MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 4 — Questions and Answers
Question 1: A commercial bank's capital adequacy ratio under Basel III requires common equity tier-1 (CET1) capital of at least what percentage of risk-weighted assets?
- 2%
- 4.5% (Correct answer)
- 8%
- 10.5%
Correct answer: 4.5%
Basel III mandates a minimum CET1 ratio of 4.5% of risk-weighted assets, plus an additional 2.5% capital conservation buffer for a combined minimum of 7%.
Question 2: The term structure of interest rates according to the expectations hypothesis implies that:
- Long-term rates reflect risk premiums demanded by investors for holding illiquid bonds
- Long-term rates are geometric averages of expected future short-term rates (Correct answer)
- Short-term rates always equal long-term rates in equilibrium
- Central banks can freely set any point on the yield curve
Correct answer: Long-term rates are geometric averages of expected future short-term rates
The pure expectations hypothesis holds that the long rate is determined by the compound average of current and expected future short rates, with no term premium.
Question 3: Quantitative easing (QE) differs from conventional open market operations primarily because QE:
- Only targets overnight lending rates rather than asset prices
- Involves large-scale purchases of longer-term or riskier assets beyond short-term government securities (Correct answer)
- Reduces the central bank's balance sheet to stimulate lending
- Is conducted by the Treasury, not the central bank
Correct answer: Involves large-scale purchases of longer-term or riskier assets beyond short-term government securities
QE involves central bank purchases of long-duration Treasuries, mortgage-backed securities, or other assets to compress long-term yields when short rates are near zero.
Question 4: Which concept explains why a dollar received today is worth more than a dollar received in the future?
- Inflation premium
- Time value of money (Correct answer)
- Currency risk
- Liquidity preference
Correct answer: Time value of money
The time value of money reflects that a current dollar can be invested to earn returns, making it more valuable than the same nominal amount received later.
Question 5: In deposit insurance systems, 'moral hazard' refers to the risk that:
- Insured banks will take on excessive risk because depositors have no incentive to monitor them (Correct answer)
- The government will run budget deficits to fund insurance payouts
- Uninsured depositors will cause bank runs at insured institutions
- Interest rates will be set too low due to government intervention
Correct answer: Insured banks will take on excessive risk because depositors have no incentive to monitor them
Deposit insurance removes depositors' incentive to discipline bank risk-taking, encouraging banks to pursue riskier strategies, which is the classic moral hazard problem.
Question 6: Which of the following best describes 'seigniorage' revenue?
- The spread banks earn between loan rates and deposit rates
- The government's profit from issuing currency whose face value exceeds production cost (Correct answer)
- Tax revenue collected on capital gains from bond trading
- Central bank profits distributed to the Treasury from interest on reserves
Correct answer: The government's profit from issuing currency whose face value exceeds production cost
Seigniorage is the economic gain a government receives from creating money, equal to the difference between a currency's face value and its cost of production.
Question 7: If the real interest rate on a loan is 3% and inflation unexpectedly rises from 2% to 5%, who benefits?
- The lender, because higher inflation raises the nominal return
- The borrower, because the real burden of debt falls (Correct answer)
- Both parties equally, because the nominal rate adjusts automatically
- Neither party, because inflation is neutral in the short run
Correct answer: The borrower, because the real burden of debt falls
Unexpected inflation erodes the real value of fixed nominal debt payments, redistributing wealth from creditors to debtors.
MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 4
A commercial bank's capital adequacy ratio under Basel III requires common equity tier-1 (CET1) capital of at least what percentage of risk-weighted assets?