Final answer:
The correct answer is option 3. The term 'asset-liability time mismatch' describes a situation where a bank's short-term liabilities are funded by long-term assets, which can create liquidity risks. Banks can mitigate these risks through diversification and maintaining higher reserves.
Step-by-step explanation:
In macroeconomics, the term asset-liability time mismatch describes a situation where a bank's liabilities, such as customer deposits, can be withdrawn in the short term, while the assets of the bank, primarily loans, are being repaid over a longer term. This mismatch can lead to liquidity risks for the bank if a large number of depositors decide to withdraw their funds at the same time.
The assets of a bank, listed on a balance sheet, may not be sufficiently liquid to cover these sudden withdrawals, especially since loans and bonds, which are part of a bank's assets, are repaid over several years. The bank's net worth or bank capital is calculated by subtracting its liabilities from its assets and can be negatively impacted by an asset-liability time mismatch.
To mitigate this risk, a bank can diversify its loan portfolio or maintain a higher reserve ratio, which is the fraction of deposits held as reserves, as a buffer against potential liquidity challenges. This principle of banking operations highlights the delicate balance between maintaining liquidity and profitability and underscores the essential role banks play as financial intermediaries in an economy where coins and currency in circulation are part of the broader money supply.