ECO 29 Vocab/ study guide
ECO 29 Vocab/ study guide Eco 029
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Date Created: 09/21/15
Chapter 1 04282015 markets in which funds are transferred from people who have an excess of available funds to people who have a shortage Security nancial instrument a claim on the issues future income any nancial claim or piece of property that is subject to ownership a debt security that promises to make payments periodically for a speci ed period of time the cost of borrowing or price paid for the rental of funds represents a share of ownership in a corporation A claim on the earnings and assets of the corporation institutions that borrow funds from people who have saved and in turn make loans to others major disruptions in nancial markets that are characterized by sharp declines in asset prices and the failures of many nancial and non nancial rms are nancial institutions that accept deposits and make loans 0 Includes commercial banks savings and loan associations mutual savings banks and credit unions development of new nancial products and services can be an important force for good by making the nancial system more ef cient nancial services done electronically anything that is generally accepted in payment forgoods total production of goods and services percentage of the available labor force unemployed the upward and downward movement of aggregate output produced in the economy periods of declining aggregate output theory that relates the quantity of money and monetary policy to changes in aggregate economic activity and in ation average price of goods and services in an economy continual increase in the price level the rate of change of the price level changeyear the management of money and interest rates 0 Central bank responsible for monetary policy 0 Federal reserve system government spending and taxation excess of government expenditures over tax revenues for a particular time period arises when tax revenues exceed government expenditures 1 measure 0f aggregate output conversion of different types of currency the price of ones countrys currency in terms of anothers the total income of factors of production land labor and capital from producing goods and services in the economy during the course of the year claims on the borrowers future income or assets IOUdebts wealth either nancial or physical that is employed to produce more wealth the number of years until that instruments expiration date 0 less than a year 0 10 years or longer 0 between 110 years claims to share in the net income and the assets of a business 0 Equity holders bene t directly from increases in the coporations pro tability or asset value because equities confer ownership rights on the equity holders o Considered long term because no maturity date 0 must pay all its debt holders before it pays its equity holders periodic payments nancial market where new issues of security are sold to initial buyers by the corporation or government agency borrowing the funds nancial market in which securities that have been issued can be resold assists in the initial sale of equities in the primary market 0 Underwriting securities agents of investors who match buyers with sellers of securities link buyers and sellers by buying and selling securities at stated prices Secondary market functions 0 1 MORE LIQUID Make it easier and quicker to sell these nancial instruments to raise cash 0 2 Determine the price of the security that the issuing rm sells in the primary market where buyers and sellers of securities meet in one central location to conduct trades dealers at different locations who have an inventory of securities stand ready to buy and sell securities quotover the counterquot to anyone who comes to them and is willing to accept their prices is a nancial market in which only short term debt instruments are traded longer term debt and equity instruments are traded Money market instruments 0 136 months to nance the federal gov set amount at maturity and no interest payments quotsell at discountquot 0 Most liquid bc more actively traded o Safest bc no possibility of default pays annual interest of a given amount and maturity pays back original purchase price 0 short term issued by large banks and well known cooporations o maturity of less than 2 weeks 0 Collateral an asset that the lender receives if the borrower does not pay back the loan 0 overnight loans between banks of their deposits at the federal reserve By banks to other banks 0 barometer of the tightness of credit market High banks are strapped for funds Low banks credit needs are low debt and equity instruments with maturities of greater than one year 0 equity claims on the net income and assets of a corporation 0 loans to households or rms to purchase land housing or other real structures in which the structure or land itself serves as collateral for the loans 0 Largest debt market in US 0 a bond like debt instrument back by a bundle of individual mortgages long term bonds issued by corp with very strong credit ratings Sends the holder an interest payment twice a year and pays off the face value when it matures o also allow the holder to convert them into a speci ed number of shares of stock at any time up to the maturity date 0 long term debt instruments issued by US treasury to nance the de cits of federal gov 0 Most liquid long term bonds issued by gov agencies such as ginnie mae etc o Municipal Bonds long term debt instruments issued by state and local governments to nance expenditures on schools roads and other programs loans to consumers made by banks and nance companies sold in a foreign country and denominated in that countries currency bond denominated in a currency other than that of the country which it is sold in foreign currencies deposited in banks outside the home country 0 Us dollars deposited in foreign banks outside the United States or in foreign branches of banks involves a nancial intermediary that stands between the lender savers and the borrower spenders and helps transfer funds from one to the other process of indirect nance using nancial intermediaries prove promote and solve info problems 0 the time and money spent in carrying out nancial transactions services that make it easier for customers to conduct transactions uncertainty about returns nancial intermediaries create and sell assets with risk characteristics that people are comfortable with use these assets to buy riskier ones 39 risk sharing 0 investing in a collection of assets whose returns do not always move together one party often does not know enough about the other party to make accurate decisions the problem created by asymmetric info BEFORE the transaction occurs when the potential borrowers who are the most likely to produce an undesirable adverse outcome are the ones who most actively seek out a loan and are thus the most likely to be selected problem created by asymmetric info AFTER the transaction occurs the risk that the borrower might engage in activities that are undesirable from the lenders point of view lower the cost of info production for each service by apply one info resource to many different services 0 when a person or institution has multiple objectives and as a result has con icts between those objectives depository institution banks contractual savings institutions investment intermediaries nancial intermediaries that accept deposits from individuals and institutions and make loans o savings and loan associations mutual savings banks credit unions 0 the nancial intermediaries raise funds primarily by issuing deposits where checks can be written dep that are payable on demand but do not allow checks with xed terms to maturity obtain funds through savings deposits and time and checkable depos s very small cooperative lending institutions organized around a particular group union members employees of a particular rm Acquire funds from deposits called shares and make consumer loans 0 nancial intermediaries that acquire funds at periodic intervals on a contractual basis Liquidity is not as important as the deposit institutions Invest in Long term securities 0 insure people against nancial hazards following a death and sell annuities Annutities annual income payments upon retirement 0 insure people against loss from theft re and accidents Use funds to buy more liquid assets than life insurance 0 provide retirement income in the form of annutities to employees who are covered by a pension plan Funds acquired by contributions from employers and from employees who have contribution automatically deducted or contribute voluntarily nance companies mutual funds and money market mutual funds 0 raise funds by selling commercial paper and by issuing stocks and bonds Help purchase homes improve furniture small businesses acquire funds by selling shraes to many individuals and use the proceeds to purchase diversi ed portfolios of stocks and bonds Can be risky characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit type accounts o hels a corporation issue securities Advises corporation on either stocks or bonds and then helps them sell underwrite by purchasing them from the corporation at a predetermined price and reselling them in the market selling securities securities and exchange commission requires corporation to issue certain securities to disclose certain info about sales assets and earnings widespread collapse of nancial intermediaries 6 TYPES OF REGULATIONS 1 controlling who is allowed to set up a nancial intermediary Must obtain a charter from the state or federal gov o 2 reporting requirements for nancial intermediaries are stringent Must make certain info available to the public 0 3 restrict the nancial intermediary from engaging in certain risky activities Another way to limit a nancial intermediary s risky behavior is to restrict is from holding certain risky assets 0 4 gov van insure peoples deposits so that they do not suffer great nancial loss if the nancial intermediary that holds these deposits should fail 5 state and federal governments at times have imposed restrictions on the opening of additional locations 0 6 competition has also been in habited by regulations that impose restrictions on interest rates that can be paid on deposits Equanns nominal GDPreal GDP nominal person consumption expenditures real PCE measure of aggregate price level xltlxlt1Xt1 x 100 different streams of cash payments to the holder based on the commonsense notion that a dollar paid to you one year from now is less valuable than a dollar paid to you today the lender provides the borrower with an amount of funds principal that must be repaid to the lender at the maturity date along with the interest payment Four Types of o 1 the lender provides the borrower with an amount of funds which must be repaid to the lender at the maturity date along with an additional payment for interest 0 2 lender provides the borrower with an amount of funds which must be repaid by making the same payment every period part principal and part interest 0 3 pays the owner of the bond a xed interest payment every year until the maturity date when a speci ed nal amount face value or par value is repaid 0 Identi ed by 4 pieces of info 1 Bonds face value 2 Corporation or gov agency that issued it 3 Maturity date 4 the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond 0 4 bought at a price below its face value and the face value is repaid at the maturity date NO interest payments the interest rate that equates the present value of cash ow payment received from a debt instrument with its value today for simple loans simple interestyield to maturity perpetual bond with no maturity date and no repayment of principal that makes xed coupon payments of C forvever yearly coupon payment divided by the price of the secur y current bond prices and interest rates are negatively related return on a bond will not necessarily equal the yield to maturity on that bond the riskiness of an assets return that results from interest rate changes interest not changed for in ation rate changed for in ation interest and principal payments are adjusted for changes in the price level EQUATIONS CF1iquotn YIELD TO MATURITY Pv cmmm LVFP1i FP1iquot1 FP1iquotn C1i C1iquot2 C1iquotn FPP Price of perp yearly payment yield to maturity of perp c Ptl Pt Pt PtnP P Nominal real in ation 1 the total resources owned by the individual including all assets quotwealth quot demand the return expected over the next period quot expected return quot demand the degree of uncertainty associated with the return quot risk V demand the ease and speed with which an asset can be turned into gowoNo cash quotliquidity quot demand tells how much of an asset people want to hold in their portfolio when the amount that people are willing to buy equals the amount that people are willing to sell quantity of bonds supplied exceeds the quant demanded quant of bonds supplied is less than quant demanded emphasizes tocks of assets rather than ows when determining asset prices Shifts in Demand Curve for bonds 1 0 quot wealth quot quant demanded right shift 2 o quot expected interest rate V quant demand left shift 0 quot expected in ation V quant demanded shift left 3 o quot risk V quant demanded shift left 0 quot liquidity quot quant demanded shift right Shifts in supply of bonds 1 o quot pro t quot supply right 2 o quot in ation quot supply right 3 o quot de cit quot supply right when expected in ation rises interest rates will rise determines the equilibrium interest rate in terms of the supply of and demand for money the amount of interest sacri ced by not holding the alternative asset Shifts in demand for money 0 1 higher level of income caused the demand for money at each interest rate to increase and the demand curve to shift to the right 0 2 rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right Variable Change in Var Change in Change in Shift Money Interest rate Income quot Mdquot quot Right Price Level quot Mdquot quot Right Money Supply quot Msquot V Ms Right EQUATIONS Interest rate Expected return FPP Quant of bonds SUP supply quant bond DEM demand relationship among these interest rates is called the relationship among interest rates on bonds with different terms to maturity the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures T bonds no default risks The spread between the interest rates on bonds with default risk and default free bonds both of the same maturity a bond with default risk will always have a positive risk premium and an increase in its default risk will raise the risk premium investment advisory rms that rate the quality of corporate and municipal bonds in terms of the probability of default Bonds with relatively low risk of default Baa Junk bonds bonds with ratings below Baa or BBB have higher default risk o 1 Default risk 0 2 Liquidity 3 Income tax a plot of the yields on bonds with differing terms to maturity but the same risk liquidity and tax considerations Inverted yield curve downward sloping LT interet rates are above ST interest rates ST and LT interest rates are the same LT interest rates are below ST rates 3 important facts 0 1 Interest rates on bonds of different maturities move together over time o 2 When ST interest rates are low yield curves are likely to have Upward slope When ST rates are high curves are likely to be inverted 3 Yield curves almost always slope upward the interest rate on a long term bond will equal an average of the short term interest rates that people expect to occur over the life of the long term bond 0 Buyers of bonds do not prefer bonds of one maturity over another so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity expected return on these bonds must be equal sees markets for different maturity bonds as completely separate and segmented Only supply and demand and no effects from expected returns on other bonds with other maturities the interest rate on a long term bond will equal an average of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium which responds to supply and demand conditions for that bond assumes that investors have a preference for bonds of one maturity over another Particular bond maturity in which they prefer to invest 0 Liquidity premium is always positive and grows as the term to maturity increase the yield curve implied by liquid prem is always above the yield curve by expectations theory and steeper slope Curve meanings ST are expected to rise not expected to rise or fall much ST are expected to fall a little in future ST are expected to fall sharply Important facts 0 1 Interest rates on bonds of different maturities tend to move together over time o 2 When short term interest rates are low yield curves are likely to have a steep upward slope 3 Yield curves usually slope upward but when interest rates are high theyre more likely to be inverted EQUATIONS int itit1 it2 itn 1n int ititn1N lnt the principal way that corporations raise equity capital those who hold stock in a corporation own interest in the corporation proportional to the percentage of outstanding shares they own the stock holder receives whatever remains after all other claims against the rms assets have been satis ed payments made periodically usual every quarter to stockholders On period valuation model you buy the stock hold it for one period to get a dividend then sell it Gordon growth model assumes o 1 Dividends continue growing at a constant rate forever 0 2 The growth rate is assumed to be less than the required return on equty changes in expectations will occur slowly over time as past data change expectations will be identical to optimal forecasts using all available information 0 Ef cient market hypothesis 0 Theory of efficient capital markets best guess predictions will not always be perfectly accurate implications of rational expectations theory 0 1 If there is change in the way a variable moves the way in which expectations of this variable are formed will change as well 0 2 The forecast errors of expectations will on average be 0 and cannot be predicted ahead of time market participants eliminate unexploited pro t opportunities returns on a security that are larger than what is justi ed by the characteristics of that security 0 the elimination of unexploited pro t opportunities involves no risk 0 arbitrageur takes on some risk when elimination the unexploited pro t opportunities In an ef cient market all unexploited pro t opportunities will be eliminated Not everyone in a nancial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the ef cient market condition holds stock prices will respond to announcements only when the information being announced is new and unexpected items that have a direct impact on future income streams of the securities 0 1 lmplies that in an ef cient capital market one investment is a good as any other because the securities prices are correct 0 2 It implies that security s price re ects all available info about the intrinsic value of the security 0 3 lmplies that security prices can be used by managers of both nancial and non nancial rms to assess their cost of capital prices of assets rise well above their fundamental values behavioral nance applies concepts from other social sciences such as anthropology sociology and psychology to understand the behavior of security prices they must borrow stock from brokers and then sell it in the market with the aim that they earn a pro t by buying the stock back again after it has fallen in price 0 people are more unhappy when they suffer losses than they are happy when they achieve gains EQUATIONS P0 div1k P1 1K P current price of the stock Div dividend after year one 0 K required return on investments in equity P price at the end of the rst period predicted sales 0 PEt1 to in nity Dt1Kquott P0 D 19 Kg D Kg Xe x of Xe expectation of variable 0 Xof the optimal forecast of X Prices PePof Return ReRof o ReRequilibrium o Rof Requil ROfgtRPtquotRofV ROfltRptVRofA Until RofR Lnt multiyear average one year Eight important facts 1 Stocks are not the most important source of external nancing for business 2 Issuing marketable debt and equity securities is not the primary way in which businesses nance their operations indirect nance which involves nancial intermediaries is many times more important than direct nance in which businesses raise funds directly from lenders in nancial markets 4 Financial intermediaries in particular banks are the most important source of external funds used to nance businesses 5 The nancial system is among the most heavily regulated sectors of the economy 6 Only large well established corporations have easy access to securities markets to nance their activities 7 Collateral is a prevalent feature of debt contracts for both households and businesses 0 property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments credit card debt 8debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower o restrict and specify certain activities that the borrower can engage in How nancial intermediaries reduce transaction costs 1 Economies of scale 0 nancial intermediary that sells shares to individuals then invest the proceeds in bonds or stocks o 2 Expertise o liquidity services analysis of how asymmetric info problems affect economic behavior How to help adverse selection problems 0 1 Private production and sale of information o occurs when people who do not pay for information take advantage of the info that other people have paid for o 2 Government regulation to increase info 0 government agency that requires rms selling their securities to have independentaud s o 3 Financial intermediation 0 banks can tell good from bad 0 4 Collateral and Net worth 0 property promised to the lender if the borrower defaults o the difference between a rms assets and its liabilities when managers own only a small fraction of the rm they work for the stockholders who own most of the rms equity principals are not the same people as the managers of the rm who are the agents of the owners Tools to help the principalAgent Problem 1 production of Information monitoring a makes the equity contract less desirable and it explain why equity is not a more important element in our nancial structure 2 government regulation to increase information 3 nancial intermediation venture capital rms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses 4 debt contacts 0 has exactly these attributes because it is a contractual agreement by the borrower to pay the lender xed dollar amounts at periodic intervals Tools to solve moral hazard in debt contracts 0 1 Net worth and collateral o aligns the incentives of the borrower with those of the lender o 2 Monitoring and enforcement of restrictive covenants o 1 Covenants to discourage undesirable behavior 0 2 Covenants to encourage desirable behavior 0 3 Covenants to keep collateral valuable o 4 Covenants to provide information o 3 Financial intermediation 0 private loans are not traded so that no one else can free ride on the intermediary monitoring and enforcement of the restrictive covenants Summary table Asymmetric info problem Tools to solve it Adverse selection private production and sale of info government regulation to increase info financia intermediation coatera and net worth Moral hazard in equity contracts principal agent problem Production of info monitoring Government regulation increase info Financia intermediation Debt contracts Moral hazard in debt contracts Coatera and net worth Monitoring and enforcement of covenents Financia intermediation anything that is generally accepted in payment for goods or services or in the repayment of debts dollars and coins total collection of pieces of property that serve to store value ow of earnings per unit of time certain amount given at point in time Role of money 1 used to pay for goods and services 0 time spent trying to exchange goods or services How to function effectively as money 0 1 Must be easily standardized o 2 It must be widely accepted 0 3 It must be divisible o o 4 It must be easy to carry 5 It must not deteriorate 2 used to measure value in the economy 3 repository of purchasing power over time 0 used to save purchasing power from the time income is received until the time when its spent the relative ease and speed witht hich an asset can be turned into a medium of exchange 0 extreme in ation method of conduction transaction Evolution of payments system 1 money made up of precious metals or other valuble commodity 2 paper currency decreed by governments as legal tender but not convertible into coins or precious metal 3 4 5 money that exists only in electronic form 0 ex Debit measures of the money supply most liquid assets 1 paper money and coins in the hands of the nonbank table 2 business checking accounts that do not pay interest All other checkable deposits and interest baring checking accounts held by households 3 not issued by the banks adds to M1 assets that have check writing features money market deposit accounts and money market mutual funds shares and other assets savings deposits and small denomination time deposits verti cates of deposit with a denomination of less than 100000 that can be redeemed only at a xed maturity date without a penalty non transaction deposits that can be added to or taken out at any time similar to money market mutual funds but are issued by banks retail accounts on which households can write checks 0 each twelve federal reserve districts has one 0 part private part gov O O O Ielected by member banks are professional bankers prominent leaders from industry labor agriculture consumer sector I elected by board of gov not allowed to be officers employees or stockholders of banks Directors Establish discount rate Decide which banks are members and who can receive discount rate Select banker to serve of federal advisory council 512 bank pres Vote on the federal open market committee with directs open market operations the purchase and sale of government securities that affect interest rates and the amount of reserves in the banking system 0 national banks commercial banks chartered by the office of the comptroller of the currency are required to be members of red reserve system 0 7 members 0 All 7 governers are members of FOMC and vote on conduct of open market operations It sets resrve requirements Effectively controls the discount rate through review and determination process Chairman of the board advises the pres of US on economic policy Meets 8 times a year 0 Makes decisions regarding conduct of open market operations 0 Setting of policy interest rate federal funds rate interest rate on overnight loans from one bank to another a rise in the federal funds rate lowering of federal funds race ROMC does not actually carry out securities purchases or sales it directs a desk at federal reserve bank of nyc spokesperson for the fed negotiates with congress and pres of US sets agenda of board and fomc meetings ability of the central bank to set monetary policy instruments ability of central bank to set the goals of monetary policy just before an election expansionary policies are persued to lower unemployment and interest rates suggests that the objective of a bureaucracy is to maximize its own welfare just as consumers behavior is motivated by the maximization of personal welfare is more goal independent a list of banks assets and liabilities sources of banks funds 0 bank accounts that allow the owner of the account to write checks to third parties primary source of banks funds 0 once the most pop Funds can be added or withdrawn at any time lnterest payments and transactions are recorded by hand 0 xed maturity length 0 borrowing from the federal reserve Discount loans 0 Bank capital uses of banks funds o these deposits plus currency that is physically held by banks called vault cash 0 reserve requirements regulation that for every dollar of checkable deposits at a banks a certain fraction must be kept as reserves the fraction of deposits additional reserves They are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn Cash items in process of collection Deposits at other banks 0 many small banks hold deposits in larger banks in exchange for a veriety of services including check collection foreign exchange transactions and help with securities purchases Secu es o because of the high liquidity short term us government bonds are considered this liability for the individual but asset for bank 0 physical capital owned by banks is included in this category banks make pro ts by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characterisitics simpli ed balance sheet that lists only the changes that occur in balance sheet items starting from some initial balance sheet position when deposits are lost because depositors make withdrawlas and demand payment the acquisition of sufficiently liquid assets to meet the banks obligations to depositiors the bank manager must persue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings to acquire funds at low cost Capital adequacy management the manager must decide the amount of capital the bank should maintain and then acquire the needed capital the risk arising because borrowers may default the riskiness of earnings and returns on bank assets that results from interest rate changes basic measure of bank pro tability O O o The net pro t after taxes per dollar of assets the net pro t after taxes per dollar of equity capital the amount of assets per dollar of equity capital banks commitment to provide a rm with loans up to a given amount at an interest rate that is tied to some market interest rate a rm receiving a loan must keep a required minimum amount of funds in a checking account at the bank refusing to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate the amount of rate sensitive liabilities is subtracted from the amount of rate sensitive assets 0 measure the gap for several maturity subintervals o accounts for the differing degrees of rate sensitivity for different rate sensitive assets and liabilities examines the sensitivity of the market value of the banks total assets and liabilities to changes in interest rates measures the average lifetime of a securities stream of payments Off balance sheet acitivity involve trading nancial instruments and generating Income from fees and loan sales activites that affect bank pro ts but don t appear on the balance sheet secondary loan participation involves a contract that sells all or part of the cash stream from a speci c loan and thereby removes the loan so that it is no longer an asset on the balance sheet Equa ons Assetsliabilities capital Percent change in market value of security percentage point change in interest rate x duration in years ROA net pro t after taxes assets ROE net pro t after taxes equity EM assetsequity capital ROEROA X EM o government agency that oversees the banking system and is responsible for the conduct of monetary policy the federal reserve system 0 the nancial intermediaries that accept deposits from individuals and institutions and make loans 0 individuals and institutions that hold deposits in banks currency in circulation and reserves 0 increase in either increase the money supply 0 the sum of the feds monetary liabilities and the us treasurys monetary liabilities treasury currency in circ primarily coins consists of deposits at the fed plus currency that is physically held by banks vault cash 0 Assets for bank but liabilities for fed 0 Required reserves and excess reserves 0 fraction of deposits that must be held as reserves securities and loans to nancial institutions 0 An increase is an increase in money supply 0 rate charged banks for these for loans 0 is currency in circ the effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or deposits no effect 0 reserves increase the effect of an open market purchase on the monetary base is always the same increases by amount of purchase whether the seller of the bonds keeps the proceeds in deposits or currency the remainder of the base is under the fed control because it s a result of open market purchases less tightly controlled the amount of the base that is created by loans from the fed temporary net increase in the total amount of reserves in the banking system occurring from the feds check clearing process when the fed supplies the banking system with 1 of additional reserves deposits increase by a multiple of this amount whether a bank chooses to use its excess reserves to make loans or to purchase securities the effect on deposit expansion is the same the multiple increase in deposits generated from an increase in the banking systems reserves change in nonborrowed MB more MB for deposit creation change in borrowed reserves more mB for deposit creation changes in required reserve ratio less multiple deposit expansion changes in currency holding less multiple deposit expansion changes in excess reserves less loan and deposit creation how much the money supply changes for a given change in the monetary base LJ39gtLJLJII I EQUATIONS MBCR Nonborrowed MB MB borrowed reserves from fed Change in deposits 1rr change in reserves Money suppy mm x MB Currency ratio CD Excess reserve ratio ERD R RRER RR rr x D MB R C rrx D ER C Money mult 1c rrec the interest rate on overnight loans of reserves from one bank to another 0 primary instrument of monetary policy Federal Funds Hate tools of monetary policy 0 1 Open market operations 2 Discount rate 3 Reserve requirements 4 Interest rate paid on reserves DEPENDS on whether supply curve intersects on its downward sope or at 0 purchase causes the fed funds rate to fall open market sae causes fed funds rate to rise DEPENDS on where supply curve it falls 0 most changes in the discount rate have no effect of federal funds rate when fed raises reserve requirements the fed funds rate rises depends on whether the supply curve intersects the demand curve in its downward or at 0 when the federal funds rate is at the interest rate paid on reserves a rise in the interest rate on reserves raises the fed funds rate oioen market operations discount lending reserve requirements intended to change the level of reserves and the monetary base intended to offset movements in other factors that affect reserves and the monetary base speci c set of dealers in government securities the fed purchases securities with an agreement that the seller will repurchase them in a short period of time matched sale purchase transactions reverse repos the fed ses securities and the buyer agrees to sell them back to the fed in the near future facility at which banks can borrow reserves from the fed 0 1 the discount lending that plays the most important role in monetary policy 0 healthy banks allowed to borrow all they want at very short maturities from primary credit facility standing lending facility 0 2 given to banks that are in nancial trouble and experiencing severe liquidity problems 0 50 points above discount rate 0 given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits 0 rate is tied to average of fed funds rate to prevent bank failures from spinning out of control central bank is unable to lower short term interest rates because they hit a oor of 0 o 1 Liquidity provisions 0 2 Asset purchases 0 3 Commitment to future monetary policy actions o lowering of the discount rate 0 made loans at a rate determined through competition auctions lending to investment banks and promote other purchases of securities expansion of the balance sheet in the reserves altering the composition of the feds balance sheet in order to improve the functioning of particular segments of the credit markets lower the markets expectations of future short term interest rates thereby causing the long term interest rates to fall 0 commitments to monetary policy 0 mentioning that the decision was predicated on a weak economy going forward 0 not stated that the decision is due to the state of the economy stronger than conditional because doesn t suggest the decision will be abandoned EUROPE predominant form of open market operations similar to the feds repos purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral which are reversed after 2 weeks much smaller source of liquidity for the euro area banking and similar to feds purchasing or sales of securities where banks can borrow overnight loans from the national central banks at the marginal lending rate set 100 basis points above the target nancing rate banks are paid a xed interest rate that is 100 basis points below the target nancing rate thte total amount of spending on domestically prodiced goods and services that households businesses the government and foreigners want to make the amount that they actually do spend the total amount of output demanded in the economy same as planned expenditure 0 the total demand for consumer goods and services the total planned spending by businesses on new physical capital plus planned spending on new homes 0 the spending by all levels of government on goods and services not including transfer payments 0 the new foreign spending on domestic goods and services equal to exports minus imports the total income available for spending equal to aggregate output minus taxes the amount of consumption expenditure that is exogenous independent of variable in the model such as disposable income re ects the change in consumption expenditure that results from an additional dollar of disposable income planned spending by rms on equipment and structures and planned spending on new residential housing spending by rms on additional holdings of raw materials parts and nished goods calculated as the change in holdings of these items in a given time period completely exogenous and so is unexplained by variables in this model such as output of interest rates emotional waves of optimism and pessimism additions to the real cost of borrowing because of asymmetric info problems in nancial markets the price of one currency in terms of other currencies 0 Ex rise in value of dollar makes US exports more expensive in foreign currencies so foreigners will buy less of them the level of net exports that is treated as exogenous shows the relationshop between aggregate output and the real interest rate when the goods market is in equilibrium 0 autonomous consumption investment government purchases net exports o taxes or nancial frictions o Increases in output at any given interest rate EQUATIONS CClbarl mpc Yd bar dr I parameter re ecting how responsive investment is to the real cost of borrowing bar d rfbar investment is positively related to business optimism NXNXbar xr o I indicated how net exports respond to real int rate 0 net exports are postiviely realted to autonomous net exports and are negatively related to the level of real int rate Y change in whatever 11mpc dx1mpc x r positive relationship between real interest rates and in ation Real interest rate is the one that affects net exports and business func ons 0 When the federal reserve lowers the federal funds rate real interest rates fall 0 When the fed raises the federal funds rate real interest rates rise the relationshop between the real interest rate the central bank sets and the in ation rate 0 Rrbar responsiveness of real intr rate to in in ation raise nominal rates by more than any rise in expected in ation so that real interest rates rise when there is a rise in in ation rise in the real interest rate which shifts monetary policy up in a recession policy akers lower real interest rates to stimulate economy and prevent in ation from falling relationshop between in ation rate and aggregare output when the goods market is in equilibrium 0 Shifts in the same way that the IS curve shifts soo Autonomous consumption expenditure Autonomous invewstment spending Government purchases Taxes Autonomous net exports Financial frictins of monetary policy rise in real interest rate shifts the AD curve to the o of monetary policy lowering the real interest rate shifts the AD curve to the 000000 Equa ons nominal in ation in ation rises o the monetary authorities raise the real interest rate to keep in ation from spiraling out of control 0 higher cost of nancing purchases makes investment ess pro table and planned investment declines aggregate output declines 1 o rquotV YadV 2 o GAYA 3 0 TA CV Yad V 7 o Fquot Yad V the relationship between the quantity of output supplied and the price level where the economy gravitates to in the long run the level of aggregate output produced at the natural rate of unemployment o AKA where the economy settles settles in the long run for any un ation rate 1 o in ation will rise one for one with increases in expected in ann 2 the difference between aggregate output and potential output 0 When output exceeds its potential level higher wages are demanded and results in higher in ation 3 when there are shocks to the supply of goods and serives produced in the economy 0 shifts in in ation that are independent of the amount of slack in the economy or expected in ation o workers push for wages higher than productivity gains shows wages and prices are sticky aggregarte price level adjusts slowly over time o The more exible wages and prices are the more they and in ation respond to deviations of output 0 more exiblegt steeper SRAS curve o 1 Increase in total amount of o 2 increase in the total amount of o 3 Increase in available o 4 Decline in the natural rate of when all markets are simultaneously in equilibrium at the point where quantity of aggregate output demand equals the quantity of aggregate output supplied regardless of where output is initially it returns eventually to potential output 0 occurs because the SRAS shifts up or down to restore the economy to the long run equilibrium at full employment rising in ation but falling level of aggregate output increase in the supply 1 decrease in the supply business cycle uctuations result from permanent supply shocks alone Shocks to taste and technology are the major driving forces behind short run uctuations in the business cycle lead to a permanent decline in output and a permanent rise in in ation leads to lower in ation and raises output in SR and LR EQUATIONS in ation expected in y output gap price shocks collections of equations that describe statistical relationships among many economic variables Long term interest rates are believed to have the larger impact on aggregate demand points out that not only conventional econometric models cannot be used for policy evaluation but also that the publics expectations about a policy will in uence the response to that policy binding plans that specify how policy will response to particular data such as unemployment and in ation when they make no commitment to future actions but instead make what they believe in that moment to be the right policy decision for the situation 0 reveals the potential limitations to discretionary policy due to the tendency to deviate from good long run plans when make short run decisions Milton Friedman the money supply is kept growing at a constant rate regardless of the state of the economy 0 followers of Milton monetary policy should react to the level of output as well as to in ation scal and monetary policy is expansionary right before elections 1 rules can be too rigid because they cannot foresee contingency 2 they do not easily incorporate the use of judgment 3 no one knows the true model of the economy so any policy that follows a certain rule is wrong if the model is wrong 4 structural changes in the economy would lead to changes in the coefficient of the model imposes a conceptual structure and inherent discipline on policymakers but without eliminating all exibility Combines the advantages of each a nominal variable that ties down the price level or in ation to achieve price stability 0 ex In ation money supply exchange rate 0 1 Credible nominal anchor has elements of a behavior rule 0 2 Credible commitment to a nominal anchor will help to anchor in ation expectations which lead to small uctuations in in ation monetary policy credibility has the bene t of stabilizing In the short run when faced with monetary policy credibility has the bene t of stabilizing in the short run when faced with monetary policy credibility has the bene t of producing better outcomes on both in the short run when faced with the greater the credibility of the central bank as an in ation ghter the more rapid will be the decline in in ation and the lower will be the loss of output to achieve the in ation objective 0 involves public announcement of a medium term numerical target for in ation and a commitment to achieve it o peg its exchange rate to an anchor country that already has a strong nominal anchor give from the political process appoint central bankers to quotattack in ationquot O the ways in which monetary policy affects aggregate demand and the economy r V l quot Yad quot o spending by consumers on durable items such as automobiles and refrigerators the rate that affects consumer and business decisions 0 real long term interest rate has the major impact on spending 0 the aggregate price level adjusts slowly over time so that expansionary monetary policy which lowers the ST nominal interest rate also lowers the ST real interest rate 0 indicates monetary policy can still be effective even when nominal interest rates have already been driven down to zero by monetary authorty explains how monetary policy can affect the economy through its effects on the valuation of equities stocks 0 I the market value of rms divided by the replacement cost of capital 0 Qhigh market price of rms is high relative to replacement costs of capital and equipment is cheap spending by consumers on nondurable goods and services differs from consumer expenditure because id doesn t include spending on consumer durables operating through asymmetric information effects on credit markets 0 banks play a special role in the nancial system because they are especially well suited to solve asymmetric information problems in credit markets 0 operates by affecting cash ow 0 Cash ow the different between rms cash receipts and cash expenditures F Short term interest rate plays a role bc interest payment on short term debt typically have the greatest effect on cash ow of households and rms operates through monetary policy effects on general price level increases in interest rates cause a deterioration in household balance sheets because consumers cash ow is adversely effected 1 a large body of evidence on the behavior of individual rms supports the view that nancial frictions of the type crucial to the operation of credit channels do affect rms employment and spending decisions 2 evidence shows that small rms are hurt more by tight monetary policy than large rms which are unlikely to be credit constrained 3 the asymmetric info view of nancial frictions at the core of the credit channel analysis is a theoretical construct that has proved useful in explaining many other important phenomena
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