19. 18. Frederic S. Mishkin (1997). The Causes


Luisa Blanco and Michael Crouch (2011). In the Aftermath of the Financial
Crisis of 2008: What Have We Learned? Pp. 13-19


shortly after house prices started to fall from their all-time high, subprime
market began collapse. March 2007 was marked with the failure of Bear Stearns,
which was followed by Lehman Brothers bankruptcy and many others. The Federal
Reserve implemented monetary policies to put downward pressure on long-term
interest rates and help the financial stability of the economy. This was done
by buying securities, such as ten-year bonds and mortgage-backed securities
using quantitative easing, forcing interest rates down and rescuing troubled
firms and institutions.19 The balance of money demand and supply in an economy
is crucial. Equilibrium of these both can let the economy grow in a smooth path
and with relatively stable prices.

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The financial
crisis of 2008 made all sectors of our economy unstable. The money demand and
money supply equilibrium was in disorder. Because of the rapid growth of
mortgage backed securities, housing prices and low interest rates, the
financial sector was booming. Banks, companies and individuals wanted to invest
and there was a great demand for money. The Federal Reverse purchased MBS
(Mortgage Backed Security) products essentially increasing the money supply and
boosting the economy.


Frederic S. Mishkin (1997). The Causes and Propagation of Financial
Instability: Lessons for Policymakers. Pp. 75-91


The central
bank uses money to indirectly influence the economy, using monetary policy it
can help to stabilize the economy assuming that money demand is stable. On the
other hand, money demand can become volatile and monetary policies will also
influence real and nominal interest rates and there is a big chance of economic
fluctuations. If monetary and credit conditions are too relaxed, then there may
be higher levels of spending which would cause prices and in turn inflation to
increase. High money supply can cause inflation and high inflation erodes the
value of money and assets. Germany in the 1920s, Zimbabwe in 2004 and a more
recent example – Venezuela in 2013 all experienced hyperinflation, which caused
major economic instability and social unrest.18


Everycrsreport.com. (2018). Monetary Policy and the Federal Reserve: Current
Policy and Conditions. online Available at:
https://www.everycrsreport.com/reports/RL30354.html Accessed 8 Jan. 2018.

Geert Bekaert, Marie Hoerova and Marco Lo Duca (2013). Risk, Uncertainty and
Monetary Policy. Pp. 760-787

Tejvan Pettinger. (2015). The link between Money Supply and Inflation,

Robert L. Hetzel. (1984). A Monetarist Money Demand: Function. Pp. 15-19

Taradas Bandyopadhyay and Subrata Ghatak. (1990). Current Issues in Monetary
Economics. Pp. 12-15



To counter this
the central bank implements contractionary monetary policy. By raising the bank
rates, increasing reserve requirements or using open market operations, central
banks effectively decrease the money supply and in turn slow down economic
growth, spending and borrowing and increase unemployment, but its main purpose
is to target inflation. The target inflation rate is near 2 percent, which is
considered to be the best for price stability and maximum employment.17


Notes: graph
shows Us interest rate changes. After the financial crisis of 2008, Ben
Bernanke, former chairman of the Federal Reverse, pushed the interest rate to
nearly zero.




The central
bank can use expansionary monetary policy to stimulate the economy, increasing
the money supply it in turn will increase consumer spending, economic growth
and decrease unemployment. As a result interest rates will go down and money
demand will go up. However, the central bank risks triggering inflation if it
injects too much liquidity. In that case demand increases faster and businesses
start to up their production and hire additional workers. If businesses expect
prices to rise they will in turn raise the prices of their products or services
to counteract inflation. If the central bank doesn’t intervene inflation may
increase even more and there is a risk of hyperinflation.16

Having said
that, raising money supply because of money demand increase caused by a price
jump rather that an output increase is unwise, as that would most likely
intensify the problem of inflation, rather than stabilizing it.15

Nonetheless, a
slow increase in money supply will have a stabilizing effect on the economy
over time. Real GDP growth will increase money demand and will in turn increase
nominal interest rate. If the money supply and money demand both increase, the
central bank can stabilize nominal interest rates.

If there was an increase in nominal income, it would shift the money demand
curve, and raise the equilibrium interest rate.


Because the
elements that influence money demand are difficult to calculate directly,
central banks judge how monetary policy affects money demand using statistics.
Nevertheless, because money demand fluctuates considerably in short-term, the
relationship between inflation and money supply is weak.

If, for
example, interest rates are too high to begin with, it means that quantity of
money supplied is greater than the demand for it. The response to this would be
a purchase of bonds by the government which would reduce money and the greater
demand for the bonds would push interest rates down.14

Money demand depends negatively on the interest rate, and positively on price
level and real income.


As the interest
rate goes up, people will be more likely to hold money and vice versa. The
interactions of money supply and demand affect interest rates and also reflect
the level of risk that lenders and investors are prepared to accept. 13

Having money in
the bank and not using it has an opportunity cost, meaning it can be invested
and earn interest. A simple form of earning interest is to put money into an
account which earns interest over time and is very safe. Interest rate
describes the cost of holding money. It tells you how much you can earn by
lending out that money and holding interest-bearing securities such as bonds or


Section B – Question 4



12. Stijn
Claessens and Laura Kodres (2014). The Regulatory Responses to the Global
Financial Crisis: Some Uncomfortable Questions. Pp. 15-29


11. Thomas
A. Russo, Aaron J. Katzel(2011). The 2008 Financial Crisis and Its Aftermath:
Addressing the Next Debt Challenge. Pp. 47, 64-88


10. Anna J.
Schwartz (2008). Origins of the Financial Market Crisis of 2008. Pp. 20-23


9. M.
Brunnermeier (2009). Deciphering the Liquidity and Credit Crunch 2007–2008.
Journal of Economic Perspectives. Pp. 77-100


8. Raja Almarzoqi, Sami B. Nazeur, Alessandro
D. Scopelliti (2015). How Does Bank Competition Affect Solvency, Liquidity and
Credit Risk? Pp. 11-25

As said by the
Bank of international Settlements in Basel it shows that 30 of the world’s most
important and globally influential banks altogether increased their equity by
around €1trn, largely through retained earnings. Hopefully these new
regulations will help the economy to fully recover from the crisis and improve
how it handles liquidity and solvency.12

Another big
change is more demanding capital requirements and liquidity rules. To manage
liquidity issues and keep banks safe from another crisis central banks improved
international laws, known as Basel III, which made banks collect and stock up
their convertible debt and equity. This helps the financial institutions,
central banks, governments and the economy because if banks face a troubling
liquidity issue it can still “soak up” the worst of it.

Since the
financial crisis, the government and central banks implemented new laws and
regulations which helped to deal with liquidity and solvency problems. The
biggest change implemented could be easily identified as regulations, more
specifically – stress tests. Small control was replaced with tight supervision
and banks were required to make more regular and thorough analysis. JP Morgan
increased the number of employees working on stress testing and liquidity
control by around 44% to 43,000 people, from 2011 to 2015 and it keeps growing.11

an example of how money was used by UK banks. Figures from Bank of England.

The Federal
Reserve Bank had to help the banks in trouble and in Section 13-3 of the
Federal Reserve Act it is stated: “In unusual and exigent circumstances the Fed
could lend to any institution, as long as the loan was secured to the
satisfaction of the Federal Reserve Bank.” This of course meant that banks have
to be solvent. During that time many banks faced liquidity crisis because money
markets “dried up” and many banks couldn’t get access to enough cash. In this
case Central Banks offered short term liquidity in cash injections ensuring the
liquidity issue doesn’t turn into an insolvency crisis.

On the
contrary, Paul Krugman and Anna Schwarz suggest that the reason there was a
liquidity issue is because the market realised that most banks were facing
insolvency. Some banks had liquidity and could afford to help others, but were
too afraid that the most banks were insolvent and so decided to accumulate as
much capital as possible, even though lending short-term money out to other
banks is considered very safe – almost as safe as lending to the government.10

This shows how the US mortgage market lending changed. Figures from Board of
Governors of the Federal Reserve System.

A good example
of solvency and liquidity issues is The Financial Crisis of 2008. Analysts
argued if it was a liquidity crisis or a solvency crisis. Those who endorse the
idea that it was a liquidity crisis argument that it was a “run” on repo
securities. John Cochrane, Robert Lucas, Nancy Stokey and others suggest that
instead of running to withdraw their money, repo customers started a fire sale
of repo securities and prevented banks from borrowing short-term. This has been
characterized by the Diamond – Dybvig model.9

However, there
are situations where a bank may undergo a liquidity issue and if it can’t pay
its short-term debts it may have to sell off assets, just to get the funds they
need. On the other hand, if a bank faces insolvency it means even if it could
sell off all assets and withdraw their loans, for example – mortgages, it still
wouldn’t be able to meet its liabilities.8

Solvency and
liquidity both refer to the financial health of a company or a bank, however
solvency refers to the ability to meet its debt and other obligations, whereas
liquidity is the ability to raise cash quickly. Both of these are equally
important, and financially healthy banks both possess decent liquidity and are


Laurence Weiss (1980). The Effects of Money supply on Economic Welfare in the
Steady State. Vol. 48, pp. 565-576

Basil J. Moore (2015). The Endogenous Money Supply. Pp. 372-383


The decrease in
money supply typically increases interest rates, which in turn reduce the
purchasing power, consumption and investment expenditures, net exports and
government purchases, resulting in a decrease in aggregate demand. This is
called a contractionary monetary policy and is used in accordance with other
government or central bank policies.7

The effect on Interest Rate following an increase in Money Supply.


Money supply is
the total quantity of liquid assets available in a country’s economy at a particular
time. It is used for controlling interest rates, inflation and increasing or
decreasing the flow of money. The central bank controls the money supply using
methods such as selling government bonds, increasing the interest rate at which
banks borrow from the central bank and increasing reserve requirements.6




5. Hans
Amman, Berc Rustem and Andrew Whinston (1997). Computational approaches to
economic problems. Pp. 144-150


4. Richard
Swedberg, (2010). The structure of confidence and the collapse of Lehman
Brothers. Volume 30, Part A


3. Luci Ellis. (2018). Stability, Efficiency, Diversity:
Implications for the Financial Sector and Policy. Reserve Bank of


2. J.
Danielsson, B. N. Jorgensen, C. G. de Vries, and X. Yang. (2008). Optimal
portfolio allocation under the probabilistic VaR constraint and incentives for
financial innovation.


1. Song, F. and Thakor, A. (2007). Relationship
Banking, Fragility, and the Asset-Liability Matching Problem.


As we can see,
the liabilities and assets of financial institutions can be quite complex. To
manage risks that arise because of mismatches between assets and liabilities
the Asset-liability management (ALM) strategies are used.They minimise risk,
loss of profit and help banks increase their asset value. These include the use
of interest rate risk management and hedging, using financial futures, swaps,
options and the use of derivatives. Using these techniques banks can understand
asset and liability structures better, operate with less risk, more efficiency
and profitability.5

Notes: Global
Liquidity Indicator showed just how illiquid and unprepared the banking system
was during the financial crisis.


A good example of how investment
banks mishandled their assets and liabilities is shown by the collapse of the
largest investment bank Lehman Brothers. When Lehman Brothers started to
collapse, its debts (liabilities) were much greater than its assets. Therefore, even though it had access to
temporary funds from the Federal Reserve, this access to liquidity couldn’t
solve the underlying problem that it couldn’t meet its liabilities and on
September 15 2008 the bank declared the largest bankruptcy filling in U.S


for investment and universal banks, they generally have most of their assets in
trading, reverse repo finance and less in loans. The same distinction is on the
liability side, where commercial banks tend to have mostly deposits, universal
and investment banks typically have mostly repo finance, trading and other
debt. 3

In the case of commercial banks,
they make their profits by taking small, short-term liquid deposits from savers
and putting these into larger, longer maturity loans e.g. mortgages or business
loans. But in order to minimise risk, banks have to diversify their assets,
since they can’t put all their funds into long-term loans, as that would put
them into a dangerous position if the loans went bad. Thus, banks diversify
their assets, putting funds into long-term and short-term loans, offshore securities,
gold, cash etc., and they effectively reduce risk, improve their liquidity, and
in the situation that if there is a market downturn they will have a better
chance of survival.2

management has become a complex endeavour. Knowledge of the different
factors that take upon this aspect of risk management is crucial to find
appropriate solution. Accurate asset allocation accounts not only for the
growth of assets, but also addresses the nature of a banks liabilities.Macroeconomic conditions, sovereign and
financial market tensions and monetary policies can change rapidly, as shown by
the 2008 financial crisis, andit is important to ensure asset quality and
profitability in response to the changing environment.1

The asset and
liability structure is important for banks in order to maximise profitability,
increase effectiveness and stability and minimise risk. With afaultystructure the
banks may be in a vulnerable position when there are changes in interest rates,
inflation, banking legislationsand global economy.