At a recent staff meeting of Economic Advisers Inc., a think-tank located in Washington, DC, Mitchell Jung made the following statements regarding the main economic functions of depository institutions. Statement 1: One of the main economic functions of depository institutions is to act as financial intermediaries. By doing so, they lower the borrowers’ cost of funds from what it would otherwise be if borrowers had to seek out individuals willing to lend. Statement 2: Depository institutions create liquidity by using loans they take in to have funds available to pay interest on short-term deposits. Are Statement 1 and Statement 2 as made by Jung correct? Statement 1 Statement 2 A) Incorrect Incorrect B) Incorrect Correct C) Correct Correct D) Correct Incorrect The answer is D. ------------------------------------ Why is statement 2 incorrect? Is statement 2 incorrect because “taking in a loan” doesn’t make sense? It doesn’t necessarily mean collecting on a loan…so I guess if that were true I can see how statement 2 is incorrect. But I’m sure when the bank collects on a loan some of that interest goes to interest on deposits. Am I right?
yeah, it should read something like: “Depository institutions create liquidity by using deposits they take in to create loans” or “Depository institutions create liquidity by using loans they take in to have funds available (to lend money and) to pay receive interest on short-term deposits”
Yup, yosh is on target. Just think of the reserve multiplier, they’re using their deposits to create loans until they become fully “loaned up.”