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Monetary policy, interest rates & FDIC insurance questions

A. Why does borrowing short and lending long present a potential problem for banks?
b. What are two effects that a government guarantee of financial institutions can have and why?
c. After a major storm cash held by individuals has increased. Should the Fed buy or sell bonds and why?
d. How does the distinction between nominal and real interest rates add uncertainty to the effect of monetary policy on the economy?
e. What are five problems in the conduct of monetary policy?

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a. Banks derive much of their earnings from the typical spread between short- and long-term interest rates. By "borrowing short and lending long," they are able to take advantage of the fact that long-term rates typically exceed short-term rates by at least a percentage point or so. The re-issue the securities which are borrowed in the interim. When the yield curve is positive (as it normally is), lending long and borrowing short manufactures spread. For an issuer routinely borrowing billions, every billion financed with five-year debt instead of ten would generate another $10,000,000 in annual earnings, every year of the first five years. But because the values of long-term instruments are much more sensitive to interest-rate changes than the values of short-term instruments, setting up a tradeoff between the expected return and interest-rate risk.

b. The Federal Deposit Insurance Corporation (FDIC) is an independent federal government agency which insures deposits in commercial banks and thrifts. A deposit insurance system can contribute to financial stability, but ...

Solution Summary

Monetary policy, interest rates, FDIC insurance, and bank borrowing