Macro 5

Question 1

When were the seeds of financial crisis planted? and why?

Answer 1

1970s onwards, with many financial innovation

Question 2

What were the type of financial innovations?

Answer 2

New types of securities

New ways to borrow short term

New ways to insure against falling asset values
(similar to deposit insurance)

Increased importance of non-bank financial institution (NBFI)

Question 3

What is securitisation? What is the process like?

Answer 3

turning loans into debt securities

1. Bank makes mortgage loans, with home as colalteral
2. Bank bundles the mortgages into a mortgage- backed security (MBS). Owner of MBS gets regular interest payments from the mortgages
3. Bank sells the MBS to another financial institution. BANK CAN WRITE OFF MORTGAGE FROM BALANCE SHEET. WHOEVER OWNS SECURITES ENTILTED TO REPAYMENT OF LOANS

Question 4

What is considered long term in securitisation?

Answer 4

20-30 years

Question 5

What is the process of slicing and dicing? What is the purpose behidn each step?

Answer 5

1. Financial institution buys many different MBS (mixture of high risk subprime and low risk prime)

2 .Chops up each MBS into slices

3. Combines slices from various MBS to form Collateralized Debt Obligations (CDOs). Security created that pays high interest and has low risk due to diversification
4. Sell CDOs to other banks( other bank get regular interest payment from MBS slices)

Question 6

How to create CDO squared?

Answer 6

do another round of slicing and dicing

Question 7

What is the new way of borrowing short term?

Answer 7

Repurchase Agreement(repo)

other party is reverse repo

Question 8

When will the repos act as collateral?

Answer 8

If the seller of the CDO defaults, then the buyer of the CDO keeps security

CDOLenders prefer liquid and safe assets as collateral in repos

Short term govt securities are considered very good collateral

Question 9

What are credit default swaps?

Answer 9

Form of insurance against seller of CDO default

will top up remaining amount

Question 10

What are shadow banks?

Answer 10

NBFIs that take on short term liabilities (such as repos) to purchase long term assets (such as MBS’s, CDOs)

highly leveraged

Question 11

What were the primary function of shadow banks?

Answer 11

Supposed to help companies to arrange ipo
Advice on financial dealing

Question 12

How were shadow banks and traditional banks similar?

Answer 12

• Assets are long term
• Liabilities are short term
• Highly leveraged

Question 13

How were they shadow banks different from traiditonal banks?

Answer 13

• Insurance is not provided by government
• Lightly or not regulated
• Has no lender of last resort

Question 14

What caused the financial crisis ?

Answer 14

• US nationwide housing market downturn
• rising mortgage default
• prices of MBS’s, CDO fell drastically
• Lenders, fearing that borrowers are insolvent, became less willing to enter into repos, and to accept these securities as collateral
• banks and NBFI’s tried to deleverage i.e. sell assets to pay off liabilities (BUT ALL AT SAME TIME)

Question 15

What is deleveraging ?When is deleveraging good and bad? Why?

Answer 15

deleveraging: sell assets to pay off liabilities

• works when few firms do it
• but bad when all sell at same time, cause price of MBS and CDO to fall further, closer to insolvency ( similar to bank run)

Question 16

What is the positive feedback loop for mortgage default rise?

Answer 16

1. Mortgage default rise
2. Price of MBS fall
3. Price of CDO fall
4. Banks and NBFI see eqwuity fall
5. Lenders fear that borrowers may be insolvent
6. Repo market stalls, banks and NBFIs can’t borrow
7. Banks and NBFIs sell MBS, CDOs
8. Go back to step 2/ step 3

Question 17

What were the actions that were taken by Fed and treasury to restore financial stability?

Answer 17

• Persuaded healthier financial institutions to buy troubled ones (JP morgan persuaded to buy Bear stearns)
• Bought securites to raise asset prices (bought large qty of MBS)
• Gave NBFI access to emergency Fed loans (goldman and morgan stanley turned into bank holding company)
• injected equity into troubled financial intermediaries (US treasury took over ownership of AIG,paid off liabilities)

Question 18

How has shadow banking industry grown in China?

Answer 18

• Wealth management products: sold to savers by banks so bank balance sheet dont include thenm
• Entrusted loans : loans between 2 companies with banks as agent for lender
• Trust companies: firms that sell securities to investotrs to buy risky high interest asset

Question 19

What have the chinese authorities done?

Answer 19

imposed regulations on sector, result in shrinking assets

Question 20

What are the 2 financial assets that people can hold their wealth i n? What are the assumptions?

Answer 20

money: no interest; used for transactions; safe
bonds: pay interest, not used for transactions, risky

assumption: interest rate is fixed(both nominal and real ir move together)

Question 21

What is money demand?

Answer 21

amount of wealth households choose to hold as money

Question 22

When do people want to hold more money?

Answer 22

Nominal interest rate falls : opp cost of holding money falls , have to give up bonds

the Price Level rises: need more money for transcations

Output rises: more gns bought and sold

Question 23

What causes a movement along money demand and shift in money demand?

When does money supply shift?

Answer 23

movement: change interest rate
shift: change in P or Y

Money supply curve shifts when Central Bank decides to change the quantity of money

Question 24

How do moeny market clear if ir above eqm?

Answer 24

If ir above eqm level,

Excess supply of money (people would rather hold less money)

Excess demand for bonds(people would rather hold more bonds)

With excess demand for bond, bond price will increase in bond market. As bond price increase, interest rate decrease until people are satisfied with holding qty of money

Question 25

In keynesian model, _____ if Y rises, money demand _________

Answer 25

other things equal rises and shift right (cause there is excess demand, bond prices fall)

Question 26

What is the full range of intereactions when Y increases?

Answer 26

if eqm increase, money demand increase, interest rate increase. This causes Ip and a to decrease, AE decrease, Y star decrease Money demand decrease again expenditure multiplier becomes smaller becasue interest rate incresae and crowidng out(which reduce size of multipler).

Question 27

What does eqm depend on?

Answer 27

how interest sensitive ae is how output sensitive money demand is

Question 28

What is monetary policy? What can the fed generally do to increase AE? What are the benefits of monetary policy compared to fiscal?

Answer 28

central bank’s actions and communications to manage the money supply to influence economic activity increasing the money supply sufficiently to reduce the interest rate monetary policy: faster to enact and easier to reverse

Question 29

How does monetary policy accomodate fiscal policy?

Answer 29

An expansionary fiscal policy leads to a rise in the interest rate --> the resultant crowding out reduces the policy impact If Central Bank wants to accommodate the expansionary fiscal policy, it can eliminate crowding out by preventing the interest rate from rising

Question 30

What does the fed do to target short term interest rate?

Answer 30

targets the Fed Funds Rate (FFR) = rate at which banks lend reserves to one another overnight, act as benchmark for other interest rate Other assets pay higher rates, due to being longer-term and higher risk, thus earning term premiums and risk premiums. Difference (spread) between these rates and the FFR is usually stable

Question 31

What is the relationship between IOR, Fed Funds Rate and Discount rate? How to get banks to reduce reserves

Answer 31

By manipulating ceiling (discount rate), and floor( IOR) , Fed can control ffr FFR: Interest rate in the interbank market for reserves. Fed use open market operations to affect the interbank rate IOR: Ir paid on reserves. Banks will not lend reserves to other banks if IOR > interbank rate Thus, IOR is the floor for the FFR Discount rate:Interest rate charged by central bank for lending reserves. Banks will not borrow reserves from other banks if discount rate < interbank rate. Thus, discount rate is the ceiling for the FFR

Question 32

In a deep, prolonged slump, conventional monetary policy may hit the __________

Answer 32

zero lower bound

Question 33

What do Fed's do as monetary policy? What are the objectives?

Answer 33

Quantitative Eaisng: large scale purchase of financial assets, paying with newly created reserves inverse relationshoip between financial asset and interest rate Objective: boost asset prices and reduce long-term interest rates, reduce pressure on financial institution to deleverage

Question 34

What were the problems of QE?

Answer 34

did not lead to a massive increase in deposit creation BECAUSE Banks wanted to hold excess reserves

Question 35

What other methods does the fed hve?

Answer 35

Forward guidance - communicating of future monetary policy - to influence business and household expectations of the future interest rate

Question 36

What are the disadvantages of QE?

Answer 36

Helped combat the slump, but effect is weak Doesn’t directly help the unemployed or people who have lost their homes; may have worsened inequality need to use fiscal policy in tandem

Question 37

What happens when nominal aggregate expenditure rises relative to real potential output, for long and short run?

Answer 37

short : economy can produce above its potential long: prices and wages rise until real aggregate expenditure falls back to equal real potential output

Question 38

What is stagflation?

Answer 38

high inflation and high unn

Question 39

What ar ethe ingredients of sustained high inflatiuon?

Answer 39

1. Central banks being hesitant to tighten monetary policy 2. People grow to expect high inflation to persist : - Unions push for cost-of-living adjustments to wages every year - Firms raise prices of their products as costs increase - Governments raise transfers to help people cope with inflation. - Indexation becomes more common EXPECTATION OF HIGH INFLATION THEN BECOMES SELF FULFILLING

Question 40

What lessons can be learnt from Volcker disinflation?

Answer 40

- high inflation involves doing contractionary monetary policy until the job is done - Central bank’s credibility is important for influencing inflation expectations - Pre-emption: best to keep inflation low and stable, rather than to let it ramp up