Mastering ECO 202: Bank Balance Sheets, IS-LM, and AS/AD in a Hydrogen Economy

Introduction: Why ECO 202 Matters for Today's Economy

Whether you're cramming for ECO 202 Test 3 or just want to understand how banks, government policy, and tech shocks shape the economy, this tutorial breaks down the core concepts with real-world examples. From the latest hydrogen-powered aircraft to universal basic income debates, we'll connect the dots between textbook models and the headlines you see in 2026.

1. Bank Balance Sheets: The 5% Reserve Ratio and Capital Requirements

Finding the Value of Loans (x)

In a bank's balance sheet, assets must equal liabilities plus net worth. Given: Loans = x, Deposits = 2000, Investment = 4000, Short-term Debt = 1000, Cash and Reserves = 100, Long-term Debt = ?, Net worth = 2000? Actually from the problem: Net worth is 1100? Wait, let's re-read: The balance sheet shows: Column A: Loans x, Investment 4000, Cash and Reserves 100; Column B: Deposits 2000, Short-term Debt 1000, Long-term Debt ?, Net worth 1100? The problem says "Net worth 2000 1100" – likely a formatting issue. Let's assume total liabilities + net worth = 2000 (deposits) + 1000 (short-term debt) + 1100 (net worth) = 4100. Then assets = loans + 4000 + 100 = loans + 4100. So loans must be 0? That doesn't make sense. Actually, the excerpt might be misaligned. For educational purposes, we'll explain the method: Assets = Liabilities + Net Worth. So if total liabilities and net worth are known, you solve for loans.

Example: Suppose a bank has deposits $2000, short-term debt $1000, net worth $1100, then total liabilities and net worth = $4100. Assets include investment $4000, cash $100, so loans = $4100 - $4000 - $100 = $0. That's unrealistic but illustrates the accounting identity.

Capital to Asset Ratio and Reserve Ratio

The capital to asset ratio is net worth divided by total assets. The reserve ratio is reserves divided by deposits. With a required reserve ratio of 5%, the bank must hold at least 5% of deposits as reserves. If it holds exactly 5%, then reserves = 0.05 * 2000 = 100, which matches the given cash and reserves. So the bank meets the reserve requirement.

Capital Requirement Check

If the required capital to asset ratio is 5%, then net worth must be at least 5% of total assets. Total assets = loans + investment + cash = 0 + 4000 + 100 = 4100. 5% of 4100 = 205. Net worth is 1100, so it meets the requirement with excess capital of 1100 - 205 = 895.

After Reform: 20% Capital to Asset Ratio

Now the bank must have capital equal to 20% of assets. 20% of 4100 = 820. Net worth is 1100, so it meets the requirement with excess capital of 1100 - 820 = 280.

Leverage Ratio and Percentage Gain

Leverage ratio is total assets divided by net worth = 4100 / 1100 ≈ 3.73. If investment increases to 4200, total assets become 4300, net worth becomes 4300 - 2000 (deposits) - 1000 (short-term debt) - long-term debt? Actually, we need to keep liabilities constant. Assume long-term debt is unchanged. The increase in assets (100) increases net worth by 100, so new net worth = 1200. Percentage gain = (1200-1100)/1100 ≈ 9.09%.

2. IS Curve with Cash Flow Effects

Expected Range of Parameter x̄

In the investment equation I = I0 - b r + x̄ Y_e, where Y_e is expected output, the parameter x̄ captures the sensitivity of investment to expected output. Typically, x̄ is between 0 and 1, as investment increases less than one-for-one with expected output.

Agency Problems in Financing

Two types of agency problems are: (1) Moral hazard – after borrowing, the borrower may take excessive risks because the lender bears the downside. (2) Adverse selection – those most likely to default are most eager to borrow, leading lenders to ration credit.

Deriving the IS Curve

Start with the goods market equilibrium: Y = C + I + G. Assume C = a + b(Y - T), I = I0 - b r + x̄ Y_e, G = G0. For simplicity, set T = 0 and Y_e = Y (static expectations). Then Y = a + bY + I0 - b r + x̄ Y + G0. Rearranging: Y - bY - x̄ Y = a + I0 + G0 - b r => Y(1 - b - x̄) = A0 - b r, where A0 = a + I0 + G0. Thus Y = (A0 - b r) / (1 - b - x̄). This is the IS curve: output decreases with real interest rate r.

Fiscal Policy in a Recession

If the economy faces a recession with Y_e = -10% (meaning output gap of -10%), the government can increase spending (increase a_G in the IS curve). The multiplier is 1/(1 - b - x̄). To close a 10% output gap, the required change in autonomous spending is 10% * (1 - b - x̄). If b=0.6 and x̄=0.2, multiplier = 1/(1-0.6-0.2)=5, so government spending must increase by 2% of GDP. Since the multiplier is >1, the government needs to spend less than the output gap (2% < 10%).

3. AS/AD Model: Hydrogen-Powered Aircraft Shock

Initial Impact on Inflation

Assume the economy is in steady state with π0 = π̄ and output gap Y_e = 0. The innovation reduces transportation costs, causing a one-time decrease in prices (ō < 0). This shifts the AS curve down. The AD curve may also shift if expectations change. Given the problem states the impact on short-run output from AD is larger than from AS, the net effect is an increase in output and a decrease in inflation. So π1 < π0.

Adjustment in Period 2

In period 2, the AS curve shifts back as the one-time price shock is over, but the economy now has a positive output gap. According to the AS/AD model, inflation will rise. So π2 > π1.

Graphical Illustration

Draw a graph with inflation on the vertical axis and output gap on the horizontal. Initially, AD and AS intersect at (0, π̄). The negative ō shifts AS down, and the positive expectation shock shifts AD right. The new intersection has positive output gap and lower inflation (π1). In the next period, AS shifts up due to the output gap, leading to higher inflation (π2) and output gap partially closing.

4. Central Bank Policy Responses

Decline in Canadian Lumber Demand

A decline in export demand reduces aggregate demand, lowering output and inflation. The central bank should lower interest rates (expansionary monetary policy) to stimulate investment and consumption, offsetting the negative demand shock.

Universal Income Program

A large increase in government spending (without tax increase) shifts AD right, boosting output and inflation. The central bank should raise interest rates (contractionary policy) to prevent overheating. However, if the program is financed by borrowing, it may also affect long-term interest rates.

Conclusion

Understanding these models helps you analyze real-world events like the hydrogen aviation breakthrough or policy debates in 2026. Practice with the calculations and graphs to ace your ECO 202 Test 3.