ECON 3371: Economics of Money and Banking - Study Guide
ECON 3371: Economics of Money and Banking - Study Guide ECON 3371
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This 8 page Study Guide was uploaded by K.Banks Notetaker on Wednesday October 15, 2014. The Study Guide belongs to ECON 3371 at University of Houston taught by Hardee in Fall. Since its upload, it has received 418 views. For similar materials see Economics of Money and Banking in Economcs at University of Houston.
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Date Created: 10/15/14
Chapter 5 The Behavior of Interest Rates Determining the Quantity Demand of an Asset Holding all other factors constant Money and Banking Exam 2 Wealth the total resources owned by the individual including all assets Expected Return the return expected over the next period on one asset relative to alternative assets Risk the degree of uncertainty associated with the return on one asset relative to alternative assets Liquidity the ease and speed with which an asset can be turned into cash relative to alternative assets Theory of Asset Demand 1 The quantity demanded of an asset is positively related to wealth 2 The quantity demanded of an asset is positively related to its expected return relative to alternative assets 3 The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4 The quantity demanded of an asset is positively related to its liquidity relative to alternative assets Response of the Quantity of an Asset Demanded to Changes in Wealth Expected Returns Risk and Liquidity Varia39ble Change in Variable Change in Quantity lDemand ed Wealth 2 T Expected return re1atlvlte to other assets j d Risk relative to other assets l Liquidity re1ative to either assets b T Note Only increases in the varlabvles are shown The effect oftl ecilteases in the va39riab39les on the change in quantity demzlntletl would be the oppo5ite of those it39tcli ce ted in the rightrrtost co lt1trIt39t Supply and Demand for Bonds At lower prices higher interest rates ceteris paribus the quantity demanded of bonds is higher an inverse relationship At lower prices higher interest rates ceteris paribus the quantity supplied of bonds is lower a positive relationship Price of Bonds P 55 l mu U 0 950 l39 53 900 l 39l11 Fquot 850 lquot 39 176 o 800 U 250 750 I 330 J C l l l l l l l l l l l S S l l l l f l l l l l rBd 100 200 300 400 500 Quantity of Bonds B billions Shifts in the Wealth in an expansion with growing wealth the demand curve for bonds shifts to the right Expected Returns higher expected interest rates in the future lower the expected return for long term bonds shifting the demand curve to the left Expected Inflation an increase in the expected rate of inflations lowers the expected return for bonds causing the demand curve to shift to the left Risk an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity increased liquidity of bonds results in the demand curve shifting right Price of Bonds P gt d 3 i l l I I I B l I 2 QuIantiity of Bonds B Shifts in the Expected profitability of investment opportunities in an expansion the supply curve shifts to the right Expected inflation an increase in expected inflation shifts the supply curve for bonds to the right Government budget increased budget deficits shift the supply curve to the rigm The Liquidity Preference Framework Shifts in the Income Effect a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right Price Level Effect a 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 Shifts in the Assume that the supply of money is controlled by the central bank An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right Everything Else Remaining Equal Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates the liquidity effect Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy the demand curve shifts to the right PriceLevel effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level the demand curve shifts to the right Expected lnflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future the demand curve shifts to the right PriceLevel Effect and Expected lnflation Effect A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year The interest rate will rise via the increased prices Price Ieve effect remains even after prices have stopped rising A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year When the price level stops rising expectations of inflation will return to zero Expected lnflation effect persists only as long as the price level continues to rise Chapter 6 The Risk and Term Structure of Interest Rates Bonds with the same maturity have different interest rates due to Default risk Liquidity Tax considerations Default risk probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value US Treasury bonds are considered default free government can raise taxes Risk premium the spread between the interest rates on bonds with default risk and the interest rates on same maturity Treasury bonds Risk Structure Liquidity the relative ease with which an asset can be converted into cash Cost of selling a bond Number of buyerssellers in a bond market Income tax considerations Interest payments on municipal bonds are exempt from federal income taxes Term Structure Bonds with identical risk liquidity and tax characteristics may have different interest rates because the time remaining to maturity is different Yield curve a plot of the yield on bonds with differing terms to maturity but the same risk liquidity and tax considerations Upward sIoping Iong term rates are above short term rates Flat short and Iong term rates are the same Inverted Iong term rates are below short term rates Facts Theory of the Term Structure of Interest Rates Must Explain 1 Interest rates on bonds of different maturities move together over time 2 When short term interest rates are low yield curves are more likely to have an upward slope when short term rates are high yield curves are more likely to slope downward and be inverted 3 Yield curves almost always slope upward Three Theories to Explain the Three Facts 1 Expectations theory explains the first two facts but not the third 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 Buyers of bonds do not prefer bonds of one maturity over another they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity Bond holders consider bonds with different maturities to be perfect substitutes 2 Segmented markets theory explains fact three but not the first two Bonds of different maturities are not substitutes at all The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond Investors have preferences for bonds of one maturity over another If investors generally prefer bonds with shorter maturities that have less interest rate risk then this explains why yield curves usually slope upward fact 3 3 Liquidity premium theory combines the two theories to explain all three facts 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 that responds to supply and demand conditions for that bond Bonds of different maturities are partial not perfect substitutes Liquidity Premium and Preferred Habitat Theories Interest rates on different maturity bonds move together over time explained by the first term in the equation Yield curves tend to slope upward when short term rates are low and to be inverted when short term rates are high explained by the liquidity premium term in the first case and by a low expected average in the second case Yield curves typically slope upward explained by a larger liquidity premium as the term to maturity lengthens Chapter 14 The Money Supply Process Players in the MS Process Central bank Federal Reserve System Banks depository institutions financial intermediaries Depositors individuals and institutions Monetary Liabilities Currency in circulation in the hands of the public Reserves bank deposits at the Fed and vault cash Assets Government securities holdings by the Fed that affect money supply and earn interest Discount loans provide reserves to banks and earn the discount rate Monetary Base Open Market Purchase from a Bank Net result is that No change in currency Banking System Federal Reserve System Assets Liabilities Assets Liabilities Securities l 00 Securities 1 00 Reserves 33 100 Reserves 100 Open Market Purchase from Person selling bonds to the Fed deposits the Fed s check in the bank Identical result as the purchase from a bank Banking System Federal Reserve System Assets Liabilities Assets Liabilities deposits Reserves 100 Checkable 3 100 Securities 33 100 Reserves 39 100 Open Market Purchase from The person selling the bonds cashes the Fed s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase Nonbank Public Federal Reserve System Assets Liabilities Assets Liabilities Securities 100 Securities 100 Currency in 10i0 circulations Currency 1 00 o 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 in deposits The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase Nonbank Public Federal Reserve System Assets Liabilities Assets Liabilities Securities H3 1 00 Securities 1 00 Currency in 100 circulation Currency 3 1 O0 Shifts from Deposits into Currency Nonbank Public Banking System Assets Liabilities Assets Liabilities Checkable 1 00 Reserves 100 Checkable 9 100 deposits deposits Currency 53 1 00 Federal Reserve System Assets Liabilities Currency in 100 circulation Reserves 1 00 Making a Discount Loan to a Bank Banking System Federal Reserve System Assets Liabilities Assets Liabilities Reserves 33 100 Discount 35 100 Discount 10i0 Reserves 100 loans loan borrowing OII 1 E ed borrowing from Fed Factors affecting the Monetary Base Float Treasury deposits at the Federal Reserve Interventions in the foreign exchange market Fed s Ability to Control the Monetary Base Open market operations are controlled by the Fed The Fed cannot determine the amount of borrowing by banks from the Fed Split the monetary base into two components The money supply is positively related to both the non borrowed monetary base MB and to the level of borrowed reserves BI3 from the Fed Critique of the Simple Model Holding cash stops the process Currency has no multiple deposit expansion Banks may not use all of their excess reserves to buy securities or make loans Depositors decisions how much currency to hold and bank s decisions amount of excess reserves to hold also cause the money supply to change Factors that Determine the Money Supply Changes in the nonborrowed monetary base MB The money supply is positively related to the non borrowed monetary base MB Changes in borrowed reserves from the Fed The money supply is positively related to the level of borrowed reserves BI392 from the Fed Changes in the required reserves ratio The money supply is negatively related to the required reserve ratio Changes in currency holdings The money supply is negatively related to currency holdings Changes in excess reserves The money supply is negatively related to the amount of excess reserves Define money as currency plus checlltabe deposits M1 0 Linllt the money supply M to the monetary base MB and let m be the money multiplier o The monetary base MB equals currency C plus reserves R MBCRCrXDER Equation reveals the amount of the monetary base needed to support the existing amounts of checlltabe deposits currency and excess reserves
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