ECO 4223: Money & Banking
Exam 2; Chapters 5,6,11,13,15
Loanable Funds Framework: Real i rates are determined by the supply & demand for bonds. Supply of Bonds: (Firm borrowing) These are the borrowers/spenders
Factors that shift bond supply:
∙ Expected profit of investment opportunity: (in a bus. cycle expansion, supply of bonds increase/ shifts to right. In recession, fewer profitability opportunities are expected, supply falls/shifts to left.
∙ Expected inflation (true cost of borrowing): [when this increases, real cost of borrowing falls] An increase in expected inflation = supply of bonds to increase/shift to right. A decrease in expected inflation = supply of bonds to decrease/shift to left.
∙ Government deficits: Caused by gaps btwn gov’t expenditures & revenues. SO, higher gov’t deficits increase supply of bonds/shift to right. Gov’t surpluses decrease supply of Don't forget about the age old question of What kinds of art objects survive from ancient sumeria?
bonds/shifts to left.
Demand for Bonds: Savers/Lenders: no use for excess funds.
Factors that shift bond demand:
∙ Wealth: During expansion, there’s an increase in demand for bonds/shifts to right. In recession, when wealth is falling = demand for bonds falls/shifts to left.
∙ Expected returns: SIMPLY; higher expected future i lower the expected returns for long term bonds, decrease bonds/ shifts to left.
♦ An increase in expected return on alt assets lowers demand for bonds/shifts to left. ♦ An increase in expected rate of inflation lowers the expected returns on bonds/bond declines/shifts to left.
∙ Riskiness: If bond is less risky (SAFER), demand for bond would increase/shift to right. MORE ATTRACTIVE. Conversely, increase in riskiness of bonds = demands for bonds to fall/shift to left. If you want to learn more check out What is the best adventure race?
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∙ Liquidity: More liquidity of bonds = increased for demands of bonds/shifts to right. VICE VERSA.
The Liquidity Preference Framework: determines the equilibrium i rates in terms of supply/bonds for money. If you want to learn more check out What are aristotle's three basic points?
Supply of Money: An increase in money supply engineered by the Fed Reserve/shifts supply curve to right/ i rates decrease/left.
Shifts in Demand for Money:
Income effect: higher demand of income = demand for $ @ each i rate to increase/shift to right. ∙ SO, if expected inflation increases then real i decreases then people want to hold more money. [MORE BONDS – LESS $: LESS BONDS – MORE $]
Price level effect: a rise in the price level = demand for money at each i to increase/shift to right. Changes in Equilibrium Interest Rates:
Change in income We also discuss several other topics like What are the powers for the state?
Changes in prices level
Change in money supply
Risk Structure of Interest Rates: looks at relationship among different i of the same time of maturity. CHARACTERISTICS: risk, liquidity, income tax determine.
Default risk: the issuer of bond is unable/unwilling to make interest PMT when promised or pay off the face value when bond matures.
Risk Premium: the spread/difference btwn i on bonds w/ default risk & i on defaultfree bonds, both of same maturity. OR, the difference btwn interest paid on risky bond & bond that has no risk at all.If you want to learn more check out What is representative democracy?
Municipal Bonds: issues by state or local gov’t & exempt from tax. More risk & less liquid than tbill. TBill: gov’t treasury bill as no risk.
Term Structure of Interest Rates:
Yield Curve: Relationship btwn i rates & time. Compares interest rates on bonds of various maturities at given point in time. Same risk, liquidity, & tax. Gov’t bonds.
If time of maturity is short, I rate is small/low. IF time of maturity is long, I rate is large/high. Upward sloping indicates long term i rates are higher than short term rates.
Inverted yield curve (downward): where short term i rates are higher than long term rates. Flat curve: where long & short term i rates are the same.
∙ 3 Empirical facts:
♦ 1. Interest rates move together
♦ 2. If short term interest rates are low upward sloping (normal). BUT, if short term i rates are high, yield curve is downward (inverted)
♦ 3. Yield curve slope upward 90% of the time (normal)
∙ Expectation Theory: (1) The interest rate on long term bond = the average of short term i rates that ppl expects to occur over the life of long term bond.
♦ Considered perfect substitutes: if bonds w/ diff maturities are perfect, then the expected returns on those bonds must be equal.
♦ (2): interest rates are expected to gravitate towards the center (normal interest)
♦ (3): it will predict a flat yield curve b/c we are not told where it starts.
∙ Segmented Market Theory: Sees markets for diff maturity bonds as separate & segmented. ♦ The interest rates on a bond of a particular maturity is determined only by the demand & supply of bonds of that maturity.
♦ Bonds are no longer considered perfect substitutes. DO NOT have to move together. ♦ Will predict a normal yield curve.
♦ PREFERS short term bonds; b/c of this they will have a higher demand, higher price & lower i rates. LONG TERM OPPOSITE.
∙ Liquidity Premium Theory: the extra incentive a saver requires to hold a longerterm bond. Prefers SHORT TERM b/c less interest rate risk. Substitutes NOT perfect, so the expected return on one bond does influence the expected return on a bond w/ diff maturity.
♦ Same as expectation plus liquidity premium & will predict upward (normal) sloping. Inverted yield curve, how? Short term interest has to fall more than premium.
∙ Can be inverted/ flat when future short term interest are expected to decline.
The Federal Reserve System: A central U.S banking system that controls the nation’s money supply under the federal gov’t/12 banks which is in BOSTON, NY, PHILLY, CLEVELAND, RICHMOND, ATLANTA, CHICAGO, ST. LOUIS, MINNEAPOLIS, KANSAS CITY, DALLAS, SAN FRAN, & ONE IN MIAMI.
EST. in 1913 to avoid money panic run on the bank.
Board of governors, most powerful is the chair of board (Jerome powell,14 yr terms) Functions:
∙ Clear checks (deliver $)
∙ Issue new currency & withdrawal damaged currency in circulation.
∙ Monetary policy (manage $ supply & interest rates)
∙ Emergency lending – if bank goes bankrupt, goes to feds.
∙ Financial regulations – banks police, decisions.
Lender of last resort: function of feds: provides funds to troubles banks that cannot find any other source of funds.
Fractional Reserve Banking: a banking system that keeps only a fraction of funds on hand & lends out the remainder. They only have to keep a fraction of what they take as deposits.
Fed Reserve Balance Sheet:
Liabilities: (Monetary liabilities)
∙ Currency in circulation: the amount of currency in the hands of public.
∙ Reserves: (Vault Cash): deposits at the Fed + currency that is physically held by banks. ♦ Reserves are assets for banks, but liabilities for fed.
∙ Increase in both of these result to an increase in money supply/shift to right.
∙ Securities – Gov’t bonds – issued by U.S Treasury; increase in gov’t bonds held by fed = increase in money supply.
∙ Discount loans/ loans to financial institutions borrowing from fed/ borrowed reserves. Reserves:
Total Reserves(R) = RR+ER fed Required Reserves: Fed sets requirement for banks to hold Only on deposits & Excess Reserves: chooses to hold.
Required Reserve Ratio: 10%
Required Reserve (RR ratio) = Deposits (D) x RR
Where are reserves held? Bank, vault cash.”It don’t matter where they are held, doesn’t matter in RR or ER.”
Simple Deposit Creation: D = R x (1/r)
∙ It’s the ratio of amount of deposits created by banks to amount of new reserves. Assumptions: The public doesn’t want more currency (they’ll deposit bond in bank) AND Banks don’t want any excess reserves.
Multiplier = 1/r
Weaknesses of Simple model ^:
Public holdings – negative to money supply
Bank holdings – negative to money supply
Fed cannot precisely control reserves. – changes in reserves come from changes in deposits & withdrawals.
Real World: (Corrected): Money mult. = M= ms x MB
Currency ratio: currency in circulation:... c = C/D
EX: C=$400 D=$800 .5 = 400/800
Excess Reserve Ratio: ER to deposits:.. e = ER/D
EX: ER=$8B D=$800B .001=8B/800B
Money multiplier; m = 1+C/D// C/D + ER/D + r ORRR 1+c/ c+e+r
Monetary Base: The sum of the Fed monetary liabilities MB = C+R
Fed can’t control reserves but CAN control MB b/c it’s the new target for money supply. How does the fed increase MS/MB/reserves? How does the Fed give money to banks/public? OPEN MARKET OPERATIONS. They BUY gov’t bonds from banks.
Purchase: Fed buying Sale: Fed selling
∙ Buying increase money supply OR when fed buys bonds, increase MS & when fed sells bonds, decrease money supply.
Open Market Operations: The purchase or sale of gov’t bonds on open market Open market purchase: purchase of gov’t bonds on open market/ increase in MS b/c of BUYING. Open market sale: Sale of gov’t bonds on open market/ decrease MS by SELLING.
Defensive open market operations: (temporary, 15 days): 2 types TEMPORARY PURCH OR SALE Repurchase Agreement (REPO): Fed buys bond w/ agreement to sell it back later – Temp purchase – increases MS
Match sell purchase agreement: Fed sells bond w/agreement to buy it backlater – Temp sale – decreases MS