exceed the bid price by the amount of a sales commission charged upon purchases of shares. Some funds have back-end loads, wherein commissions are charged upon redemption of funds within a few years. Others, known as Section 12b-1 funds, charge a small percentage of assets annually to cover sales costs. In any case, all funds earn small percentage annual fees to cover administrative costs. These funds comprise the third largest group of financial institutions, behind banks and insurance companies.

Closed-End Funds

These funds issue a limited number of shares and are very similar to shares of common stock. They are then sold on the open market like other securities. Investors pay a broker’s commission. The NAV of closed-ended funds is determined by supply and demand. The market price of these shares may thus differ from net asset value, often at a discount from it. The discount results from large tax liabilities on capital gains that swell the net asset value, while investors are pricing future after-tax distributions. Premiums can result because such funds often have inexpensive access to overseas stocks.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They make an IPO, and then their shares are traded on the secondary market, just like any corporate stock.

The relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and closed-end funds. ETFs are essentially hybrid closed-end vehicles, which trade on exchanges but typically trade very close to NAV.

Unit Trusts

 A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. They are different from closed-end funds in the following. First, they typically invest in bonds. Second, they do not trade. Third, a fixed amount of securities is assembled with a defined termination date. The major benefit of such funds is lower operating costs due to the absence of trading.

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

There are two types of costs borne by investors in mutual funds. The first is shareholders fee, usually called the sales charge. This type of charge is related to the way the fund is sold and distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund's expenses. The largest of which is for investing managements. Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. The sum of annual management fee, the annual distribution fee and other expenses is called the expense ratio.

Sales Charge

Sales charges on mutual funds are related to their method of distribution. The two types of distribution were sales force and direct. Sales force occurs via an intermediary agent. Direct distribution takes place without an intermediary. Funds with no sales charges are called no-load mutual funds. Some have speculated that load funds would eventually disappear, but the trend has gone the other way. Among the recent adaptations of the sales load are back-end loads.

Annual Operating Expenses (Expense Ratio)

The operating expense, also called the expense ratio, is debited annually from the investor’s fund balance by the fund sponsor. Operating expenses are deducted from NAV and therefore reduce the reported return. The management fee, also called the investment advisory fee, is the fee charged by the investment advisor for managing a fund’s portfolio. In 1980, the SEC approved the imposition of a fixed annual fee, called the 12b-1 fee, which intended to cover distribution costs. Such 12b-1 fees are now imposed by many mutual funds.

Multiple Share Classes

Share classes were first offered in 1989 following the SEC’s approval of multiple share class. Initially share classes were used primarily by sales-force funds to offer alternatives to front-end load as a means of compensating brokers. Later, some of the funds used additional share classes as a means of offering the same fund or portfolio through alternative distribution channels in which some fund expenses varied by channel.

ECONOMIC MOTIVATIONS FOR FUNDS

An investment company is a financial intermediary because it pools the funds of market participants and uses those funds to buy a portfolio of securities. They provide at least one of the following six economic functions: (1) risk reduction via diversification, (2) lower costs of contracting and processing information, (3) professional portfolio management, (4) liquidity, (5) variety, (6) payments mechanism.  

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

Investment funds tend to have a variety of investment objectives. In general, there are stock funds, bond funds, money market funds and others. They seek to accommodate a wide range of desires and needs, among them income, capital gains, growth, and income. Some funds specialize by securities, examples of which are indexed funds, government bond funds, municipal bond funds, corporate bond funds, money market mutual funds, and balanced funds--combination of bonds and stocks.

CONCEPT OF FAMILY OF FUNDS

Now many management companies offer investors a choice of numerous funds. Some firms provide a choice of funds and objectives. Changing from one to the other to reflect changing needs can then be accomplished at low or no cost to the investor. The funds in a family usually include choices ranging from money market funds to global funds, and funds devoted to particular industries such as medical technology or gold mining companies. Concentration in the mutual funds industry continues to increase.

INVESTMENT VEHICLES FOR MUTUAL FUNDS

Mutual funds may be included in different investment vehicles. An investment vehicle can be a non-qualified vehicle because it does not quality for tax advantages. The same fund can also be included in a retirement plan such as 401(k), Roth 401(k), IRA or Roth IRA. These retirement plans are called qualified plans.

MUTUAL FUND COSTS

From 1980 to 2006, the measure of mutual fund costs declined from 2.32% to 1.07% for stock funds and from 2.05% to 0.84% for bond funds. There were three reasons for this decline. First, loads in general declined. Second, no-load mutual funds grew. Third, mutual fund expenses have also declined due to economies of scale and intense competition.

TAXATION OF MUTUAL FUNDS

Mutual funds must distribute at least 90% of their net investments income earned, exclusive of realized capital gains or losses to shareholders to be considered a regulated investment company (RIC) and, thus not be required to pay taxes at the fund level prior to distribution to shareholders. Consequently, funds make these distributions. Capital gains distributions must occur annually, and typically occur late during the calendar year. New investors in the fund may assume a tax liability even though they have no gains. The investors must also pay ordinary income taxes on distribution of income.

REGULATION OF FUNDS

All investment companies are regulated under the Investment Company Act of 1940. They must register with the SEC and file periodic reports. No taxes are levied on funds, which distribute 90% of their income. There are minimum diversification and liquidity requirements as well as maximum fees that can be applied. Currently under consideration is a proposal allowing less redemption over a quarter, thus permitting funds to hold smaller proportions of liquid assets.

Among the recent SEC priorities, which directly affect mutual funds, are:

1.           Reporting after taxes.

2.           More complete reporting fee.

3.           More accurate and consistent reporting of investment performance.

4.           Requiring fund investment practices to be more consistent with the name of a fund to more accurately reflect their investment objectives.

5.           Disclosing portfolio practices such as "window dressing".

6.           Various rules to increase the effectiveness of independent fund boards.  

STRUCTURE OF A FUND

A mutual fund organization is structured as follows: (1) board of directors, (2) mutual fund, (3) investment advisor, (4) distributor, (5) other service providers. The role of the board of directors is to represent the fund shareholders. External advisers are called subadvisers, and they are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

Distribution Channels

Traditionally, funds were sold direct or through a sales force. However, funds have moved increasingly to nontraditional sources of sales.

Supermarkets: The organizer of a supermarket, like Charles Schwab, offers funds from a number of different mutual fund families.

Wrap programs: Wrap accounts are managed accounts, typically mutual funds or ETFs, wrapped in a service package. The service provided is often asset allocation counsel, i.e., advice on the mix of managed funds or ETFs.

Fee-based financial advisors: Fee-based financial advisors are independent financial planners who charge a fee rather than a transaction charge for investment services. These fees are typically a percentage of assets under management or alternatively an hourly fee or a fixed retainer.

Variable annuities: Variable annuities represent another distribution channel.

Changes in the Costs of Purchasing Mutual Funds

The purchase cost of mutual funds has declined significantly. In general, load funds responded to the competition of no-load funds by lowering distribution cost.

Mix and Match

The investors’ demands for choice and convenience, and also the distributors’ need to appear objective, have motivated essentially all institutional users of funds and distribution organizations to offer funds from other fund families in addition to their own.

Domestic Acquisitions in the US Funds Market

There merger and acquisition business in the US asset management business has been active. The US asset management business continues to grow and consolidate across the various types of asset management firms.

Internationalization of the US Funds Business

The combination of a US fund company and international asset manager could occur in either two directions, i.e., with either being the acquirer. But the dominant direction has been the acquisition of US funds by international institutions.

EXCHANGE TRADED FUNDS

While mutual funds have become very popular with investors, they are often criticized for two reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day (closing) price. The second relates’ to taxes and the investors’ control over taxes. Withdrawals by some shareholders may cause taxable realized capital gain for shareholders who maintain their positions.

Closed-end funds trade all during the day on stock exchange, but there is often a difference between the NAV and the price of the closed-end funds. Both mutual funds and closed-end funds are similar in that they are instruments based on the portfolio of their securities, but closed-end funds are transacted continuously throughout the day.

An investment that embodies a combination of the desirable aspects of mutual funds (open-end funds) and closed-end funds is the exchange-traded fund (ETF). These are mostly index funds. They are traded on an exchange, and they are like open-end funds in that the number of shares can change.

ETC Creation/Redemption Process

For ETCs, individuals do not deal directly with the provider of the ETF. That privilege is reserved for a few very large investors called authorized participants (AP) who are arbitragers. Authorized participants are mainly large institutional traders who have contractual agreements with ETF funds. They are the only investors who may create or redeem shares of an ETF with the ETF sponsor and then only in large specified quantities called creation/redemption units. These unit sizes range from approximately 50,000 to 100,000 ETF shares.

ETF Sponsors

Like mutual funds, ETFs require a company to sponsor them. The ETF sponsor must (1) develop the index, (2) retain the authorized participants, (3) provide seed capital to initiate the ETF, (4) advertise and market the ETF, (5) engage in other activities.

Mutual Funds versus ETFs: Their Relative Advantages

The following are ETF advantages. Mutual funds are priced only once a day. But ETFs are traded on an exchange and so there is continuous pricing. Both passive mutual funds and ETFs have low fees, but ETF fees tend to be somewhat lower. All ETFs trade on an exchange and incur commission. As to taxes, mutual funds may lead to capital gains taxes for investors who do not even liquidate their fund. Because of the unique structure of ETFs, ETFs can fund redemptions by in-kind transfers without selling their holdings, which have no tax consequences.

Mutual funds have the following advantages. While ETFs have been exclusively passive or indexes, mutual fund families offer many types of active funds as well as passive funds. Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or commissions.

Separately Managed Accounts

Many high net worth people object to mutual funds because (1) lack of control over taxes, (2) lack of any input into investment decision, (3) absence of services. The use of separately managed accounts responds to all these limitations of mutual funds.

ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding.

1. What is its NAV?
2. Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive?

a.       Net asset value = (Total assets minus liabilities) / numbers of shares

                                = 1,050,000 – 50,000 = $100

                                             10,000

b.      Net asset value = 2,100,000 – 0 = $210

10,000

No of shares = 5000 = 23.81 shares.

                                210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.” Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

     

4. Why do some closed-end funds use leverage to raise more funds rather than issue new shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus many funds become leveraged to raise more funds without issuing new (additional) shares.       

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV.

6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a specified number of years and then liquidated. The charges are low since there is no trading of securities or redemption prior to maturity.

7.

1. Describe the following: front-end load, back-end load, level load, 12b-l fee, management fee.
2. Is there a limit on the fees that a mutual fund may charge?

a.       Back-end load funds charge sales fees upon redemption within a period of a       few years. Front end is commissioned charged up front of the time of sale. A level load is amount of sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual sales fee of around 1.5% annually.

b.      Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors and their risk preferences. It permits the distributor and its client to select the type of load they prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns.

10.

1. What is meant by a target-date fund?
2. What is the motivation for the creation of such a fund?

a.       Target date funds are mutual funds that base their asset allocations on a specific date, the assumed retirement date for the investor, and then rebalance to a more conservative allocation as that date approaches.  

b.      These funds are designed to be “one-size-fits-all” portfolios for investors with a given number of years to retirement.  

11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees, selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the sales charge. This type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.  

15.

1. How can a fund qualify as a regulated investment company?
2. What is the benefit in gaming this status?

a.       A regulated investment company must provide information on its fees and its objectives. It must file financial reports and indicate amount of income distributed.

b.      A regulated investment company is exempt from taxation on all its ordinary and capital gains income as long as at least 90% of these funds are distributed to the stockholders. Such distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade like a stock on an exchange. The price is determined continuously rather than the closing price e.g. QQQ.

17. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds:

1. supermarket
2. wrap program
3. segregated managed accounts
4. family of funds

a.       Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company.

b.      Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package. The service provided is often asset allocation counsel; that is advice on the mix of managed funds.

c.       Segregated managed accounts: are in response to individuals who object to mutual funds because of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts.

d.      Family of funds: In the U.S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.

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Financial Institution

CHAPTER 5

Central Bank

AND THE CREATION OF MONEY

CENTRAL BANKS AND THEIR PURPOSE

The primary role of a central bank is to maintain the stability of the currency and money supply for a country or a group of countries. The role of central banks can be categorized as: (1) risk assessment, (2) risk reduction, (3) oversight of payment systems, (4) crisis management.

One of the major ways a central bank accomplishes its goals is through monetary policy. For this reason, central banks are sometimes called monetary authority. In implementing monetary policy, central banks, acting as a reserve bank, require private banks to maintain and deposit the required reserves with the central bank. In times of financial crisis, central banks perform the role of lender of last resort for the banking system. Countries throughout the world may have central banks. Additionally, the European Central Bank is responsible for implementing monetary policy for the member countries of the European Union. 

There is widespread agreement that central banks should be independent of the government so that decisions of the central bank will not be influenced for short-term political purposes such as pursuing a monetary policy to expand the economy but at the expense of inflation.

In implementing monetary and economic policies, the United States is a member of an informal network of nations. This group started in 1976 as the Group of 6, or G6: US, France, Germany, UK, Italy, and Japan. Thereafter, Canada joined to for the G7. In 1998, Russia joined to form the G8.

THE CENTRAL BANK OF THE UNITED STATES: THE FEDERAL RESERVE SYSTEM

The Federal Reserve System consists of 12 banking districts covering the entire country. Created in 1913, the Federal Reserve is the government agency responsible for the management of the US monetary and banking systems. It is independent of the political branches of government. The Fed is managed by a seven-member Board of Governors, who are appointed by the President and approved by Congress.

The Fed’s tools for monetary management have been made more difficult by financial innovations. The public’s increasing acceptance of money market mutual funds has funneled a large amount of money into what are essentially interest-bearing checking accounts. Securitization permits commercial banks to change what once were illiquid consumer loans of several varieties into securities. Selling these securities gives the banks a source of funding that is outside the Fed’s influence.

INSTRUMENT OF MONETARY POLICY: HOW THE FED INFLUENCES THE SUPPLY OF MONEY

The Fed has three instruments at its disposal to affect the level of reserves.

Reserve Requirements

Under our fractional reserve banking system have to maintain specified fractional amounts of reserves against their deposits. The Fed can raise or lower these required reserve ratios, thereby permitting banks to decrease or increase their lending and investment portfolios. A bank’s total reserves equal its required reserves plus any excess reserves.

Open Market Operations

The Fed’s most powerful instrument is its authority to conduct open market operation. It buys and sells in open debt markets government securities for its own accounts. The Fed prefers to use Treasury bills because it can make its substantial transactions without seriously disrupting the prices or yields of bills.

The Federal Open Market Committee, or FOMC, is the unit that decides on the general issues of changing the rate of growth in the money supply, by open market sales or purchases of securities. The implementation of policy through open market operations is the responsibility of the trading desk of the Federal Reserve Bank of New York.

Open Market Repurchase Agreements

The Fed often employs variants of simple open market purchases and sales, these are called the repurchase agreement (or repo) and the reverse repo. In a repo, the Fed buys a particular amount of securities from a seller that agrees to repurchase the same number of securities for a higher price at some future time. In a reverse repo, the Fed sells securities and makes a commitment to buy them back at a higher price later.

Discount Rate

A bank borrowing from the Fed is said to use the discount window. The discount rate is the rate charged to banks borrowing directly from the Fed. Raising the rate is designed to discourage such borrowing, while lowering should have the opposite effect.

DIFFERENT KINDS OF MONEY

Money is that item which serves as a numeraire. In a basic sense money can be defined as anything that serves as a unit of account and medium of exchange. We measure prices in dollars and exchange dollars for goods. Hence coins, currency, and any items readily exchanged into dollars (checking deposits or NOW accounts) constitute our money supply.

MONEY AND MONETARY AGGREGATES

Monetary aggregates measure the amount of money available to the economy at any time. The monetary base is defined as currency in circulation (coins and federal reserve notes) and reserves in the banking system. The instruments that serve as a medium of exchange can be narrowly defined as M₁, which is currency and demand deposits. M₂ is M₁ plus time and savings accounts, and money market mutual funds. Finally, M₃ is M₂ plus short-term Treasury liabilities. While all three aggregates are watched and monitored, M₁ is the most common form of the money supply, with its trait as being the most liquid. The ratio of the money supply to the economy’s income is known as the velocity of money.

THE MONEY MULTIPIER: THE EXPANSION OF THE MONEY SUPPLY

The money multiplier effect arises from the fact that a small change in reserves can produce a large change in the money supply. Through our fractional reserve system, a small increase will allow an individual bank, to lend out the greater part of these additional funds. These loans subsequently become deposits in other banks allowing them to expand proportionately. So, while one bank can expand its loans (or deposits) by an amount 1% of reserves required, all banks in the system can do likewise. Thus, in a simple format total change in deposits can be stated as change in reserves divided by the reserve requirement, which is also the formula for perpetuity. For example, if the change in the level of reserves is $100 and the reserve requirement is 20%, the change in total deposits will be $500 for a multiplier of 5. Of course, major assumptions are that banks will fully loan out their excess reserves and that depositors will not withdraw any of these extra reserves.

THE IMPACT OF INTEREST RATES ON THE MONEY SUPPLY

High rates of interest may make keeping excess reserves costly, since unused funds represent loans not made and interest not earned. High rates of interest will also affect the public’s demand for holding cash. If deposits pay competitive interest rates, customers will be more willing to hold such bank liabilities and less cash. Therefore, a higher rate of interest can actually spur growth of the money supply. More likely, however, it will deter borrowing and slow monetary growth.

THE MONEY SUPPLY PROCESS IN AN OPEN ECONOMY

In the modern era, almost every country has an open economy. Foreign commercial and central banks hold dollar accounts in the United States. Their purchases and sales of these deposits can affect exchange rates of the dollar against their own currency. The Fed has responsibility for maintaining stability in exchange rates. A purchase of foreign exchange with dollars depreciates the dollar’s value, but it also adds dollars to the accounts of foreign banks in this country, thus adding to the U.S. monetary base. Most central banks of large economies own or stand ready to own a large amount of each of the world’s major currencies, which are considered international reserves. Sales of foreign exchange transactions have monetary base implication and hence consequences for the domestic money supply, emphasis is given to coordinating monetary policies among developed nations.

ANSWERS TO QUESTIONS FOR CHAPTER 4

(Questions are in bold print followed by answers.)

1. What is the role of a central bank?

The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations.

2. Why is it argued that a central bank should be independent of the government?

Central banks should be independent of the short-term political interests and political influences generally in setting economic policies.

3. Identify each participant and its role in the process by which the money supply changes and monetary policy is implemented.

The Fed determines monetary policy and seeks to implement it through changes in reserves. It is up to the nation’s banking system to act on changes in reserves thereby affecting deposits, which constitute the greater part of the M₁ definition of the money supply.

4. Describe the structure of the board of governors of the Federal Reserve System.

The Board of Governors of the Federal Reserve System consists of 7 members who are appointed to staggered 14-year terms. The Board reviews discount operations and sets legal reserve requirements. In addition, all 7 members of the Board serve on the Federal Open Market Committee (FOMC), which determines the direction and magnitude of open-market operations. Such operations constitute the key instrument for implementing monetary policy.

5.

1. Explain what is meant by the statement “the United States has a fractional reserve banking system.”
2. How are these items related: total reserves, required reserves, and excess reserves?

a.       A fractional reserve system requires that a fraction or percent of a bank’s reserve be placed either in currency in vault or with the Federal Reserve System.

b.      Total reserves are the amounts that banks hold in cash or at the Fed. Required reserves are amounts required by the Fed to meet some specific or legal reserve ratio to deposits. Excess reserves are bank reserves in currency and at the Fed which are in excess of legal requirements. Since these amounts are non-interest bearing, banks are often willing to lend these surplus funds to deficit banks at the Fed funds rate.

6. What is the required reserve ratio, and how has the 1980 Depository Institutions Deregulation and Monetary Control Act constrained the Fed’s control over the ratio?

The required reserve ratio is the fraction of deposits a bank must hold as reserves. The DIDMCA constrained the Fed’s control over the ratio by letting Congress set ranges of reserves for demand and time deposits.

7. In what two forms can a bank hold its required reserves?

A bank can hold its reserves in the form of currency in vault or in deposit at the Fed.

8.

1. What is an open market purchase by the Fed?
2. Which unit of the Fed decides on open market policy, and what unit implements that policy?
3. What is the immediate consequence of an open market purchase?

a.       An open market purchase by the Fed consists of the purchase of U.S. Treasury securities.

b.      The FOMC decides on open market policy and directs the Federal Reserve Bank of New York to implement it through sales and purchases of these securities.

c.       The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply.

9. Distinguish between an open market sale and a matched sale (which is the same as a matched sale-purchase transaction or a reverse repurchase agreement).

A matched sale or reverse repo involves the sale of a Treasury security with an agreement to buy it back at a later date and at a higher price as the cost for borrowing the funds. This contrasts with an outright sale at some discounted or premium price.

10. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right.”

11. Define the monetary base and M₂

The monetary base includes total bank reserves plus currency in the hands of the public. M₂ = M₁ (currency and demand deposits) + savings and time deposits.

12. Describe the basic features of the money multiplier.

The money multiplier is crucial to the concept of money creation and is analogous to the idea of the autonomous spending multiplier and formula for a perpetuity. It is the inverse of the required reserve ratio (1/rr). If the reserve ratio is .2 then the money supply will expand five times any increase in new deposits. The multiplier will be less if banks hold excess reserves or experience cash drains.

13. Suppose the Fed were to inject $100 million of reserves into the banking system by an open market purchase of Treasury bills. If the required reserve ratio were 10%, what is the maximum increase in M₁ that the new reserves would generate? Assume that banks make all the loans their reserves allow, that firms and individuals keep all their liquid assets in depository accounts, and no money is in the form of currency.

The maximum increase in M₁ will be $1 billion assuming no cash drains in the system, and banks are fully loaned up.     

14. Assume the situation from question 13, except now assume that banks hold a ratio of 0.5% of excess reserves to deposits and the public keeps 20% of its liquid assets in the form of cash. Under these conditions, what is the money multiplier? Explain why this value of the multiplier is so much lower than the multiplier from question 13.

Substitute the given values of currency ratio, required reserves ratio, and excess reserves ratio of 20%, 10% and 0.5% respectively into the formula given on page 94 of the textbook. Now we have a lower multiplier value of 3.9=1.20/. 305. This is because public and banks do not deposit or lend, all they can.