Class Note for ECON 311 at UMass(5)
Class Note for ECON 311 at UMass(5)
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Date Created: 02/06/15
Jan 7 Risk and Term Structure L Reconstructing money etc Risk and term structure of i Exchange rates briefly CR1 Money Copyrrgm 2007 Pearson Addrsoanestey AH rrgme reserved 12 06Jan 2009 and nfati0n quotar 3 a it Copyright 2009 Vahoo Inc 305 mm H inance Hahao com Money and Bond Mrkts 1x more 39 Ms k constant fixed by monetary authorities 39 Md YLi 39 Transactions demand for money function of income 39 Liquidity preference i is the cost of inducing individual to forgo liquidity Copyngnt 2007 Peavson Addisoanesiey AH tights vesevved 62 Money and Bond Mrkts 1x more Money mrkt meets Bond Mrkt 39 Individual chooses liquid Iorisk asset money is barren or hirisk asset bonds 39 Monetary authority controls Ms assume Fed has a money switch 39 Shifting Ms curve changes i individual reacts by adjusting moneybond portfolio 39 Pricelevel effect and expectedinflation effect gt MA should tightly manage Ms Copyright 2007 Pearson Addisoanesley All rights reserved 63 Money and Bond Mrkts 1x more Conclusion I 39 Money is a commodity no different than other commodities part of individual cons Basket 39 Interest rate is the equilibrium price in the market for loanable funds 39 MA can manage growth of the Ms 39 Coordinate inflation expectations 39 Via interest rate manage the quantity of credit Copyright 2007 Pearson Addisoanesiey AH tights reserved 64 M gtY or Y gtM Money Growth Rate quoto 15 Money Growth Rate M2 5 I 0 I 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 F I G U RE 4 Money Growth M2 Annual Rate and the Business Cycle in the United States 19502005 Note Shaded areas represent recessions Source Federal Reserve Bulletin p A4 Table 110 wwwfederalresenlegovreleasesh6histh6hist1txt Granger causality test Y causes M usually Endogenous money Copyright 2007 Pearson AddisonWesley All rights reserved 65 How tightly are Ms and irelated l t t Money anterEs Growth Rate a e 0 annual rate 32 28 30 26 28 24 22 2 6 20 24 18 22 Money Growth Rate M2 16 20 14 12 16 1o W 12 I quot 8 6 8 1 4 1 y I 4 Interest Rate rquot 39 3 4 2 4 8 6 12 I I I I I I I I I I I 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 F I G U RE 1 2 Money Growth M2 Annual Rate and Interest Rates ThreeMonth Treasury Bills 19502005 Sources Federal Reserve wwwfederalreservegovreleasesh6histh6hist1txt Copyright 2007 Pearson AddisonWesley All rights reserved What is happening 39 Financial world is more complex than described by neoclassical textbook theory 39 Money not like other commodities Zero elasticity of production Nearzero elasticity of substitution No automatic stabilizer 39 Subject to market coordination failures 39 Role of expectations 39 Endogenous money and financial innovation Copyright 2007 Pearson Addisoanesley All tights reserved 67 Coordination Failures Henry Guilty Not Guilty Dave 8 l l l Markets as coordination w 1 Yr mechanism Market amp coord failure Prisoner39s dilemma Public goods and environmental degradation Copyrrgm 2007 Pearson Addisoanesley All rrgme reserved NotGuilty l i 39ll l l i ll W39i lYears 5Years l l l quot l Ir 5Years 3Years 39 Micromoives macrobewavior 68 Coordination Failures Core of economics 39 L mrkt noncontractible effort labor discipline 39 Corp Governance mrkt potential incentive conflict bw manager and owner 39 Credit markets Adverse selection evaluation of borrower Moral Hazard noncontractible choice of risk probability of default 69 Copyrrgm 2007 Pearson Addisoanesley All rrgme reserved Coordination Failures Partial Solutions 39 L mrkt technology traumatized worker 39 Corp Governance mrkt stock options 39 Credit markets Post collateral Interest rates as screening device credit exclusion not equilibrium price Relational lending reputation Board appointments Copyright 2007 Pearson Addisoanesley All rights reserved 610 Coordination Failures Results 39 Different people pay different interest rates 39 Wealth is important for accessing finance 39 Rich have access to more instruments pay lower K costs 39 Some people are creditexcluded 39 Increased competition leads to increased risk taking Copyright 2007 Pearson Addisoanesley All rights reserved 611 Endogenous money Letter of Credit Republic of A B Iand Sales contract 4 Corninamf x1 Buyerfanplicant Company B Sellerfbeneficiarv Buyer applies Seller s bank for LC authenticates LC and credits Company B lilliilllllilll iiili w 7 7 issues 7 LC and sends to A Plus Bank selleris bank Bank B See newly posted Macroblog on trade credit Copyiignt 2007 Peaison Addisoanesiey Aii Hng ieseived 612 Endogenous money M1 Muney Multlplier MULT Source Federal Reserve Bank of St Louis 20 18 M 1 6 E y g 1 4 12 10 y 0 a I t I t r 2000 2002 2004 2006 2008 2010 2009 Federal Reserve Bank of St Louls researchtstlnuisfednrg Sometimes banks expand M sometimes contract M it depends on the degree of leverage deemed safe Copyngnt 2007 Pearson Addtsoanestey AH ngnts reserved 613 Wray Money and Inflation Bank reserves interbank means of payment Markup pricing and market power gt surplus 39 Real sector 39 Financial sector No equilibrium Inflation not such a big problem if lt40 o G as employer of last resort Copyrrgm 2007 Pearson Addisoanesley All rrgme reserved 614 Sidenote Inflation and Measuring Prices 39 How do we measure prices How accurate 39 Which goods go in the basket 39 Hedonic prices qualitative change in goods 39 Consumer electronics 39 Airfares 39 Housing prices 39 Core inflation excludes food and fuel Copyright 2007 Pearson Addisoanesley All rights reserved 615 Stiglitz Money Market Funds Monetization of ST securities Money no longer barren earns risky rate no opportunity cost Central bank policy targeting ist is less not effective Copyright 2007 Pearson Addisoanesley All rights reserved 616 Sneak Preview of What39s to Come Financial structure the nexus of institutions policy rules and social norms that define 0 how savings surplus value is collected and allocated for investment 0 who makes investment decisions 0 how investment performance is monitored and enforced Endogenous money banks financial crises 2007 Pearson Addisoanesley All rights reserved 617 Risk and Term Structure 06Jan2009 rent have different interest rates oz Copyngm 2007 PeavsonAddwsoanesby AH ngms vesevved 3m 3y 5g 10g 309 Copyright 2009 Vahoo Inc http inancegahoocom 0 12 quot fr Risk Structure of Interest Rates 39 Default risk occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value US Tbonds are considered default free Risk premium the spread between the interest rates on bonds with default risk and the interest rates on Tbonds 39 Liquidity the ease with which an asset can be converted into cash 39 Tax considerations Copyright 2007 Pearson Addisoanesley All rights reserved 619 FIGURE 1 Annual LongTerm Bond Yields Yield I 9 I 92005 1 6 Sources Board of Governors of the Federal Reserve System 14 Banking and Monetary Statistics 1941 7970 Federal Reserve 12 wwwfederareservegovreleases hlSdatahtm 10 8 6 4 US Government LongTerm Bonds 2 State and Local Government Municipal 0 l l 1920 1930 1940 1950 1960 1970 1 980 1 990 2000 Fiisk premium spread between risky and safe bond Note data are maturityadjusted Copyright 2007 Pearson AddisonWesley All rights reserved 620 sf sset my Noi ee aux I 39 n394quot39quotr quot 391 39 39 5 Hr g 2 3 V C J 4 3 f f quot 541quotquot 5 A 1 u What makes a US Treasury bond safe Copyright 2007 Pearson AddisonWesley All rights reserved 621 Tangent The first Latin Debt Crisis Citibank CEO Sandy Weill 1980 Countries don 39t go bankrupt 1982 Latin American Debt Crisis Resolution restructure debt Brady Bonds structural adjustment depreciation and austerity Foreign debt gt must earn in order to pay back Copyvlgnt 2007 Pearson Addisoanesley All tights reserved 622 Price of Bonds P Price of Bonds P SC 0 Quantity of Corporate Bonds Quantity of Treasury Bonds a Corporate bond market b Defaultfree US Treasury bond market FIGURE 2 Response to an Increase in Default Risk on Corporate Bonds Copyright 2007 Pearson AddisonWesley All rights reserved 623 TAB LE 1 Bond Ratings by Moody39s and Standard and Poor s Rating l i 3 Standard Examples of Corporations with 5D Moody s and Poor s Descriptions Bonds Outstanding in 2006 m g Aaa AAA Highest quality General Electric Pfizer Inc D lowest default risk United Parcel Service Inc 3 Aa AA High quality Wal Mart PepsiCo H m Credit Suisse First Boston g A A Upper medium grade Dell Anheuser Busch Q McDonald s Boeing CD Baa BBB Medium grade Motorola PedEX Corp Royal Caribbean H Tommy Hilfiger g Ba BB Lower medium grade Ford Allied Waste Industries W Jack in the BOX Inc 6 B B Speculative Rite Aid General Motors 0 Levi Strauss a Caa CCC CC Poor high default risk Revlon Fedders Corp m Integrated Electrical Services Inc C D Highly speculative United Airlines Corp Pliont Corp Northwest Airlines Corp Private rating agencies also rate sovereign debt affect countries39 access to international capital Copyright 2007 Pearson AddisonWesley All rights reserved 624 Price of Bonds P Price of Bonds P Quantity of Municipal Bonds Quantity of Treasury Bonds a Market for municipal bonds b Market for Treasury bonds FIG URE 3 Interest Rates on Municipal and Treasury Bonds Mishkin tax considerations are important for bond demand duh Copyright 2007 Pearson AddisonWesley All rights reserved 625 H Uis Treasury Vlield Curve 06Jan2009 Term Structure of 2 Interest Rates W any Copyright 2009 Vahool Inc httpJhnanceyahnomum Bonds with identical risk liquidity and tax characteristics may have different interest rates because the time remaining to maturity is different Yield cune a plot of the yield on bonds with differing terms to maturity but the same risk liquidity and tax considerations Upwardsloping gtlongterm rates are above shortterm rates Flat gt short and longterm rates are the same Inverted gtlongterm rates are below shortterm rates Interest Rate 16 14 Threeto 11 12 FiveYear Averages 1 10 J I lv 1 If r 8 r 20Year Bond A 439 y r 6 Averages 39 ifquot A In J 1 4 I I v quotquot 2 V I J I ThreeMonth Bills V 1 ShortTerm I 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 F I G URE 4 Movements over Time of Interest Rates on US Government Bonds with Different Maturities Whe cei rti39 Ete i ri tesr esetm rates are low vi l 2 w 0 man u 39 39 gs are i ely to slope e inverted Three Theories to Explain the Three Facts Expectations theory explains 1 2 not 3 Segmented markets theory explains 3 but not 1 and 2 Liquidity premium theory combines the two theories explains 13 2007 Pearson Addisoanesley All tights reserved 628 Expectations Theory 39 LT interest rate avg of ST interest rates 39 Buyers don39t care about maturities as long as returns are equal Copyright 2007 Pearson Addisoanesiey AH rights reserved 629 Expectations Theory Example Copyright 2007 Pearson Addisoanesiey AH rights reserved Let the current rate on oneyear bond be 5 You expect the interest rate on a oneyear bond to be 9 next year Then the expected return for buying two one year bonds averages 5 92 7 The interest rate on a twoyear bond must be 7 for you to be willing to purchase it approximately 630 39 Expectations Theory In General Expected return over the two periods from investing 1 in the two period bond and holding it for the two periods 1 iZt1 iZt 1 12i2t i2t2 1 21 iv 2 Since i22 is very small the expected return for holding the two period bond for two periods is 21 Copyrrgm 2007 Pearson Addisoanesley All rrgms reserved 631 Expectations Theory In General cont d If two oneperiod bonds are bought with the investment 0 m z39gt e Qae ll lt l gf 409 l l itie is extremely small t Simplifying we get 9 l ztz Copynght 2007 Feavson Addisoanesley AH thts vesevved 632 Expectations Theory In General cont d Both bonds will be held only if the expected returns are equal e 2l2t lt lt1 e lt lt1 12 2 The two period rate must equal the average of the two one period rates For bonds with longer maturities e l lt lt1 nt ie e l tn71 t2 n The n period interest rate equals the average of the one period interest rates expected to occur over the n period life of the bond oopyngm 2007 Peavson Addisoanesley All ngms vesewed 633 Expectations Theory 39 Explains why the term structure of interest rates changes at different times 39 Explains why interest rates on bonds with different maturities move together over time fact 1 39 Explains why yield curves tend to slope up when shortterm rates are low and slope down when shortterm rates are high fact 2 39 Cannot explain why yield curves usually slope upward fact 3 Copyright 2007 Pearson Addisoanesley All rights reserved 634 Segmented Markets Theory Bonds of different maturities are not substitutes at all The interest rate for each bond is determined separately by distinct supply and demand schedules Investors have maturity preference most prefer ST over LT So demand for Bst gt Blt and therefore ist lt ilt explains Fact 3 C What fact if true might undermine this theory Copyright 2007 Pearson Addisoanesley All rights reserved 635 Liquidity Premium amp Preferred Habitat Theories Where lm is the liquidity premium for the n period bond at time t lm is always positive Rises With the term to maturity Bonds of different maturities are substitutes but not perfect substitutes investors have maturity preference Copyright 2007 Pearson Addisoanesiey AH rights reserved 636 Interest Liquidity Premium Preferred Habitat Theory Rate int Yield Curve Liquidity Premium Int Expectations Theory Yield Curve l l l I 0 5 1 0 1 5 2O 25 30 Years to Maturity n FIGURE 5 The Relationship Between the Liquidity Premium Preferred Habitat and Expectations Theory Copyright 2007 Pearson AddisonWesley All rights reserved 637 Liquidity Premium and Preferred Habitat Theories Explanation of the Facts Interest rates on different maturity bonds move together over time explained by the first term in the equation a ist low gt YC tends to slope up b ist high gt YC tends to be inverted a explained by the liquidity premium term and b by a low expected average in the second case Liquidity premium directly related to maturity gt tendency toward upward slope Copyright 2007 Pearson Addisoanesley All rights reserved 638 Emhame Ra tag and arm Mrktg i The Mercantili39sts 3 Exchange rates and Forex Mrkts How Floating or peggedmanaged exchange rate Spot market Forward market and futures and options Swap market repurchase agreements Key and vehicle currencies Interbank market Copyright 2007 Pearson Addisoanesiey Aii rights reserved 640 Exchange rates and Forex Mrkts Why Means of payment for internationally traded goods services and assets May enhance efficiency by moving resources from savers to investors internationally from Kabundant to Kscarce countries Investors may diversify home market risk and earn potentially higher returns abroad Speculation Developing country import technology goods forex reserves Copyright 2007 Pearson Addisoanesley All rights reserved 641 International Reserve Currencies Tank 1 slum nmaln Cmnclrs In Total I tnll ul 0mm noMurFontn Examch Cop I995 9 36 997 was 1999 20m 20m 20m 2003 200 ms All mum us may 59m 51m es in am 7109 ms mm 5050 55m 6590 054 lip05 tn HID 07D 5X0 6110 6 N 53I JjD 4 HID 358 Nuldsltding 2 1m 200 290 2110 7 79 15 no 15 5 win Ann LSD 030 L10 0 IL 0 BAD LID in D Ll Eula 1790 1350 I935 211 2530 3190 1L3 Dmbrh mud I5 l77 50 330 Fltchin um um mu m 7 7 7 7 7 7 7 mum quota gumquot run 01 oAn run 7 7 7 7 7 7 ECU 850 7 m 001 120 7 7 7 7 7 7 7 Olkrzumxi s J30 430 W 450 LN 40 12 IA L JD JU I l Indus Calm U huh sun S39IJU MINI 7351 Tl39rl M90 50 717 blunts ycn 67 570 5 90 670 1M JAB UID 332 Found alcllinu 2 us 100 220 XI lll L90 2 Swhl an 0quot JD LID DJG DJI Dbl quotJD DJ Eum lb II I8 UD ZlJ 2090 NJ 3 Dalian mark IMJD I190 310 1310 Frncll nu ma nu rum L20 7 7 7 7 7 7 7 Nnkdmd znihkr rm 1 11 run run 7 7 7 7 7 7 7 ECU 11M llll I 120 l 7 7 7 7 7 7 7 Okkrmmxiu 600 473 4J0 62 140 UK 15I LTI L JV 100 I Deva CDIHIIII u Inlbl mm new 7240 7120 320 6820 men mm mm 5991 49 hpw yrn mu m nu ma am rm 4m 4 7 440 430 am Pand Hiding 121 j 110 110 37 1 00 36 38 J ll ID 5 5w hm ma Mm um quot50 um run Inn 020 01 quot10 015 Eu 7 7 7 7 NM DMD 2130 l JD DUN 2910 HEB Dnnsrh mutt LL IHKI l1 7 Furch In 1 11quot IJD 12 International Balance of Payments Account of all payments for international flows of goods services and finance Financial Account formerly K Acct Portfolio investment Direct investment 39 Current Account Stock International Investment Position httpwwwbeagov Copyright 2007 Pearson Addisoanesley All rights reserved 643 125 115 Value of the ms and 85 US Trade Bal 75 65 lillllllllglllllllllllglll 1980 1985 1990 1995 2000 0 00 e 4 00 V2 00 Va 00 74 00 75 00 600 my ma was 937 mm mm ma was 997 mg 200 2003 2005 2007 Copwgm 2007 FemonAdd SonVWeS e 930 932 mm was mm 990 992 994 was max 2000 2002 2004 200a Somce Me and Emeau ov Economy Anahsws International Trilemma 2 of 3 Fixed exchange rate Free capital flows Macro policy autonomy Gold Standard 1 and 2 Bretton Woods 1 and 3 PostBW Copynght 2007 Peavson Addtsoanestey AH Hgnts vesevved 645 Final exam options 1 Final exam Lecture and review on Jan 23 then takehome final due 5pm Jan 24 39 2 56 pg 12001500 word paper 39 Must cite required readings optional readings as well as some books from suggested reading list 39 Must decide by next Wed Jan 14 submit 1 paragraph introduction statement of thesis and outline arguments as well as preliminary biblio 39 I will offer topics or you can suggest your own Copynght 2007 Peavson Addisoanesley All thts vesevved 646 JV Leavethe 7 39 gun take the cannoli Hquot Pollin Mishkin Ch 8 39 PS1 due 5pm Copynght 2007 Peavson Addwsoeres ey AH thts vesevved 647
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