Depository Institution

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1a)Explain the characteristics of the three types of depository institutions.

Depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms. There are three types of depository institutions that are commercial banks, thrift institutions and money market mutual funds.

i) Commercial banks
Is a firm that is licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans. The aim of a bank is to maximize the net worth of its stockholders. To achieve this objective, the interest rate at which a bank lends exceeds the interest rate at which it borrows. But a bank must perform a delicate balancing act. Besides, a bank must be prudent in the way it uses its deposits, balancing security for the depositors against profit for its stockholders. To achieve securities for its depositors, a bank divides the funds it receives in deposits into two parts that are reserves and loans.

Reserves are the cash in the bank’s vault plus its deposits at Federal Reserves banks. A bank keeps only small fraction of its funds in reserves and lends the rest. It has three types of assets which are firstly, liquid asset. For example, U.S government Treasury bills and commercial bills. The second asset is investment securities, that are longer- term U.S government bonds and other bonds.

Loans are commitments of fixed amounts of money for agreed-upon periods of time. Example of loan is outstanding balances on credit card accounts.

ii) Thrift institutions
The thrift institutions are savings and loan associations, savings banks, and credit unions.

Savings and loan association is a depository institution that receives checking and savings deposits and that make personal, commercial and home purchase loans. Saving banks is a depository institution that accepts savings deposits and makes mostly home-purchase loans. Some savings banks that are called mutual savings banks are owned by their depositors.

Credit union is a depository institution owned by a social or economic group such as a firm’s employees that accepts savings deposits and makes mostly personal loans.

iii) Money market mutual funds
It is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S Treasury bills or short term commercial bills. This type of depository institution shares act like bank deposits. Shareholders can write checks on their money market mutual fund accounts. But there are restrictions on most of these accounts. For example, the minimum deposit accepted might be $2500 and the smallest check a depositor is permitted to write might be $500.

1b)What factors affect the demand for money?

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Demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.

First factor: interest rate
A change in the interest rate brings a movement along the demand for money curve. Figure a shows a demand for money curve, MD. Initially, the interest rate of money is 5 percent per year and quantity of real money demanded is 3.0 trillions dollars at E1. When the interest rate rises from 5percent per year to 6percent per year, everything else is remaining the same, the opportunity cost of holding money rises, and quantity of real money demanded decreases from 3.0 trillions dollars to 2.9 trillions dollars. So, there is a movement up along the demand for money curve, shown by (a), and the equilibrium changes from E1 to E2. However, when the interest rate falls from 5percent per year to 4percent per year, the opportunity cost of holding money falls and quantity of real money demanded increases from 3.0 trillions dollars to 3.1 trillions dollars. So, there is a movement down along the demand for money curve, shown by (b), and the equilibrium changes from E1 to E3....
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