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Money Bank & Fin Markets

by: Kareem Larkin PhD

Money Bank & Fin Markets EC 330

Marketplace > Michigan State University > Economcs > EC 330 > Money Bank Fin Markets
Kareem Larkin PhD
GPA 3.81

A. Lakdawala

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A. Lakdawala
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This 16 page Class Notes was uploaded by Kareem Larkin PhD on Saturday September 19, 2015. The Class Notes belongs to EC 330 at Michigan State University taught by A. Lakdawala in Fall. Since its upload, it has received 13 views. For similar materials see /class/207661/ec-330-michigan-state-university in Economcs at Michigan State University.

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Date Created: 09/19/15
EC330 I FINAL EXAM STUDY GUIDE Chapter 3 The main reasons borrowers charge interest on loans are to compensate for 1 inflation 2 default risk the risk that the bond issuer will fail to make payments of interest or principal 3 opportunity cost of waiting to spend the funds being loaned on goods amp services today Most financial transactions involve payments in the future Compounding the process of earning interest on interest as savings accumulate over time Future value the value at some future time of an investment made today Present value the value oftoday s funds that will be received in the future Discounting used to calculate present values Time value of money economists refer to the way that the value ofa payment changes depending on when the payment is received The price of a financial asset is equal to the present value ofthe payments to be received from owning it Debt instruments credit market instruments fixed income assets fact above applied to determine these prices 4 basic categories of debt instruments simple loans discount bonds coupon bonds and fixed payment loans Simple loan borrower receives from the lender an amount of funds called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures Discount bond borrower pays the lender an amount called the face value at maturity but receives less than the face value initially Coupon bond different from discount bonds make interest payments in the form of coupons at regular intervals typically semiannually or annually and repay the face value at maturity borrowers issue Fixed payment loan borrower makes periodic payments to the lender Current yield value ofthe coupon expressed as a percentage of the current price of the bond Coupon rate value of the coupon expressed as a percentage of the par value of the bond The price of a bond or other financial security should equal the present value of the payments an investor would receive from owning the security Yield to maturity equates the present value of the payments from an asset with the asset s price today When participants in financial markets refer to the interest rate of an asset they are usually referring to the YTM The YTM on a coupon bond equates the present value of the annual coupon payments and the final face value payment to the price of the bond For a simple loan the YTM and the interest rate specified on the loan are the same The YTM for a discount bond is the interest rate that equates the current purchase price with the present value of the future payment The YTM on a fixed payment loan equates the present value of the loan payments to the initial loan amount Coupon bonds issued by corporations and governments typically have maturities of 30 years and are actively traded in secondary markets Once a bond has been sold for the first time the corporation or government issuing the bond is not directly involved in any ofthe later transactions When market interest rates rise the YTM on newly issued bonds increase Higher YTM lower the prices of existing bonds When market interest rates fall the YTM on newly issued bonds decrease Lower YTM raise the prices of existing bonds Financial arbitrage the process of buying and selling securities to profit from price changes over a brief period oftime this process results in comparable securities having the same yield Nomina interest rate the stated interest rate on bonds and loans it is not adjusted for changes in purchasing power Real interest rate adjusted for changes in purchasing power Expected real interest rate equals the nominal interest rate minus the expected inflation rate The actual real interest rate equals the nominal interest rate minus the actual inflation rate Borrowers gain relative to lenders when the actual inflation rate exceeds the expected inflation rate and they lose when the expected inflation rate exceeds the actual inflation rate Chapter 4 The determinants of portfolio choice are wealth expected return risk liquidity and the cost of acquiring information Expected return on an investment is calculated by multiplying the value of each event by the probability of its occurring Risk the degree of uncertainty of an asset s return because most investors are risk averse there is a trade off between risk and return Diversification allocating savings among many different assets can eliminate unsystematic risk which is risk that is unique to a particular asset but not marketor systematic risk which is risk that is common to most assets Market interest rates are determined by the interaction of the demand and supply for bonds In drawing the demand curve and supply curve for bonds we need to hold constant everything that could affect the willingness of investors to buy bonds or firms and investors to sell bonds except for the price of bonds Changes in the following factors will cause the demand curve for bonds to shift wealth expected returns on bonds risk liquidity and information costs Changes in the following factors will cause the supply curve for bonds to shift the expected profitability of physical capital investment business taxes expected inflation and government borrowing Movements in interest rates occur because of shifts in the demand for bonds the supply of bonds or both The model of the bond market can be used to explain the movement of interest rates over the business cycle and the movement of interest rates in response to changes in the expected rate of inflation The Fisher effect holds that the nominal interest rate rises or falls point for point with changes in the expected inflation rate The loanable funds approach to the bond market is useful when looking at the flow offunds between the US and foreign financial markets Loanabe funds approach buyer is the borrower raising funds and the seller is the lender supplying funds Closed economy households firms and governments do not lend internationally Open economy nearly all economies are open where financial capital or loanable funds is internationally mobile Small open economy quantity of loanable funds supplied or demanded is too small to affect the world real interest rate interest rate that is determined in the international capital market small open economy s domestic real interest rate equals the world real interest rate Large open economy can affect the world real interest rate Chapter 5 Risk structure of interest rates relates to the relationship among the interest rates on bonds that have different characteristics but the same maturities Bonds differ in the following key characteristics default riskor credit risk liquidity information costs and taxation of coupons Default risk premium on a bond is the difference between the interest rate on the bond and the interest rate on a treasury bond with the same maturity Bond ratings assigned by credit rating agencies which are single statistics that summarize the rating agencys view of the bond issuers likely ability to make the required payments on the bond Bonds with higher default risk will all other factors being equal have higher interest rates Bonds that are less liquid will have higher interest rates than will bonds that are less liquid will have Bonds that have high information costs will have higher interest rates than will bonds that have low information costs Bonds that have coupons subject to high tax rates will have higher interest rates than will bonds that have coupons subject to low tax rates Term structure of interest rates refers to the relationship among the interest rates on bonds that are otherwise similar but differ in maturity Term structure is often illustrated using the treasury yield curve which is a graph showing for a particular day the interest rates on treasury bonds of different maturities 3 important facts about the term structure 1 interest rates on long term bonds are usually higher than interest rates on short term bonds 2 interest rate on short term bonds are occasionally higher than interest rates on long term bonds 3 interest rates on bonds of all maturities tend to rise and fall together Economists have developed 3 theories to explain the term structure expectations theory segmented markets theory and liquidity premium theory Expectations theory argues that for a given holding period say 5 years the interest rate on a long term bond is the average ofthe expected interest rates on the short term bonds during that period The theory does a good job of explaining facts 2 amp 3 but cannot explain fact 1 Segmented markets theory sees the markets for bonds of different maturities as being completely separated from each other Because there are more investors who prefer to hold short term bonds than there are investors who prefer to hold long term bonds short term bonds will have lower interest rates than long term bonds The theory can thus explain fact 1 but has difficulty explaining facts 2 amp3 Liquidity premium theory favored by most economists holds that interest rates on long term bonds are averages of the expected interest rates on short term bonds plus a term premium Term premium the additional interest investors require in order to be willing to buy a long term bond rather than a comparable sequence of short term bonds The theory successfully explains all 3 facts about the term structure nformation in the term structure can be useful in forecasting future rates of inflation and future levels of economic activity Chapter 6 By buying stock in a firm an investor becomes partial owner of the firm Limited liability what stockholders in corporations have and cannot lose more than the amount they have invested in the firm Dividends corporations distribute some of their profits to stockholders by making these payments Pubicy traded companies about 5100 corporations sell stock in the US stock market Stock exchange where stocks are bought and sold face to face on a trading floor NYSE Over the counter market dealers linked by computer buy and sell stocks NASDAQ Stock market indexes averages of the stock prices how the overall performance of the stock market is measured Fuctuations in stock prices affect the ability offirms to raise funds by selling stock and also affect the spending of households and firms In determining stock prices the following key fact can be applied the price ofa financial asset is equal to the present value of payments investors will receive from owning it The fundamental value of a share of stock is the present value ofthe dividends investors expect to receive from owning the stock Required return on equities re used by investors to calculate the present value of dividends Dividend yield for a particular holding period the rate of return from owning a share of stock equals the DY which is the expected annual dividend divided by the current price plus the rate of capital gain Gordon growth model states that if investors expect a firms dividend to increase at a constant growth rate g then the price of the firms stock is related to the current dividend Dt the growth rate of the dividend and the required return on equities according to the following equation Pt Dt x 1 g re g nvestors expectations of the future profitability of firms plays a crucial role in determining stock prices Adaptive expectations early approach to understanding expectations which assumes that investors expectations ofthe price ofa firms stock depend only on past prices ofthe stock Rational expectations approach used by economists in recent years with RE people make forecasts using all available information Efficient markets hypothesis the application of rational expectations to financial markets states that when investors and traders use all available information in forming expectations offuture dividend payments the equilibrium price of a stock equals the markets optimal forecast of the stocks fundamental value Random walk an implication ofthe EMH is that stock prices are not predictable but instead follow a RW which means they are equally likely to rise or fall According to the EMH the advice of financial analysts on which stocks to buy is probably not useful because that info is already incorporated into the prices of stocks Some economists are skeptical about whether the stock market is actually an efficient market These economists point to three differences between the theoretical behavior of financial markets and their actual behavior 1 pricing anomalies refers to the possibility that investors might use trading strategies such as buying stock issued by small firms to earn above average returns 2 mean reversion tendency of stocks that have recently been earning high returns to experience low returns in the future and stocks that have recently been earning low returns to experience high returns in the future 3 excess volatility refers to the fact that actual prices appear to fluctuate much more than their fundamental values Economists debate whether these apparent deviations from efficient markets can be explained within the efficient markets framework Studies have shown that in the long run it is difficult to use trading strategies to earn above average returns in financial markets Chapter 7 Credit swap interest rate payments are swapped with the intention of reducing default risk rather than interest rate risk as with basic interest rate swaps Credit default swap misleadingly named because they are actually a form of insurance rather than a swap The issuer ofa CDS receives payments from the buyer in exchange for promising to make payments to the buyer should the security go into default CDS were heavily involved in the financial crisis as some firms most notably AIG issued CDS against mortgage backed securities without having sufficient reserves to offset the losses incurred when the housing bubble burst Chapter 8 Nominal exchange rate typically called the exchange rate is the price of one country s currency in terms of another country s currency Appreciation an increase in the value of one country s currency in exchange for another country s currency Depreciation a decrease in the value of one country s currency in terms of another country s currency Real exchange rate measures the rate at which goods and services of one country can be exchanged for goods and services of another country Foreign exchange markets currencies are traded in these markets around the world FE markets are over the counter markets with traders linked together by computer Spot market transactions involve an exchange of currencies at the current exchange rate Forward transactions traders agree today to a forward contract to exchange currencies or bank deposits at a specific future date at an exchange rate known as the forward rate Futures contracts differ from forward contracts in several ways While forward contracts are private agreements among traders to exchange any amount of currency on any future date futures contracts are traded on exchanges Chicago Board of Trade CBOT and are standardized with respect to the quantity of currency being exchanged and the settlement date on which the exchange will take place With forward contracts the exchange rate is fixed at the time the contract is agreed to while with futures contracts the exchange rate changes continually as contracts are bought and sold on the exchange Exchange rate risk a US firm is subject to this when it sells goods and services in a foreign country Theory of purchasing power parity PPP holds that exchange rates move to equalize the purchasing power of different currencies Because the exchange rate is a price we can analyze the most important factors affecting exchange rates by using a demand and supply model The demand for US dollars is determined by the demand by households and firms outside the US for US goods and US financial assets The supply of dollars in exchange for another currency is determined by the willingness of households and firms that own dollars to exchange then for the other currency In a graph with the vertical axis measuring the exchange rate expressed as units of foreign currency per dollar and the horizontal axis measuring the quantity of dollars exchanged for foreign currency the demand curve for dollars will be downward sloping and the supply curve of dollars will be upward sloping The trade weighted exchange rate an index number representing the exchange rate The TWER for the US dollar weights each individual exchange rate by the share of that country s trade with the US nternationa capital mobility refers to the ease with which investments can be made in other countries nterest rate parity condition states that the interest rate on a domestic bond should be equal to the interest rate on an equivalent foreign bond minus the expected appreciation ofthe domestic currency against the foreign currency The IRPC does not always hold exactly Investors usually demand a currency premium to hold and investment denominated in a foreign currency Chapter 9 Asymmetric information involved in many financial transactions with one party to the transaction having better information than the other party Economists distinguish from two problems arising from asymmetric information Adverse selection the problem investors experience in distinguishing low risk borrowers from high risk borrowers Moral Hazard the problem investors experience in verifying the borrowers are using funds as intended ndividua investors are usually willing to invest only in large firms about which plentiful information is available Credit rationing lenders often restrict loans to borrowers because they believe that raising interest rates will make adverse selection problems worse Congress established the Securities and Exchange Commission SEC in 1934 to regulate the information that firms must provide to investors Colatera adverse selection in bonds and loans is reduced by this requirement that is assets that the lender claims if the borrower defaults Debentures can only be issued by large corporations which are bonds issued without specific collateral Net worth requirements that lenders have high NW which is the difference between the value of a firms assets and the value of its liabilities can also reduce adverse selection Relationship banking banks can reduce adverse selection through this which refers to the ability of banks to assess credit risks on the basis of private information Principal agent problem moral hazard in the stock market results in part from this in which shareholders legally own a firm but the firms top managers run the firm and may take actions that are not in the best interests of shareholders A key way investors try to reduce moral hazard in bond markets is by writing restrictive covenants into bond contracts Restrictive covenants either place limits on the uses ofthe funds the borrower receives or require that the borrower pay offthe bond if the borrowers net worth drops below a certain level Venture capital firms moral hazard in the financial system reduced by these which raise funds from investors and use the funds to make investments in small start up firms and private equity firms which invest in mature firms The financial system has adapted in ways that reduce transactions costs and information costs The result has been 3 key features of the financial system 1 loans from financial intermediaries are the most important external source of funds to small to medium sized firms 2 the stock market is a less important source of external funds to corporations than the bond market 3 debt contracts usually require collateral or restrictive covenants Chapter 10 The key commercial banking activities are taking in deposits from savers and making loans to businesses and firms Balance sheet statement that shows and individuals or firms financial position on a particular day Asset something of value owned by an individual or a firm Liabiity something that an individual or a firm owes Bank capital the difference between the total value of a banks assets and the total value of its liabilities Checkabe deposits accounts against which depositors can write checks Federa deposit insurance covers checkable deposits up to a limit of 250000 Reserves banks assets consisting of vault cash and deposits banks have with the federal reserve Vault cash cash on hand in a bank includes currency in ATMs and deposits with other banks Required reserves reserves the fed requires banks to hold against demand and deposit and NOW account balances Excess reserves reserves banks hold above those necessary to meet reserve requirements Marketable securities liquid assets that banks trade in financial markets Banks earn a profit by matching savers and borrowers T account shows changes in balance sheet items To be successful a bank must make prudent loans and investments so that it earns a high enough interest rate to cover its costs and to make a profit Net interest margin the difference between the interest it receives on its securities and loans and the interest it pays on deposits and debt divided by the total value of its earning assets Return on Assets ROA a banks after tax profits divided by the value of its assets Return on Equity ROE the ratio ofthe value of a banks after tax profit to the value of its capital ROE equals ROA multiplied by the ratio of bank assets to bank capital Bank leverage the ratio ofthe value of a banks assets to the value of its capital the inverse of which capital to assets is called a banks leverage ratio Banks take on debt by for instance accepting deposits to gain the funds to accumulate assets Leverage a measure of how much debt an investor assumes in making an investment Liquidity risk refers to the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost Banks reduce liquidity risk using strategies of asset management and liquidity management Credit risk the risk that borrowers might default on their loans banks reduce credit risk by 1 diversification 2 credit risk analysis in which bank loan officers screen loan applications to eliminate potentially bad risks and to obtain a pool of creditworthy borrowers 3 collateral which is assets pledged to the bank in the event that the borrower defaults 4 credit rationing where the bank grants a borrowers loan application but limits the size ofthe loan or simply declines to lend any amount to the borrower at the current interest rate 5 monitoring and restrictive covenants 6 long term business relationships nterest rate risk the risk that changes in market interest rates will cause bank profits and bank capital to fluctuate Gap analysis looks at the difference or gap between the value of the banks variable rate assets and the value of its variable rate liabilities how banks can measure their exposure Duration analysis measures how vulnerable a banks capital is to changes in interest rates A banks duration gap is the difference between the average duration ofthe banks assets and the average duration of the banks liabilities Banks can reduce their exposure to interest rate risk by making more variable rate loans by entering into interest rate swaps or by hedging using futures and options contracts 104 Chapter 11 nvestment banking a financial activity that centers on underwriting new security issues and providing advice on mergers and acquisitions Underwriting an activity in which an investment bank guarantees the price of a security to the issuing firm and resells the security for a profit nitia Public Offering IPO the first time a firm sells stock to the public Syndicates large security issues are typically underwritten by these groups of investment banks nvestment banks have played a large role in designing new securities a process called financial engineering In recent years investment banks have engaged in more proprietary trading buying and selling securities for the banks own account rather than for clients During the 2000s some large investment banks began to rely heavily on financing their long term investments with short term borrowing that involved either issuing commercial paper or participating in repurchase agreements During this period many investment banks increased their leverage and invested in mortgage backed securities quotRepo financing increased leverage and investments in mortgage backed securities increased the risk investment banks faced During the Great Depression the Glass Steagall Act separated investment banking from commercial banking In 1999 congress repealed the Glass Steagall Act and commercial banks reentered the investment banking industry During the financial crisis of 2007 2009 all the large standalone investment banks failed merged with commercial banks or became financial holding companies nvestment institutions financial firms that raise funds to invest in loans and securities The most important investment institutions are mutual funds hedge funds and finance companies Mutual funds financial intermediaries that allow savers to purchase shares in a portfolio of financial assets Closed end mutual funds issue a fixed number of nonredeemable shares that investors trade on exchanges and in over the counter markets Open end mutual funds issue shares that can be redeemed each day after the market closes Exchange traded funds ETFs trade continually throughout the day but unlike closed end funds they hold a fixed portfolio of assets that the funds managers do not change Money market mutual funds hold high quality short term assets such as treasury bills In recent years money market mutual funds have become an important source of demand for commercial paper Hedge funds financial firms organized as partnerships of wealthy investors that make relatively high risk speculative investments Finance companies financial intermediaries that raise money through sales of commercial paper and other securities and use the funds to make small loans to households and firms The 3 main types of finance companies are consumer finance business finance and sales finance firms Contractual savings institutions pension funds and insurance companies because the payments individuals make to them are the result of a contract Pension funds invest contributions of workers and firms in stocks bonds and mortgages to provide for pension benefit payments during workers retirement Some pension funds are defined contribution plans in which contributions from employees are invested and the employees own the funds in the plan but are not guaranteed a particular dollar payout Other pension funds are defined benefit plans in which employees are promised a dollar benefit payment based on the employees earnings and years of service nsurance companies financial intermediaries that specialize in writing contracts to protect their policyholders from the risk of financial loss associated with particular events During the past 15 years nonbank financial institutions such as investment banks hedge funds and money market mutual funds have become an increasingly important means for channeling money from lenders to borrowers these nonbank financial institutions have been labeled the quotshadow banking system The shadow banking system is not subject to many of the federal regulations that constrain the behavior of commercial banks Nonbanks such as investment banks and hedge funds can be subject to runs because investors who make short term loans to them are not covered by federal deposit insurance Shadow banks can also invest in more risky assets and be more highly leveraged than commercial banks During the 2000s shadow banks invested more heavily in securities based on mortgages which left them vulnerable to a downturn in housing prices Systemic risk the fragility of the financial system increased SR or risk to the whole financial system rather than to individual firms or individual investors and may have contributed to the severity of the financial crisis of 2007 2009 Chapter 12 Financial crisis a significant disruption in the flow of funds from lenders to borrowers Financial crises lead to recessions as households and firms cut their spending in the face of difficulty borrowing money Banks face liquidity risk because they can have difficulty meeting their depositors demands to withdraw their money nsovent bank the value of whose assets are less than the value of its liabilities may be unable to meet its obligations to pay off its depositors Bank run the process in which withdrawals by a banks depositors results in the bank closing Contagion process by which bad news about one bank can affect other banks Bank panic banks simultaneously experience runs A government has two main ways to avoid a bank panic 1 it can act as a lender of last resort in making loans to banks 2 it can insure bank deposits The Federal Deposit Insurance Corporation FDIC was established by congress in 1934 to insure deposits in commercial banks Recessions that involve financial crises tend to be particularly severe In addition to resulting from bank panics financial crises can result from exchange rate crises and sovereign debt crises The recession of 2007 2009 has been the most severe economic downturn in the US during the post World War II period The most important cause of the recession was the bursting ofthe housing market bubble New home sales rose 60 between January 200 and July 2005 and between January 2000 and May 2005 house prices more than doubled The fact that house prices rose much more than house rents indicated that the housing market experienced a bubble When the bubble burst and house sales and prices fell many home buyers defaulted on their mortgages Defaults were particularly widespread among subprime and Alt A borrowers as well as among borrowers who made small down payments or had taken out exotic mortgage loans Financia firms that were heavily invested in mortgage backed securities suffered severe losses and had difficulty borrowing money The federal reserve the treasury congress and the president responded vigorously with new policies intended to contain the financial crisis Many economists and policymakers are concerned that these policies may have increased problems of moral hazard in the financial system Financia regulations are often implemented as a result ofa financial crisis Over time there has been a regular pattern of 1 crisis 2 regulation 3 response to new regulations by financial firms 4 response by regulators Congress created the federal reserve system as the lender of last resort to provide liquidity to banks during bank panics but the Feds lender of last resort role has changed greatly over the years The fed failed as a lender of last resort during the great depression which led congress to establish the FDIC in 1934 The fed successfully acted as a lender of last resort during the post world war II period although it became clear that the fed and the FDIC had developed a too big to fail policy under which the largest commercial banks would not be allowed to fail During the great depression congress attempted to increase bank stability by enacting Regulation Q which placed limits on the interest rates commercial banks could pay on deposits To circumvent regulation q banks introduced negotiable certificates of deposit or negotiable CDs and negotiable order of withdrawal NOW accounts Chapter 13 Federal Reserve System created by the federal reserve act in 1913 to serve as the central bank of the US The act divided the US into 12 federal reserve districts each of which has a federal reserve bank Federal Reserve Bank a district bank ofthe federal reserve system that among other activities conducts discount lending Nationa banks must join the federal reserve system while state banks may choose to join When banks join the federal reserve system they are required to buy stock in their district bank although they receive few of the usual rights and privileges of shareholders Board of governors located in Washington DC has 7 members appointed by the president of the US One member is appointed chairman and serves a four year renewable term Federal Open Market Committee FOMC 12 members consists of the members ofthe board of governors the president of the federal reserve bank of NY and the presidents of 4 ofthe other 11 federal reserve banks The chairman of the board of governors also serves as chairman of the FOMC Congress set up the federal reserve system to have many formal checks and balances but over time power has become concentrated in the board of governors In 2010 the Dodd Frank Act expanded the responsibilities of the fed while making several minor changes in its operations The US constitution has no provision explicitly authorized a central bank so the fed must operate in a political arena where it is subject to pressure from members of congress and white house officials The fed is self financing because it earns billions on its holdings oftreasury securities but it is still subject to outside pressure The president ofthe US appoints members of the board of governors and congress can revise the federal reserve act at any time Through the years there have been conflicts between the fed and the US treasury Pubic interest view 1 of 2 views ofthe feds motivation economists have proposed holds that the fed acts in the best interests of the general public Principa agent view holds that fed officials maximize their personal well being rather than that ofthe general public fthis view is correct the result could be a political business cycle in which policymakers urge the fed to lower interest rates to stimulate the economy prior to elections The main argument in favor of fed independence is that monetary policy is too important and technical to be determined by politicians Opponents of fed independence argue that in a democracy elected officials should make public policy The degree of central bank independence varies greatly from country to country In most countries the members of the governing board of the central bank serve shorter terms than do members of the feds board of governors but the heads of the central banks serve longer terms than does the fed chairman Studies have shown that the more independent a countrys central bank is the lower the country s inflation rate The push for central bank independence to pursue a goal of low inflation has increased in recent years The European Central Bank ECB is charged with conducting monetary policy for the 16 countries that use the euro as their common currency During the financial crisis of 2007 2009 the ECB had trouble developing a policy acceptable to all 16 countries Chapter 14 Money supply process how a country s money supply is created 3 main actors in the process are 1 the central bank the federal reserve in the US 2 the banking system 3 the nonbank public households and firms Monetary base aka high powered money is equal to currency in circulation plus bank reserves The fed s balance sheet lists its assets and liabilities The unusual policy actions the fed took during the financial crisis caused a large increase in the size of its balance sheet Currency in circulation equals currency outstanding minus vault cash CIC is paper money amp coins held by the nonbank public Vault cash currency held by banks Bank reserves on the fed s balance sheet equal vault cash plus bank deposits with the fed Required reserves total reserves that are made up of amounts that the fed requires banks to hold Excess reserves extra amounts that banks elect to hold Required reserve ratio fed specified percentage of deposits that banks must hold as reserves Open market operations the most direct method for the fed to change the monetary base Open market purchase the federal reserves purchase of securities usually US treasury securities raises monetary base increases bank reserves Open market sale the fed sells treasury securities reduces bank reserves The fed can also increase bank reserves by increasing discount loans to banks An open market purchase increases bank reserves Banks typically use their excess reserves to make loans An increase in loans results in an increase in checkable deposits Multiple deposit creation the process of banks making loans out of their excess reserves and creating new checkable deposits Simple deposit multiplier the ratio of the amount of deposits created by banks to the amount of new reserves created equal to 1 divided by the required reserve ratio er1er The simple deposit multiplier assumes that during the multiple deposit creation process banks hold no excess reserves and the nonbank public does not increase its holdings of currency We can take into account that banks hold excess reserves and that the nonbank public typically increases its holdings of checkable deposits by examining movements in the currency to deposit ratio CD and excess reserves to deposit ratio ERD The money multiplierm links the monetary baseBto the money supplyMaccording to the equation M m x B the equation for the money multiplier is m CD 1 CD er ERD Therefore the relationship between the monetary base money multiplier and money supply can be written as M CD 1CD er ERD x B The money supply will increase if either the money multiplier or the monetary base increases An increase in CD ERD or er will decrease the value of the money multiplier and if the base remains constant the money supply During the financial crisis of 2007 2009 the money supply increased but the monetary base increased much more The monetary base actually became larger than the money supply causing the money multiplier to drop below 1 Banks holdings of excess reserves soared during the fall of 2008 and remained high through mid 2010 The increase in excess reserves was caused by the feds beginning to pay interest on banks reserve balances banks desire to remain liquid and a decline in the number of creditworthy borrowers Chapter 15 The overall aim of a countrys monetary policy is to advance the economic well being of the country s citizens Economic well being is determined by the quantity and quality ofthe goods and services that individuals can enjoy The federal reserve has 6 monetary policy goals that are intended to promote a well functioning economy 1 price stability 2 high employment frictional structural cyclical Frictional unemployment enables workers to search for positions that maximize their well being Structural unemployment refers to unemployment that is caused by changes in the structure of the economy such as shifts in manufacturing techniques increased use of computers and increased in the production of services instead of goods Cyclical unemployment the fed attempts to reduce levels of this with business cycle recessions 3 economic growth increases in the economy s output of goods and services over time 4 stability offinancial markets and institutions 5 interest rate stability 6 foreign exchange market stability Until the financial crisis of 2007 2009 the fed relied primarily on 3 monetary policy tools 1 open market operations or the purchase and sale of treasury securities 2 discount policy which includes setting the discount rate and terms of lending at the discount window which is the means by which the fed makes discount loans to banks 3 reserve requirements which determine the percentage of checkable deposits banks must hold as reserves Open market operations have been the most important of the feds policy tools Two new policy tools connected with bank reserve accounts were introduced during the financial crisis and were still active mid 2010 1 interest on reserve balances which was introduced in October 2008 and involves the feds paying banks interest on their required and excess deposits 2 term deposit facility which was introduced in April 2010 and under which banks have the opportunity to purchase term deposits with the fed Federal funds policy focus of fed policy in recent decades which is the interest rate that banks charge each other on very short term loans The equilibrium federal funds rate is set by the interaction of the demand and supply of reserves in the federal funds market The FOMC sets a target for the federal funds rate The fed uses open market operations to hit its target for the FFR Open market operations have several benefits that other policy tools lack control flexibility ease of implementation Quantitative easing engaged in by the FOMC during the financial crisis QE is the buying of long term securities The fed engaged in a second round of QE beginning in Nov 2010 There are 3 categories of discount loans 1 primary credit available to healthy banks with adequate capital and supervisory ratings 2 secondary credit intended for banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings 3 seasonal credit consists of temporary short term loans to satisfy seasonal requirements of smaller banks During the financial crisis the fed introduced several new loan programs but ended them by mid 2010 Targets variables that the fed can influence directly and that help achieve monetary policy goals Tradionally the fed has relied on 2 types of targets policy instruments and intermediate targets Intermediate targets are typically either monetary aggregates such as M1 and M2 or interest rates Policy instruments are typically either the federal funds rate or a reserve aggregate such as total reserves or nonborrowed reserves A policy instrument should meet the criteria of being measurable controllable and predictable fthe fed chooses reserves as its policy instrument the federal funds rate will fluctuate in response to changes in the demand for reserves fthe fed chooses the federal funds rate as its policy instrument reserves will fluctuate in response to changes in the demand for reserves used the FFR for past 30 yrs as PI Taylor rule a monetary policy guideline for determining the target for the federal funds rate The FOMC kept the federal funds rate at levels well below indicated by the Taylor rule during the recovery from the 2001 recession Some economists have argued that by doing so the fed contributed to the housing bubble Some economists and policymakers believe the fed should adopt an explicit target for the inflation rate Chapter 17 Aggregate expenditure on the economy s output is the sum of consumption spending planned spending government purchases and net exports AP C G NX Aggregate demand curve AD illustrates the relationship between aggregate expenditure and the aggregate price level Real money balances the market for money shows the interaction of the demand and supply of RMB which is the value of money held by households and firms adjusted for changes in the price level or MP The aggregate demand curve is downward sloping because an increase in the price level causes a higher interest rate in the market for money and a higher interest rate reduces consumption planned investment and net exports The federal reserve can cause the aggregate demand curve to shift to the right by following an expansionary monetary policy and to shift to the left by following a contractionary monetary policy The Short Run Aggregate Supply Curve SRAS represents the quantity of aggregate output or GDP that firms supply at each price level in the short run The Long Run Aggregate Supply Curve LRAS is vertical at the level of potential GDP The LRAS curve shifts over time to reflect growth in potential GDP Sources of this economic growth include increases in capital and labor inputs and increases in productivity growth output produced per unit ofinput The SRAS curve is upward sloping In the new classical view an unexpected increase in the aggregate price level increases the quantity of output that firms are willing to supply in the SR In new Keynesian view the SRAS curve is upward sloping because many firms have sticky prices In both new classical and new Keynesian views shifts in the SRAS curve reflect shifts in the expected price level or in firms costs of production Suppy shock an unexpected change in production costs or in technology that causes the SRAS curve to shift 3 main factors that shift the SRAS curve 1 changes in labor costs labor typically accounts for most of the costs of producing output When output Y exceeds potential GSP Yp the high volume of output produced raises the demand for labor The higher labor demand in turn bids up wages increasing firms labor costs As a result the SRAS curve will eventually shift to the left because at any given price level firms will supply less output when their costs are higher In the case when output falls below potential GDP firms begin to lay off workers and workers wages decline The resulting drop in production costs eventually shifts the SRAS curve to the right 2 Changes in other input costs unexpected shifts in the price or availability of raw materials or in production technologies affect production costs and the SRAS curve Such changes are called supply shocks SS include unexpected changes in technology weather or the prices of oil and other raw materials Positive SS such as the development of labor saving technologies or lower food prices due to good growing seasons shift the SRAS curve to the right Negative SS such as an increase in the price of oil shift the SRAS curve to the left 3 Changes in the expected price level when workers bargain for wages they compare their wages to the costs of goods and services that they buy When workers expect their price level to rise they will demand higher nominal wages to preserve their real wages Similarly firms make decisions about how much output to supply by comparing the price of their output to the expected prices of other goods and services When the expected price level rises firms raise prices to cover higher labor and other costs An increase in the expected price level shifts the SRAS curve to the left A decline in the expected price level shifts the SRAS curve to the right This shift occurs because firms reduce prices as nominal wages and other costs fall thereby supplying more output at every given price level The economys short run equilibrium output and price level occur at the intersection of the AD curve and the SRAS curve The economys long run equilibrium occurs at the intersection of the AD curve the SRAS curve and the LRAS curve Movements in AD can move aggregate output away from its potential GDP in the short run but in the long run output is always equal to potential GDP Monetary neutrality exhibited by the economy which means that changes in the money supply have no effect on output in the long run Business cycle output grows during expansions and contracts during recessions Stabilization policy attempts to offset the effects of the business cycle through shifts in the AD curve


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