Reference no: EM133129365

Assume that in an economy where central bank only lends against treasury bills, there are only two banks and a central bank and the balance sheets of Bank A & Bank B look like below.

T-accounts previous to the exercise

Bank A

Assets	Liabilities + Equity
Reserves 10 Loans 50 Lending to Bank B 40 Treasury Bills 40 Other securities 20	Deposits 100 Other liabilities 50 Capital 10
Total Assets =  160	Liabilities + Equity = 160

Bank B

Assets	Liabilities + Equity
Reserves 10 Loans 130 Treasury Bills 40 Other securities 20	Deposits 100 Borrowing from Bank A 40 Other liabilities 50 Capital 10
Total Assets =  200	Liabilities + Equity = 200

1. Now assume that following a panic in the financial system, Bank A stops lending to Bank B in the interbank markets. What will Bank B have to do if the central bank does not act as a lender of last resort? How would the balance sheets look like if the central bank lends to Bank B.
2. Now assume that after Bank A gets back its interbank loan from Bank B, the government immediately implements a spending policy and consumers receive a tax rebate worth £60, which is distributed equally between the two banks. How would this affect the balance sheets?
3. As a response to its liquidity problems, assume that Bank B borrows $100 from a US bank (assume £1=$2). Could it use these dollars as reserves? How?
4. Using the initial balance sheets given in the question, assume this time that following a crisis, Bank B's customers cannot pay back their loans and loan default ratios reach 25%. What does Bank B's balance sheet look like in this case? How can the central bank/government solve the problem now?
5. Using the same initial balance sheets given in the question, now assume instead that following the crisis, panic leads to a fire sale of securities in the markets and an increase in bond interest rates, thus leading to a 10% drop in treasury bill prices and 60% drop in securities prices. What does bank B's balance sheet look like now? Can the central bank do anything about this?