Money Banking and The Canadian Financial System

Assignment 2 Due: After Unit 8

Credit Weight: 15% of your final course grade. The marks allocated to each question are indicated in parentheses.

Instructions: Upload your assignment. Keep a copy of your completed assignment for your records.
1.    Formulate James Tobin’s model of risk and portfolio choice, and with the use of a diagram, show how his model explains the inverse relationship between the demand for money and the rate of interest. (12 marks)
2.    Formulate the square root rule for optimum transactions balances, and discuss its conclusions with respect to the determinants of the demand for money. (7 marks)
3.    The money supply is broadly defined to include all the deposits held with the chartered banks and near banks. The deposits with near banks, on average, are equal to 80 percent of those held with the chartered banks. Currency held by the public to satisfy their day-to-day needs is equal to 10 percent of total deposits held by the depositary institutions. The chartered banks cash reserve ratio is 3 percent, and that of the near banks is 3.5 percent.

a. The Bank of Canada increases the monetary base by $50 million. Calculate the chartered banks’ deposit multiplier, and the increase in chartered bank deposits. (3 marks)

b. Calculate the increase in the money supply. (3 marks)

c. Derive the money supply multiplier equation, and use it to check your answer in (b) above. (2 marks)
4.    Describe, and illustrate with balance sheets of both the Bank of Canada and the direct clearers with the Canadian Payments Association, the change in the monetary base in response to the following transactions:

a. A Bank of Canada open market sale to the public of $100 million of Government of Canada securities. (2 marks)

b. Are deposit of $200 million worth of Government of Canada deposits. (2 marks)

c. A $300 million advance made by the Bank of Canada to a chartered bank. (2 marks)

d. A $400 million Purchase and Resale Agreement made by the Bank of Canada with the money market jobbers. (3 marks)

e. The Bank of Canada intervenes in the foreign exchange market with a $500 million purchase of American currency ($US 1.00 = $Can. 1.55). It uses an open market transaction to sterilize its foreign exchange intervention. (3 marks)

f. Rather than an open market transaction, the Bank of Canada shifts Government of Canada deposits to sterilize its foreign exchange intervention in (e) above. (3 marks)
5.    Describe the large value transfer system (LVTS), and list the major reasons for adopting the system. (7 marks)
6.    Indicate how each of the following international transactions is entered into the Canadian balance of payments with double-entry bookkeeping:

a. A Canadian resident purchases $1,000 of foreign stock, and pays for it by drawing down his bank balances abroad. (2 marks)

b. A Canadian exporter sells merchandise worth $1 million in the United States, and is paid by a US importer with a cheque drawn against Canadian dollar deposits with a bank in Tokyo. (2 marks)

c. A Canadian resident receives an interest payment on a US government bond, and deposits it in her American dollar account at a Canadian chartered bank in Toronto. (2 marks)
7.    Suppose the spot foreign exchange rate of the Canadian dollar is $US 1.53, while its 12-month forward rate is $US 1.58. One-year interest rates are 6 percent in Canada and 10 percent in the United States. Are there quick profits to be made from foreign currency arbitrage here? If so, show the sequence of purchases and sales, using $Can. 100,000 as your starting point. (6 marks)
8.    Use a diagram to explain the “new economics” proposition of monetary policy effectiveness. Describe the underlying assumptions of the new economics model.What is the policy ineffectiveness proposition? (9 marks)
9.    Describe the major characteristics of the Bretton Woods system and the role of the IMF in this system. Explain why the Bretton Woods system failed. (10 marks)
10.    Briefly describe each of the following terms:

a. Eurocurrency markets (2 marks)
b. International debt crises (2 marks)
c. Purchasing power parity (2 marks)
d. Currency arbitrage (2 marks)
e. Interest-rate parity condition (2 marks)
11.    Complete all three parts of this question.

a. Use Figure 7-5 on page 159 of your textbook to demonstrate the gains and losses to a short put and a long put on dollars with identical maturity dates, where the strike price is 0.50DM/$1, and the option premiums are identical at 0.05DM. Is there a net gain to short and long puts in this example? Why or why not? (3 marks)

b. Will a short put be exercised if the market price at maturity is greater than the strike price? Why or why not? Will a long call be exercised if the market price at maturity is lower than the strike price? Why or why not? Use properly labelled diagrams to support your answers. Assume that the strike price on each option is 4.2DM/$1, and that the option premiums are identical at 1.1DM/$1. (3 marks)

c. Explain the motives of both the seller and buyer of a straddle. Use properly labelled diagrams to support your explanation. Assume that the strike prices are 0.50DM/$1, that the option premiumon the call is 0.05DM/$1, and that the option premium on the put is 0.035 DM/$1. (4 marks)