0
Q
Unexpected inflation
A
- Transfers from creditors to debtors (debtor pays 6% on loa an either way, so inflation negatively impacts creditor)
- Reduction in real wages (salary contract locks you in)
1
Q
Inflation
A
Sustained increase in price level
2
Q
Costs of inflation
A
- Expected inflation
- Unexpected inflation
- Inflation uncertainty
3
Q
Expected inflation
A
Spend more resources (ie brokerage fees) to minimize cash balances
4
Q
Inflation uncertainty
A
- Adds a risk premium to interest rates
2. Can make investment planning difficult (effectively a tax on investment)
5
Q
Causes of inflationary monetary policy
A
- Inflation tax
- Faulty central bank policies
- Attempts to monetize government debt
- Political explanations
6
Q
Why is the potential for instability greater in financial services than in non-financials?
A
- Leverage- different standards for financial institutions (average was 10:1), which leaves them with a thinner cushion to respond to negative shocks
- Liquidity- short term deposits finance long term transactions, making them more vulnerable to liquidity squeezes
- High degree of interconnectedness to other institutions
7
Q
Inflation tax
A
Tax the holders of government money by increasing the growth rate of the money supply. The real revenue from government money creation can be expressed as the difference between the money stock today and the money stock last period divided by the price level today: (Mt-Mt-1)/Pt
8
Q
Faulty central bank policies
A
Policies by the fed to:
(I) accommodate high wage demands (II) accommodate increases in other input prices (eg oil)
(III) achieve too low of an unemployment
(IV) achieve too high of a GDP target
-all could lead to inflation
9
Q
Attempts to monetize government debt
A
Budget deficits have no impact on monetary base or supply. If the CB, however, decides to increase its purchases of government debt when the government is running large deficits, then this policy choice can lead to inflation. Note it is the political pressure that is the cause of inflation, not the deficit itself.
10
Q
Political explanations
A
The desire of a Fed chairman to be reappointed and the desire of a politician to be reelected can put pressures on the monetary authority to inflate in order to achieve a short-term goal of the appearance of improved economic conditions
11
Q
What causes deflation?
A
Consistent decline in aggregate demand
12
Q
What is crucial difference between ‘normal recession’ in which the inflation rate is at least modestly positive and deflationary recession?
A
- Delay consumption
- If wages are sticky, real costs of production increase, aggregate supply shifts back
- Real debt burdens rise
13
Q
Describe real debt burden increase cycle
A
- Real debt burden rises ->
- increase real costs of debt and debt service. ->
- Demand is reducing, so you get less per unit & sell fewer units ->
- bankruptcy ->
- asset value declines ->
- unemployment rate increase ->
- AD reduces even further ->
- steeper deflation ->
- increase in debt burden
14
Q
What policy actions can try to prevent deflation?
A
- Preemptively reduce interest rates and provide reserved to system to increase money supply
- Buffer zone for target inflation rate (during normal times do not try to push inflation all the way to zero). Normal inflation target is around 2%
- Use forward guidance to convince people the fed will fight deflation
- Act as lender of last resort -> provide liquidity to maintain a functioning financial system
15
Q
Once monetary policy is at the zero interest rate lower bound, what are the actions a central bank can undertake to cure the deflation or prevent it from taking hold?
A
- Push interest rates further down, slightly below zero, which is what the ECB is considering
- Large scale asset purchases “QE”- buy long term assets bc short term rates are already at zero
- Forward guidance- commit to low interest rates for long horizon
- Expand maturity of lending, collateral that’s accepted, and counter parties
- Buy foreign bonds
16
Q
Phillips curve
A
- Describes the relationship between a measure of real economic activity (unemployment rate x axis) and a nominal variable (rate of changes of prices or nominal wages y axis) in the short run.
2 In the long run, it is vertical since unemployment level returns to its natural rate. - Graphs trade off between inflation and unemployment
17
Q
Source of inflation
A
Only money supply growth leads to continually rising general price level. While supply shocks and changes in government expenditure can lead to one-time increases, they cannot cause inflation
18
Q
How has the financial system evolved to increase the layers/chains of intermediation and what are the implications for financial fragility?
A
- interconnections
- more involvement in a variety of markets
- over-the-counter derivatives -C.D.S.
- globalization
- consolidation in the industry
- securitization
- credit rating agency (conflict of interest- who was issuing the security was paying the CRA to advise them on how to structure the security)
19
Q
What are some of the key contributing factors to the financial crisis?
A
- High reliance on short term external finance (commercial paper and repo agreements)
- Excess risk taking and poor risk management (false sense of confidence with Freddie & Fannie guarantees), moral hazard (large banks assume fed will step in & find a partner for them), lack of transparency & complexity of securities
- Over allocation of resources in real estate (global savings glut- a lot of capital was flowing in from emerging markets), poor mortgage underwriting (permitting high loan to value ratios, high leverage and very little skin in the game)
20
Q
What are traditional crisis responses by central banks?
A
- Direct lending (discount window lending)
- Open market operations
- Reserve requirements (rarely used)
- no guarantees that these bank reserves will revive lending
21
Q
What was the motivation for the non-traditional responses by the federal reserve and how can those “non-traditional” uses of the asset side of the Fed balance sheet be categorized?
A
Motivation: With interest rates at zero, you aren’t going to spur more investment. Lower bound interest rate at zero bc people would rather hold cash than earn a negative ROI.
- intermediation by banks “broken”- give $ to banks and they’ll allocate it out but banks were so concerned with their own survival, they were hoarding liquidity.
- non-banks became crucial
22
Q
Non traditional uses of the asset side
A
- Expand collateral that was accepted (ie commercial paper market)
- Expand counter parties
- Lengthen maturity- stabilize system- need to guarantee that money isn’t going to disappear tomorrow
23
Q
What did the fed do to remove the stigma associated with discount window borrowing?
A
- It put the term auction facility in place. It initially made 28-days available and eventually increased to as long as 84 days.
- It can also bring the fed funds rate and the discount rate closer together
24
Given the fed has a balance sheet roughly two times bigger, what tools does it have to maintain control of growth of the monetary base and the fed funds rate as the economy recovers?
1. Provide interest on reserves (incentivizes banks to hold reserve balances rather than lend them out).
2. Offer interest-bearing deposits for excess reserves (which commits the bank to keep its reserves with the fed for a specified period of time).
3. Traditional tool of reverse repurchase agreements (drains reserves directly from the system)
25
True or false: reinstating glass steagall would insulate banks from financial market shocks and help promote stability
False. Bear Stearns, Merrill lynch and Lehman were not commercial bank holding companies. The downfall of wamu, indymac and wachovia was primarily due to risky choices and concentrations in mortgage origination and lending, unrelated to investment banking
26
Bitcoin advantages
1. solves Byzantine generals problem- established trust between otherwise unrelated parties
2. low to nonexistent fees - great for small businesses and remittance population
3. Eliminates risk of credit card fraud
27
Basel II
Pillar I: minimum capital requirements
Pillar II: Supervisory review process
Pillar III: disclosure & market discipline
28
Impacts of the end of bank branching restrictions across states on the banking industry?
1. Consolidation (small, low capital, low profit, community banks disappeared)
2. Increased diversification (lower volatility)
3. Increased competition
29
Is there an impact on banking deregulation on entrepreneurship?
1. New business formation
2. More credit available
3. Lower interest rates/borrowing costs
4. Positive impact on state GDP (volatility of state gdp growth declines)
30
Why does monetary policy need to be forward-looking and preemptive?
If the CB waits, inflation expectations will already be embedded in the wage and price setting policy process, creating an inflation momentum that will be hard to halt.
31
Why does inflation become harder to control once it has been allowed to gain momentum?
Because higher inflation expectations become ingrained in various types of long term contracts and pricing agreements. There is a long lag (up to two years) before inflation policy takes effect.
32
Why is forward guidance important?
It puts downward pressure on longer term interest rates and thereby lowers the cost of credit for businesses and home buyers.
33
In what way is the us economy insulated from inflation?
1. Resilience & structural stability (flexible & efficient markets for capital & labor helps)
2. Entrepreneurial tradition
3. Healthy, well-regulated banking system
34
Define deflation
General decline in prices
35
Define 'zero bound'
Once nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept negative interest rates and instead will hold cash.
36
Dual mandate of the Fed
Price stability (long run goal) and maximum employment (short term focus). There is no long run trade off between the two.
In the short run, the fed may have to sacrifice output and increase interest rare instability to prevent the economy from overheating (due to inflation).
37
Inflation targeting
1. Public announcement of medium term numerical targets for inflation
2. An institutional commitment to price stability as the primary, long run goal of monetary policy and the commitment to achieve the inflation goal
3. Information approach in making decisions about monetary policy
4. Increase transparency of monetary policy strategy to public & markets
5. Increased accountability of CB for attaining inflation objectives
38
Fed funds rate
Rate at which banks borrow from each other overnight. It is the base rate that determines the level of all other interest rates in the us economy.
39
How can the fed raise interest rates under normal circumstances?
The FOMC can reduce the supply of reserves. Banks have to hold a minimum level of reserves, and when the supply falls, they have to pay more to borrow them. They then pass that rate on to their customers.
40
Considering the $3 trillion in excess reserves, how will the fed eventually raise interest rates?
It can raise the rates it pays on excess reserves. Then, banks won't want to lend for anything less.
41
Reverse repurchase agreements
Agreement to buy a security and sell it in the future. If fed starts doing this and offers a relatively high rate, broker dealers would be forced to compete and offer higher rates.
42
Impact of IOER (interest on excess reserves)
Puts a floor on interest rates even as the fed is increasing its balance sheet. If banks can earn 25bps by holding reserves at the fed, then they will be unwilling to lend at a rate below 25bps. But not all banks can benefit from holding reserves at the fed, so the rate is below 25 bps.
43
How does friedmans approach differ from the Keynesian approach?
1. Friedman viewed permanent income (Yp) as more important than current income in determining money demand
2. Friedman considers multiple rates of return and considers the relative returns to be important (Interest rate on M is positive & can vary)
3. Friedman viewed money and goods and substitutes (more than just bonds compete with money as store of value)
44
The three primary motives for holding money according to Keynes:
1. Transactions motive
2. Precautionary motive
3. Speculative motive
45
Transactions motive
Money is a medium of exchange, and people hold money to buy stuff. So as income rises, people have more transactions and will hold more money. This doesn't factor in advanced in payment technology, which reduces the demand for money.
46
Precautionary motive
People hold money as a cushion against unexpected wants or emergencies. Precautionary money demand is again expected to rise with income.
47
Speculative motive
The opportunity cost of holding money (which earns no interest) is the nominal interest rate on bonds, i. As the interest rate i rises, the opportunity cost of money rises and the quantity of money demanded falls. Thus, money demand is negatively related to the interest rate.
48
Keynes made the following assumptions:
1. Money and bonds are the only assets
| 2. Money pays no interest but bonds pay interest
49
Equation of exchange
MV=PY
| The aggregate nominal income equals the money stick times the average rate of money's turnover.
49
Income velocity of money
Average number of times per year that a dollar is spent purchasing the total amount of final goods and services produced in the economy.
49
Income velocity of money equation
V=PY/M
M=nominal stock of money
Y=real aggregate output in one year
P=an index of prices
50
Classical quantity theory assumptions
1. Md is purely a function of nominal income (PY)
| 2. Interest rates play no role
51
Classical quantity theory equation
```
Md=k x PY, where k is roughly constant and k=1/V
Md=money demand
k= some constant variable
P=price level
Y= aggregate output/income
```
52
What two assumptions did fisher make regarding the quantity theory of money?
1. Velocity is constant in the short run. This is bc velocity is affected by institutions and technology that change slowly over time.
2. Flexible wages and prices guaranteed output, Y, to be at its full employment level, so Y was also constant in the short run.
53
If V and Y are constant, what does the quantity theory of money say?
A change in the money supply, M, results in an equal percentage change in the price level, P.
54
What is the big difference between fisher and Keynes theories?
Keynes places importance on interest rates. Since interest rates fluctuate quite a bit, then velocity must too.
55
Why is friedman's money demand more stable than Keynes?
1. Permanent income is very stable, and
2. The spread between returns will also be stable since returns would tend to rise or fall at once, causing the spreads to stay the same. So in friedman's model, interest rates have little or no impact on money demand. This is not true in Keynes model.
56
Monetizing the debt
The government does not have the right to issue currency to pay for its bills. The government must finance its deficit by first issuing bonds to the public to acquire extra funds to pay for its bills. If the public doesn't pay for the bonds, the central bank will purchase them through an open market purchase, which increases the monetary base and supply.
57
The quantity theory of money is a good theory of inflation in the long run, but not the short run.
QTM provides long run theory of inflation bc it is based on the assumption that wages and prices are flexible. Classical assumption that wages and prices are completely flexible may not be a good assumption for short run fluctuations in inflation and aggregate output.
58
How can deposit insurance be described as a put option?
If a bank becomes insolvent, the depositors can "put" the bank to the FDIC and then receive dollar for dollar payment for their deposits, up to the insured limits.
59
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 1
Flat rate deposit insurance means that regardless of the riskiness of the portfolio, all institutions pay the same rate for insurance. Since depositors were 100% insured, riskier institutions did not have to pay higher rates in order to attract deposits. The flat rate structure of the deposit insurance increased the moral hazard problem associated with any insurance contract. Bank owners may choose a risky portfolio bc the bank can "put" losses to the FDIC but keep the gains.
60
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 2
Became a problem in the early 80s due to economic & regulatory shocks. Interest rates rose dramatically. When interest rates rise, the value of long term, fixed rate bonds and mortgages declines. Thrift institutions were structured to have the bulk of assets in long term, fixed rate mortgages, so it destroyed the capital in these institutions.
61
Is there a trade off between price stability and employment?
In the long run, no. In the short run, the fed may need to sacrifice output by increasing interest rates, which will increase price stability at the expense of higher employment levels.
62
What determines the demand for an asset (such as money or bonds)? (Theory of portfolio choice)
1. Wealth (positive correlation)
2. Expected return relative to another asset (positive correlation)
3. Risk of asset (negative correlation)
4. Liquidity of asset (positive correlation)
63
Impact of expected interest rates on demand for bonds
Higher expected interest rates in the future lower the expected return for long term bonds, decrease the demand, and shirt demand curve left.
64
Impact of inflation on demand for bonds
An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to decline and shift demand curve to the left.
65
Players in money supply process
1. Central bank
2. Banks
3. Depositors
4. Borrowers
66
Fed balance sheet
Assets: securities and loans to financial institutions
Liabilities: currency in circulation and reserves
67
What leads to an increase in the money supply?
An increase in the Fred's liabilities (either an increase in reserves or an increase of currency in circulation)
68
Monetary base
The sum of the Feds liabilities (currency in circulation and reserves) and the treasury's monetary liabilities (treasury currency in circulation, primarily coins).
69
Reserves
Deposits held at the fed
70
Discount rate
The rate the fed charges banks to borrow money from the fed.
71
Open market operations
The way in which the fed exercises control over the monetary base through its purchase or sale of securities in the open market
72
Open market purchase
When the fed purchases bonds, which increases securities (asset) and reserves (liabilities)
73
Risk associated with large accumulation of reserves held by banks at the fed
It could result in inflationary expansion of money and credit in the future if banks decided to lend out those reserves.
74
Aggregate demand curve
Consumption + investment + government purchases + net exports
75
Rightward shift in AD
1. Decrease in autonomous monetary policy
2. Increase in government purchases
3. Decrease in taxes
4. Increase in net exports
5. Increase in autonomous investment
6. Decrease in financial fractions
76
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 3
The net worth of the thrift went to roughly zero. For owners, the value of the put option is greatest around zero (when owners have nothing to lose and everything to gain by taking risks). Before the shocks, owners would be risking the positive net worth of the bank if they took excessive bets. Only after the shock hit did owners have an incentive to take advantage of the put option of deposit insurance.
77
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 4
Additionally, regulatory "forbearance" made problems worse by permitting owners to continue to gamble even when institution was insolvent. The 1982 st. Germaine act, for example, gave regulators more discretion to engage in forbearance & permitted thrifts to become involved in risky activities. Both of these regulatory shocks helped to increase the value of the put option of deposit insurance.
78
Provide Keynes explanation on why the income velocity of money tends to be pro cyclical. Part I
In Keynes model of money demand, the real demand for money is a function of the real volume of purchases, Y, and the level of the nominal interest rate, i. The opportunity cost of holding money is the rate of interest received on bonds (i). In this approach, the negative relationship between interest rates and money demand can be motivated either through Keynes (unsatisfying) "speculative motive" or baumol-Tobin-allays model of optimal cash management.
79
Provide Keynes explanation on why the income velocity of money tends to be pro cyclical. Part II
The demand for real money balances increases with Y and is inversely related to the opportunity cost i: M/P = f(Y,i). Using the definition of velocity, in this approach, V=Y/f(Y,i), so velocity increases when interest rates rise. Interest rates are pro cyclical, that is, the demand for loanable funds rises during boom times, interest rates tend to rise, and vice versa in econ downturns. Thus, GDP rises in a boom, interest rates rise, money demand falls, hence velocity rises.
80
Provide a monetarist explanation for why available evidence indicates that the income velocity of money tends to be pro cyclical
In the monetarist model, real money demand is a function of the permanent income and the differentials between the return on money and on other assets that carry purchasing power across time, such as bonds, equities, and non-perishable commodities. Money can and does pay interest. The opportunity cost of holding money balances is the difference between the return on money and the return on alternatives. Friedman claims that empirically these interest rate differentials do not fluctuate significantly. In friedman's view, expenditures are roughly proportionate to permanent income. Thus, for Friedman, money demand effectively is a positive function of permanent income and interest rates do not enter: M/P=f(Yp). Velocity thus is V=Y/f(Yp). As current income Y rises (falls) over the business cycle, permanent income Yp rises (falls) by much less than 1:1; hence, velocity rises (falls). The monetarist explanation of the pro cyclicality of velocity has nothing to do with interest rate movements.
81
Explain why the following statement is true, false or uncertain: "commercial banks can create both assets (loans) and liabilities (demand deposits). This, w/o reserve requirements, there would be no limit to the amount of money banks could create.
False. In the absence of legal reserve requirements banks will still choose to hold some level of reserves to meet deposit demand and new loan requests. And, private individuals wish to hold some portion of the money balances in the form of currency. Both of these factors prevent the banking system from expanding the money supply without limit through the multiple deposit expansion process. The money supply multiplier is likely to be higher in the absence of legal reserve requirements, but it will not be infinitely large.
82
Explain the following logic behind Milton friedman's statement: paradoxically, the monetary authority could assure low nominal rates of interest - but to do so would have to start out in the opposite direction, by engaging in deflationary monetary policy. Part I
The economic logic rests on:
(I) the recognition that the nominal interest rate equals the real interest rate plus the expected inflation rate (the fisher effect) and
(II) a distinction between the liquidity effect and the expected inflationary effect of a deflationary monetary policy
83
Explain the following logic behind Milton friedman's statement: paradoxically, the monetary authority could assure low nominal rates of interest - but to do so would have to start out in the opposite direction, by engaging in deflationary monetary policy. Part II
1. A deflationary monetary policy will initially raise nominal and real rates due to the liquidity effect.
2. The liquidity effect, however, is temporary and persists only until the price level adjusts in full proportion to the change in money supply.
84
Milton Friedman: The liquidity effect
In a recession, the fed will increase the money supply to make credit more readily available. The liquidity effect describes how expansionary monetary policy affects three elements of the economy: 1. Interest rates (decrease) 2. Income and 3. Inflation (increase)
85
Explain the following logic behind Milton friedman's statement: paradoxically, the monetary authority could assure low nominal rates of interest - but to do so would have to start out in the opposite direction, by engaging in deflationary monetary policy. Part III
The expected inflation effect works in the opposite direction and is long-lived. A deflationary money policy will cause a decline in the rate of inflation and, as expectations adjust, a decline in the expected rate of inflation. Borrowers will then offer, and lenders will accept, a lower nominal interest rate. Hence, the nominal interest rate will eventually fall to low levels under a deflationary monetary policy - even though this policy "would have to start out what seems like the opposite direction" when viewed solely in terms of the liquidity effect.
86
Define nominal interest rates
Real interest rates plus expected inflation
87
Contractionary policy
1. Increase reserve requirements
2. Reduce money supply of reserves, thereby increasing interest rates
3. Increase interest rates
88
T, F, U: the fed has too much autonomy from government. Monetary policy would improve if a representative from the treasury department could vote at the FOMC meetings. Part I
False. The cross-country evidence shows greater independence of the CB from the rest of government is associated with lower inflation rates and lower variability of inflation. The direct influence of the treasury at the CB increase the pressure in the CB to monetize government debt, thereby leading to inflation.
89
T, F, U: the fed has too much autonomy from government. Monetary policy would improve if a representative from the treasury department could vote at the FOMC meetings. Part II
Using our "positive theory" of the CB actions, the presence of the treasury at the FOMC meetings is likely to reduce the credibility of the Feds anti/inflation stance, leading the public to expect higher inflation. The fed realizes that the public expects this and will likely "validate" these expectations by choosing a higher inflation rate than it would have w/o the loss of credibility due to direct treasury influence at the FOMC.
90
Use the baumol Tobin allaid optimal inventory model of money demand to predict what would happen to income velocity of money in the following circumstance: nominal interest rates return to levels near 20%. Part I
An increase to 20% would increase the opportunity cost of holding non-interest bearing forms of money. To the extent that the return on interest bearing forms of money does not increase 1:1 with increase in market rates, the opportunity cost of holding interest-bearing forms of money would increase.
91
Use the baumol Tobin allaid optimal inventory model of money demand to predict what would happen to income velocity of money in the following circumstance: nominal interest rates return to levels near 20%. Part II
The BTA model of money demand indicates that total costs equal the opportunity cost of holding money plus the costs of exchanging money for other, less liquid, assets like bonds. An increase in the opportunity cost of holding money encourages people to economize on their money balances at the expense of greater bond-money exchange costs. When people behave in this way, their average money balance over a given interval declines; alternatively, the rate at which money turns over- it's velocity - rises. The prediction: this rise in interest rates would lead to an increase in the income velocity of money.
92
Use the baumol Tobin allaid optimal inventory model of money demand to predict what would happen to income velocity of money in the following circumstance: brokerage & conversion fees decline to near zero.
If brokerage and conversion fees decline to near zero, individuals will focus primarily on their foregone interest costs in deciding how much money to hold. Individuals are likely to hold little cash and simply undertake a bond-to-money conversion each time they wish to make a purchase. The prediction of the BTA model would be that the income velocity of money would increase.
93
The BTA model of money demand indicates that total costs equals:
The opportunity cost of holding money plus the costs of exchanging money for other, less liquid, assets like bonds.
94
Required Reserves (RR)=
rrD*DD + rrT*TD
95
Simplify RR
R=rrD*DD+rrT*TD
R=rrD*DD+rrT*2DD
R=(rrD+2*rrT)*DD
96
Use simplified RR to define monetary base
B=C+R, and C=DD
B=DD+(rrD+2*rrT)*DD
B=(1+rrD+2*rrT)*DD
97
Money supply equals currency + demand deposits
C+DD, or 2*DD, or M1
98
Suppose the CB increases the reserve requirement ratio on demand deposits to .12. What happens to money supply and monetary base?
Since the fed engaged in no open market transactions, the banks can meet their increased reserve requirements only by calling in loans. As banks call in loans, the money supply reduces and the composition of the monetary base shifts toward greater reserves and a smaller currency component. The level of the monetary base remains unchanged at 116. M1, however, falls to roughly 196.
99
Monetary base
Reserves + Currency
100
Define M1 using monetary base
DD=B*1/(1+rrD+2*rrT)
M1=C+DD=2*DD=
B*2/(1+rrD+2*rrT)
101
Feds options to raise rates
1. IOER
2. Term deposit facility
3. Aggressive reverse repos
4. Cautious reverse repos
102
IOER only
1. Fed can raise rates by raising interest rates on excess reserves
2. Simplest & cheapest option
3. No direct control over market rates bc not every market player can deal with the fed
103
Why can't the fed simply reduce the supply of bank reserves to raise rates?
Reserves at the fed are $3trillion greater than the regulatory requirement. No banks need to borrow them. The fed could reduce the supply and it wouldn't make any difference.
104
Term deposit facility
1. TDF turns reserves into longer term deposits at the fed
2. Pro: keeps change to a minimum & tight control over fed funds rate
3. Con: expensive
4. Too expensive and cumbersome for now
105
Aggressive Reserve Repos
1. Aggressive version would be to offer a high interest rate
2. Pro: tight control of fed funds rate at moderate cost
3. Encourages shadow banking by giving money market funds an attractive place to deposit. Fed doesn't want to encourage MMFs bc it didn't reform them.
106
Cautious reverse repos
1. Control over fed funds within a range. Minimal cost
| 2. Fed funds rate won't be pinned down and will fluctuate between IOER and red verse repo floor.
107
What is taylor principle?
Rule says that for each one percent increase in inflation, the CB should raise the nominal interest rate by more than one percentage point.
2. Failure to increase interest rates leads to inflation spiral.
108
The chicago plan
1. 100% reserves against checking accounts
| 2. Give the Fed the sole power to create money (remove banks from the equation)
109
Chicago plan pros
1. reduce boom-bust credit cycles. The plan would reduce cyclicality by preventing banks from creating their own funds during times of prosperity and eliminating funds during economic downturns
2. It would eradicate bank runs bc there is no incentive to withdraw with 100% reserve requirements
3. Banks would borrow from treasury to meet reserve requirements, thereby increasing Feds assets & reducing amount of public debt O/S
110
Chicago plan cons
2. Banks would have to charge depositors a fee for holding their money
2. Pushes lending activities into unregulated shadow banking system
3. Doesn't address excess leverage
111
Bitcoins impact on money demand & velocity
1. Could alter amount in circulation (so far it hasn't bc operates on prepaid basis - is exchanged in and out of real money)
2. Limited network of users and relatively low volume of transactions. Has not had significant impact on velocity of money for this reason.
112
SIFI (systematically important financial system)
A financial institution whose failure, due to its size, complexity and financial interconnectedness, could result in a financial crisis. SIFS are subject to higher capital requirements, leverage restrictions, and reallocation of resources to comply with heightened reporting requirements.
113
Should the FSOC declare Fannie & Feddie SIFIs?
Yes, cautiously they should. Designating an institution as "too big to fail" imposes a moral hazard.
1. Size (Fannie would be number 1. Freddie would be number 4)
2. Involvement in mortgage securitization render them complex and interconnected
3. Highly levered (each well over 100x)
114
Federal funds rate target
Inflation rate + equilibrium real fed funds rate + .5 (inflation gap) + .5 (output gap).
Equilibrium real fed funds and inflation target are 2%
115
Bernanke versus taylor
Taylor said monetary policy was too accommodative in the early 2000s, which led to the housing bubble. Bernanke says no, we were worried about slipping into deflation and had to keep rates low. Changes in mortgage contracts ultimately led to bubble.
116
How can banks respond to sudden outflow in deposits?
1. Sell securities and loans
2. Call in loans
3. Borrow from other banks in the fed funds market
4. Borrow from the fed (discount window lending)
5. Issue short term securities (CP)
6. Engage in repos
117
BTA model
1. Demand for money rises less than proportionately with income because there are economies of scale associated.
2. Key variables include: 1. Nominal interest rate, 2. Level of real income, 3. Fixed transaction costs
118
Why is the demand for money less stable now?
1. Changes in definition of M2
2. Technological & financial innovation (credit card, ATM, MMFs)
3. Economic volatility
119
Neutrality of money
A change in the nominal quantity of money affects only nominal variables, such as the price level and nominal interest rates, and leaves real variables, such as unemployment rate or real gross domestic product, unaffected. The traditional Phillips curve implies that money was non-neutral.
120
Why did the fed employ non traditional responses to the crisis?
1. Interest rates were already near zero, so open market operations would not have been enough
2. Allowing banks to borrow overnight did not assure the market that banks would remain solvent
121
Non traditional responses by the fed
1. Extended maturity of loans (up to 90 days) - TAF
2. Accepted broader range of collateral (CP and repos)
3. Expanded counter parties (MMMFs)
122
Would volker rule prevent the 2008 crisis?
No. Prohibit prop trading and forces institutions to divest covered funds. These measures will improve the effectiveness of capital requirements, reduce risks associated with failure of covered funds, and increase awareness of risks being taken, these measures are forward looking & wouldn't have prevented the crisis. Crisis due to exposure to mortgages, banks that engaged in prop trading did better than those that didn't (wamu). Prohibition of prop trades reduces diversification of cash flow and pushes these activities into the shadows.
123
Northern Rock
1. It was highly levered with a thin capital cushion
2. Relied heavily on wholesale funding rather than retail deposits. Deposit sources weren't sticky and quickly dried up due to exposure of the subprime market
3. Interconnectedness to subprime lending market that affected the health of their funders.
124
RWA versus leverage ratio requirement
Requiring banks to hold more capital against risky activities provides an incentive to reduce risk taking and more protection to taxpayers if bank gets into trouble. Be careful though - Basel I classified zero risk weight on high yield sovereign debt that may not be safe.
125
Financial development
1. Better performance if state economies
2. Higher rate of new business formation
3. Macro economic stability improved
4. Local economies become less sensitive to local banks
5. Improved capitalization of small banks
6 more competitive pricing of loans
126
Glass steagall implemented to prevent banks from taking advantage of asymmetric symmetry (sell bonds to public for bad companies to repay their loans)
1. Banks relied on trust and developed Chinese Walls between commercial and investment banks to maintain that trust
2. Default rates for bonds underwritten by commercial banks were lower than I-banks.
127
How does lower expected income in the future impact interest rates and quantity of funds?
Shifts supply of loans right (lower interest rate, higher quantity)
128
How does negative shock so that productivity of investment falls?
Demand shifts left, which will decrease quantity of funds and reduce interest rates.
129
Properties of money
1. Divisibility
2. Portable
3. Standardized
4. Scarcity
5. Durable
6. Verifiable
130
Functions of money
1. Store of value
2. Medium of exchange
3. Unit of account
131
Schumpter's approach
Services provided by financial intermediaries are essential for technological innovation and ecocide development. Others say it increases volatility. The data says schumpter is right. It allows for consumption smoothing and diversification. But it also leads to interconnections and exposure to common risks.
132
Increase in wealth today and liquidity
Both shift loan supply curve right
133
Increase in risk and future wealth
Supply curve left
134
Key elements of new Basel regulations?
1. Raise quality, consistency and transparency of capital base and strengthen risk coverage of capital framework
135
Aspects of leverage requirements
1. Benefit is that it's a simple tool
| 2. Complication is how you define the denominator (banks assets can be difficult to measure)
136
Benefit of financial intermediary
1. Economies of scale & scope
2. Delegates credit monitoring
3. Diversification benefit
4. Search costs and transaction costs are reduced
137
Value of put option (insurance contract)
138
Value to depositors
Space to the left of vertical axis, below solid line. The 45 degree angle
139
Value to owners
Left of vertical line, above solid line, below dotted line
140
When the thrift is insolvent, the value of it equals
The amount it FSLIC assistance necessary to cover net worth deficit
141
M1
Currency & demand deposits
142
M2
C+DD+time deposits + MMDA
143
Money supply and base
Monetary base equals liabilities of fed (currency in circulation & reserves). An increase in either of these two will increase the supply.
144
Open Market operations increases the monetary supply because
An increase in securities on the asset side corresponds with a simultaneous increase in reserves on the liability side. An increase in reserves increases the supply.
145
New policy responses
1. Lending to financial institutions
2. Provide liquidity to credit markets
3. Purchase longer term securities (traditional tools aimed at short term)
146
Taylor
Actual inflation
147
Bernanke
Expected inflation
148
Bernanke argument
Fed kept interest rates low bc inflation was low and didn't want to slip into deflation. Deregulation caused crisis.
149
Why didn't QE work in Japan?
Dropped the program too soon. Foot in mouth. Said they would drop it once rates were close to zero (just as prices started rising).
150
Lessons from 1930s
Make smooth adjustments to avoid market disruption
151
ECB negative rate
1. Spur lending & fight deflation
2. Hurt fragile institutions
3. Lower value of euro, making it cheaper to export
4. Won't fight demand for new loans
152
Why is Rs horizontal?
Bc fed will be willing to make as many discount loans as banks want at Rs
153
What causes money supply to fall?
1. Increase in required reserves
2. Increase in currency holdings
3. Increase in excess reserves
154
What causes money supply to increase?
1. Increase in nonborrowed monetary base (is reserves through open market operations)
2. Increase in loans to banks from fed
3.
155
Fed controls the monetary base through
1. Open market operations
2. Extension of loans to financial systems
It has better control over monetary base than reserves.
156
Deposit creation process
Bank can make loans up to the amount of its excess reserves, thereby creating an equal amount of deposits. As each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make more loans and deposits.
157
What impacts model of multiple deposit creation?
If depositors increase their holdings of currency or banks hold excess reserves, there will be smaller expansion of deposits.
158
Ior (bottom of demand curve, horizontal part).
At bottom of graph. Interest paid on reserves. If the fed funds falls to this rate, it is horizontal bc banks would keep adding to their excess reserves indefinitely rather than lend overnight at a lower rate. Banks can either lend to each other or accumulate reserves.
159
Id (vertical than flat to the right)
The discount rate the fed charges banks to borrow reserves. Borrowing from other banks (at Iff) is a substitute for borrowing from the fed. If fed funds raises to discount rate, banks will want to borrow more and more and lend out the proceeds at the fed funds rate.
160
M1 questions
B. Currency = 100
Reserves = 16
C. Since the fed engages in no open market operations, the bank can meet their increased reserve requirements only by calling in loans. As banks call in loans, the money supply contracts and composition of monetary base shifts toward greater reserves and a smaller currency component. Base remains unchanged at 116, M1 falls to 196
161
Taylor rule
Inflation + equilibrium + .5 (inflation gap) + .5 (GDP gap)
162
Pithy
Concise, terse, forcefully expressive
Pithy quote
Money & Banking
flashcards
Decks in class (4)
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