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by: Bethany Conn


Bethany Conn
GPA 3.71

Bernard Sharkey

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Bernard Sharkey
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This 41 page Class Notes was uploaded by Bethany Conn on Tuesday October 13, 2015. The Class Notes belongs to ECON 2035 at Louisiana State University taught by Bernard Sharkey in Fall. Since its upload, it has received 15 views. For similar materials see /class/223035/econ-2035-louisiana-state-university in Economcs at Louisiana State University.




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Date Created: 10/13/15
Chapter 1 Why study money banking and financial markets 11 Why study financial markets 0 financial markets promote economic efficiency by channeling funds from savers to investors or borrowers o wellfunctioning financial markets promote growth 0 poorly functioning financial mkts can be the cause of poverty 0 bond market and interest rates 0 important bc they determine interest rates 0 interest rate price paid for the rental of borrowed funds I personal level high int rates could deter from taking loans out but encourages saving I general level affect biz investment decisions similarly which can negatively affect economy security claim on issuer s future income or assets bond debt security that promises to make payments periodically for a specified period of time 0 compared to long term us gov bonds int rates on 3 month treasury bills fluctuate more and are lower 0 stock market 0 most widely followed financial mkt in the US 0 stock prices are extremely volatile o rising stock market index due to higher share prices increases people s wealth and willing to spend stock prices fall individual wealth and willing to spend decreases changes in stock prices affect firm s decisions to sell stock to finance investment spending 0 common stock claim on corporation s earnings and assets 0 financial crises 0 fear of major recession causes stock prices amp consumer spending to decrease 12 Why study financial money and monetary policy 0 money anything generally accepted in payment for goods and services or in the repayment of debt 0 money and biz cycles 0 aggregate output total production of goods and services 0 business cycles up amp down movement of agg output produced in the economy I 39 39 t 39 quot 39 39 in the biz cycle 0 output declines higher unemployment o preceded by decline in money growth 0 monetary theory relates changes in q of money to changes in agg economic activity and price lvl 0 money and inflation o aggregate price level avg price of goods and services in an economy 0 inflation rate continual increase in price lvl 0 O O O 0 high inflation rate high growth in money supply 0 if price was higher 10 years ago then agg price lvl has decreased 0 money and interest rates 0 mgmt of money amp int rates is monetary policy and conducted by central bank I fed reserve system 0 fiscal policy involves decisions about govt spending and taxation 0 budget surplus tax revenues gt govt expenditures 0 budget deficit tax revenues lt govt expenditures I can result in gt monetary growth ie gtinflation 14 Why study international finance 0 foreign exchange mkt where one currency is converted into another currency 0 foreign exchange rate price of one country s currency in term s of another 0 stronger dollar decrease in price of euro I less expensive to do things in other countries I us goods exported will cost more in foreign countries so foreigners buy fewer I benefits american consumers hurts american businesses 0 weaker dollar increase in price of euro I hurts imports bc price of foreign goods increases I decrease purchase of foreign goods increase purchase of domestic I helps american businesses who sell domestically Chapter 2 An overview of the financial system 21 Function of Financial Mkts 0 getting people with funds to lend together with people who want to borrow improve economic welfare by allowing consumers to time their purchase better wellfunctioning fin mkts produce an efficient allocation of capital breakdown of fin mkts political instability principal lendersavers households direct finance 0 lendersavers I households I biz firms I gov t I foreigners o borrowerspenders I biz firms I gov t I households I foreigners o ls sends funds through financial mkts to bs in the form of securities I securities are assets for the person who buys them ls but liabilities for the person who sells them bs I example you borrow 2500 from a firend I example corporation issues new shares of stock I example people buy shares of common stock in primary mkts o indirect finance 0 ls sends funds through financial intermediaries to bs I financial intermediaries can also send funds from ls to financial mkts which send the funds to bs 0 example you buy shares in a mutual fund 0 example you make a deposit at a bank 22 Structure of financial Mkts 0 Debt amp equity mkts 0 Method 1 for obtaining funds in financial mkts I issue a debt instrument bond or mortgage 0 debt instrument contractual agreement by the borrower to pay the holder fixed dollar amounts at regular intervals interest amp principal pymts until specified date maturity date when final pymt is made 0 short term less than 1 year 0 long term 10 years or longer 0 intermediate term 110 years 0 Method 2 for obtaining funds in financial mkts I issuing equities common stock 0 claims to share in the net income and the assets of biz o periodic pymts dividends 0 long term bc no maturity date 0 disadvantage equity holders are residual claimants 0 corporate must pay debt holders before equity 0 Primary amp Secondary markets 0 primary mkt financial mkt in which new issues of security are sold to initial buyers by corporation or govt agency borrowing the funds I not wellknown to public bc takes place behind closed doors I done by investment bank by underwriting securities 0 guaranteeing a price for a corp s securities then selling to public 0 secondary mkt fin mkt in which securities that have been previously issued can be sold I Examples 0 NASDAQ amp NYSE 0 foreign exchange mkts o futures mkts 0 options mkts brokers agents of investors who match buyers with sellers of securities dealers link buyers amp sellers by buying amp selling securities at stated price makes it easier to sell financial instruments to raise funds makes fin instruments more liquid I Exchanges 0 buyers and sellers of securities meet in one central location to conduct trades 0 example NYSE I overthecounter mkt 0 dealers at diff locations who have an inventory of securities stand ready to buy and sell securities otc to anyone who comes to them and is willing to accept their prices very competitive not very different from a mkt with organized exchange examples of what is traded in otc mkts 0 US gov t bonds negotiable certificates of deposit federal funds foreign exchange 000 0 Money amp Capital mkts 0 money mkt fin mkt in which only shortterm debt instruments are traded 0 capital mkt mkt in which longerterm debt are traded 23 Financial Mkt Instruments 0 Money mkt instruments 0 US treasury bills I pay no interest but sold at a discount I safest of all money mkt instruments bc no risk of default I 1 3 6 month maturities 0 Negotiable certificates of deposit debt instrument sold by a bank to depositors that pays annual interest of given amt and at maturity pays back at original price I sold in secondary mkts I important source of funds for 0 commercial banks 0 money mkt mutual funds 0 charitable institutions 0 gov t agencies 0 commercial paper short term debt instrument issued by large banks and wellknown corporations 0 repurchase agreements short term loans in which treasury bills are collateral 0 federal funds loans made by banks to eachother 0 capital mkt instruments 0 stocks 0 mortgages and mortgage backed securities 0 corporate bonds 0 us gov t securities 0 us gov t agency securities 0 state amp local gov t bonds municipal bonds 0 consumer and bank commercial loans 24 Internationalization of Financial Mkts 0 international bond mkt eurobonds and eurocurrencies 0 foreign bond bonds sold in a foreign country and denominated in the country s currency in which they are sold Eurobonds bonds sold in a foreign country and denominated in a currency other than that of the country in which it is sold eurocurrencies foreign currencies deposited in banks outside of the home country I eurodollars US dollars deposited in foreign banks outside of teh US or foreign branches of US banks 25 Function of financial intermediaries indirect finance 0 financial intermediation process of indirect finance using financial intermediaries 0 primary route for moving funds from lenders to borrowers 0 loans from financial intermediaries are far more important for corp finance than securities mkts o transaction costs time and money spent carrying out financial transactions 0 economies of scale reduction in transaction costs per dollar of transactions as the size of transactions increases 0 liquidity services services that make it easier for customers to conduct transactions 0 risk sharing process where financial intermediaries create and sell lowrisk assets and use the proceeds to purchase riskier assets 0 asset transformation turning risky assets into safer assets 0 diversification reducing risk through the purchase of assets whose returns do not always move together I don t put all of your eggs in one basketquot 0 profitable for financial institutions bc low transaction costs 0 asymmetric info adverse selection amp moral hazard o asymmetric info borrowers have superior info relative to lenders about potential returns amp risks associated with an investment project adverse selection bad credit risks are most likely to seek out a loans and therefore receive them from financial intermediaries occurs BEFORE transaction I associated with equity and debt contracts arising from lender s lack of info about borrower s potential returns and risks of investment activities moral hazard borrower might engage in activities AFTER the loan is given that would make it less likely the loan would be paid back 0 economies of scope and conflicts of interest 0 economies of scope lower the cost of info production for each service by applying one info resource to many diff services I can create conflicts of interest moral hazard problem 0 O O O 26 Types of Financial Intermediaries I Depository Institutions financial institutions that accept deposits and make loans Type of Intermediary Liabilities source of funds Assets use of funds intervals on a contractual basis Commercial banks deposits bizconsumer loans mortgages US gov t securities municipal bonds savings and loan deposits mortgages associations mutual savings bank deposits mortgages credit unions deposits consumer loans 0 f t 39savings39 quot financial39 quot39 ies that acquire funds at periodic Type of Intermediary Liabilities source of funds Assets use of funds Life insurance companies premiums from policies corp bonds mortgages quot quot ins from policies I r municipal bonds corp bondsstock US govt securities pension funds govt retirement funds employeremployee contributions corp bondsstock 0 Investment intermediaries Type of Intermediary Liabilities source of funds Assets use of funds finance companies commercial paper stocks consumerbiz loans bonds mutual funds shares stocksbonds money mkt mutual funds shares money mkt instruments 27 Regulation of the Financial System Increasing info available to investors ensuring soundness of financial intermediaries restrictions on entry disclosure restrictions on assets and activities deposit insurance limits on competition restrictions on interest rates 0 00000 Chapter 3 What is money 32 Functions of Money 0 Medium of exchange 0 distinguishes money from other assets 0 for a commodity to function as money I easily standardized I widely accepted I divisble I easy to carry I not deteriorate quickly 0 economies that use a barter economy instead of medium of exchange I higher transaction costs I requirement of double coincidence of wants I multiple number of prices for each good 0 unit of account 0 used to measure value in an economy 0 reduces the number of prices that need to be calculated 0 store of value 0 way for saving for future purchases 0 hyperinflation period of extreme inflation greater than 50 per month I money no longer functions as good store of value and people may resort to barter transactions at much larger scale 33 Evolution of the payments system 0 payment system method of conducting transactions in an economy commodity money money made of precious metals fiat money paper currency decreed by gov t as legal tender checks electronic payment 0 emoney 34 Measuring money 0 Federal reserve s monetary aggregates o defining money becomes more difficult as pace of fin innovation quickens monetary aggregates measures of money supply reported by fed reserve M1 currency narrowest monetary aggregate traveler s checks demand deposits other checkable deposits total M1 M2 M1 small denomination time deposits certificates of deposit lt 100000 savings deposits and money market deposit accts money mkt mutual fund shares retail total M2 not as liquid as M1 OOOOOOOOOOO Chapter 4 Understanding Interest Rates 41 Measuring Interest Rates 0 Present value based on notion that dollar paid to you one year from now is less valuable than a dollar paid to you today 0 int rate increases pv decreases 0 time to promised future pymt increases pv increase 0 simple loan see pg 69 for formula instructions 0 four types of credit mkt instruments 0 simple loan 0 fixed pymt loan fully amortized loan I paid back with same payment every period principal int rate 0 coupon bond I fixed int pymt every year until maturity when face value is repaid I example US treasury bonds corp bonds 0 discount bond zero coupon bond I bought at price below face value and face value repaid at maturity date I no int pymts 0 yield to maturity way to calculate int rates int rate that equate the pv of cash flow pymts to cash flow today see pg 72 78 42 The distinction between interest rates and returns 0 rate of return pymts to the owner plus the change in a security s value expressed as a fraction of the security s purchase price 0 does not necessarily int rate on the bond sum of current yield and rate of capital gain see pg 80 to calculate return initial yield to maturity has time of maturity holding period int rates increase bond price decrease capital losses on bonds whose terms to maturity are longer than holding period 0 bonds maturity is more distant greater size of price change associated with int rate change lower rate of return increase in int rate 0 even with substantial initial int rate return can be negative if int rates rise 0 maturity and volatility of bond returns interest rate risk 0 int rate risk riskiness of an asset s returns due to changes in int rates 0 prices and returns for long term bonds are more volatile than short term bonds 0 no int rate risk for any bond whose time to maturity matches the holding period 43 The distinction bn real and nominal int rates 0 real int rate reflects the true cost of borrowing nominal int rate expected rate of inflation ex ante real int rate adjusted for expected changes in price lvl on low real int rate greater incentives to borrow and fewer incentives to lend ex post real int rate int rate that describes how well lender has done in real terms after the fact 0 fisher equation nominal int rate real int rate exp rate of inflation O O O O 0000 Chapter 5 The Behavior of Interest Rates 51 Determinants of asset dem nd a Wealth o i crease wealth increase quantity demanded expected returns 0 increase dexp returns increase qd ris increase risk decrease qd liquidity increase liquidity increase qd bond mkt 52 Supply and demand in the supplydemand curve Supply Demand 1 0 53 Changes in equilibrium interest rates 39 i to b nds its ndemand r 0 Factors that Shift the Bond Demand LWnalth A EmmyT mum T Evil Ed has mm m 2 Expected Return A ilm rum Rm faxlmgrtemi bmdsT 5391th mm gm ii mm Rm T gum gum ngn 3Risk A Riskufbmd TEdsh sauttangn if gum T EaT 54mg mum W 4 Liquidity A Liqun ty ufEands T E T Edshn s mum git E Liqunity if ache ism i Ed T 54 sum nut in gm o shifts in supply of bonds lawn EREl ti l Wf iW O 54 Supply and Demand in the market for money liquidity preference framework 0 liquidity preference framework determines equilibrium int rate in terms of supply and demand of money 0 individuals assumed to hold wealth in two forms I money I bonds 0 excess supply of bonds implies excess demand for money 0 assumes money has 0 rate of return I when int rates rise exp return on money falls relative to exp return on bonds causing demand for money to fall o opportunity cost of holding money int rate 0 excess supply of money increase demand for bonds int rates decrease 0 int rate below equilibrium excess demand formoney int rate increase 55 Changes in equilibrium interest rates in liquidity preference framework upmam u g Idle of Interest Ratei Interest Rate i Interest Rate i upply we inlele um a Liquidin effmargenhan mlwr 2mm T me Liquidity Income PriceLevel Eflec and n atlon Effects it b Liquidity Effedsnmlerrhan T othere ect undslowadfustmen I l 39 39 me Liquidity lncomePriceLevel Effett and Expected In ation Effects a Liquidiry e m xmaler than T experredIn arlon arrenandian I I 39 39 Wme Liqu d nyand mmmeandPrice a d7 LevelE ects pe In ation Effects Chapter 6 The risk and term structure of interest rates 61 Risk Structure of int rates 0 default risk risk that pymts will not be made 0 US Treasury Bonds are risk free I fed govt can increase taxes to pay its obligations 0 risk premium spread bn int rates on bonds with default risk and default free bonds 0 corp suffers large losses probability of bond default increase default risk on corp bonds increase exp return on corp bonds decrease 0 bond with default risk has positive risk premium I increase in default risk risk premium decrease o liquidity o liquidity increase corp bonds increase price corp bonds increase yield treasury bonds 0 corp bonds less liquid than US treasury bonds bc risk premium 0 income tax considerations 0 municipal bonds are NOT default free 0 municipal bonds are not as liquid as treasury bonds 0 int payments on municipal bonds are exempt from fed income tax I have lower int rates than treasury bonds I if taxes are lower int rates are higher on municipal bonds because it means less to have them 62 Term structure of interest rates 0 term structure the relationship among interest rates on bonds with different maturities 0 yield curve plot of int rates on default free gov t bonds with diff terms to maturity 0 diffs in yield to maturity is why int rates on treasury securities aren t the same 0 usually gently upward sloping 0 when steeply upward sloping long term int rates are above short term 0 when flat short term int rates are about the same as long term 0 when downward sloping short term int rates above long term 0 inverted yield curve slopes downward o expectations theory int rates on long term bond will equal the avg of short term int rates that people expect to occur over the life of the long term bond 0 if bonds with diff maturities are perfect substitutes then the expected return on the bonds is equal 0 pg 136 for how to calculate 0 int rates on bonds of diff maturities move together over time 0 yield curves should be equally likely to slope downward as upward o segmented markets theory int rate for each maturity bond is determined by supply and demand for that maturity bond 0 int rates on bonds of diff maturities do not move together over time 0 bonds of diff maturities are not substitutes at all 0 explains why yield curves slope upward hqmdtty premtum and preterred hapttat premtum tt ytetd eurves are detwnward S uptngt then shetrtterm tnt rates are aH by set mueh that Even when the petstttve term premtum ts betDW Shunterm rates th the purehaseretta treasury term seeurtty rather than shun term steepty upward stdptng ytetd eurve means shetrtterm tnt rates rtse tn the future shgh y upward stdptng ytetd eurve means shetrtterm tnt rates stay the same uNE means shun term tnt rates dEEhnE muderatety um ttatytetd e e preterred hapttattheetry etdsetyretatedtp ttdutdttypremt Chapter 7 The Stuck Market the Theetry uf Rattdnat Expemattuns and the Entetent Market Hyputhests 7 t cdmputtng the F39Hce uf Cummun Stuck etne penetd vatuattetn mu u re uf stuck tuday depends upetn the presentvatue uf petth dtvtdends vat e uf a s and the Expected sates rt e eurrent steteh pnee tnereases tt the Expected sates pnee tnereases stuck mireufslurk mm d m p 7Eqm7vn39 nhnn mt mmmmtt g per mm uf pmm e generahzed dtvtdend mudet tt Expected sates prtee ts tn dtstant future tt dues nut affect eurrent stuck ee p ep Esentvame tsa sum uf presentvame uffutur gurdun gretwth mu e steteh s pnee tmust D e dtvtdend stream e th tnerease tf the deEnd gruwth rate tnereases n L Dali 49 nail3 Dgliiwiquot quot1 39 39n Tm 39 39 11quot r1m I1ryf1 ij39llLSJ 1 31 w it 39e w fchin39 ant 9 LE DO as yer i quote PCS pt 39 5 quotr of 534 5 339139 11139 zzr 39 251 39ate at 39etL39r vrt39v arr rim153 5 i39v39xrigv39mth 1t 0 72 how the market sets stock prices 0 asset s price is set by the buyer willing to pay the highest price 0 info allows buyer to more accurate judge risk 0 an expected decrease in lvl of future dividends will decrease an asset s price 0 change in perceived risk of a stock changes the required rate of return 0 stock s price fails if increase in required rate of return 0 monetary expansion increases stock prices bc decrease in required rate of return and increase in dividend growth rate 73 The theory of rational expectations 0 adaptive expectations changes in expectations will occur slowly over time as past data changes 0 example if inflation had formerly been steady at 5 expectations of future inflation would be 5 0 BAD bc people use more info than just past data on a single variable 0 rational expectations expectations will be identical to optimal forecasts best guess of the future using all avaiable info 0 optimal forecast best guess 0 even if additional info is not used with forming optimal forecasts bc it is not available expectations are STILL RATIONAL o expectation is not rational if relevant info is available and not used 0 still may not be accurate 0 implications of the theory I if there is a change in the way a variable moves the way in which expectations of this variable are formed will change as well I the forecast errors of expectations will be zero and cannot be predicted ahead of time 74 The Efficient Market Hypothesis Rational expectations in financial mkts o theory of rational expectations when applied to financial mkts efficient mkt hypothesis 0 current price of a financial security full reflects all available relevant info if optimal forecast of return on security gt equilibrium return mkt is inefficient in an efficient mkt unexploited profit opportunities will be quickly eliminated see pg 156 for rate of return formula rationale behind the hypothesis I arbitrage occurs when mkt participants observe returns on a security that are larger than what is justified to by the characteristics of that security and take action to quickly eliminate financial mkts quickly quot 39 39 I 39 quot quot profit I I quot39 through changes in asset prices I elimination of unexploited profit opportunities requires only that a few mkt participants be well informed I purchasing reports of financial analysts is not likely to be an effective strategy for increasing financial returns bc profit opportunity has already been seen and taken I PAST PERFORMANCE IS NO GUARANTEE FOR THE FUTURE insider info will allow exploitation of profit opportunity investors do better if they adopt a buy and holdquot strategy 0 net profits will be higher bc fewer brokerage commissions o investors should purchase noload mutual funds which have low mgmt fees 0 bubble situation when an asset price differs from fundamental value I investors can have rational expectations that a bubble is occurring but continue to hold the asset anyway 75 Behavioral Finance 0 behavioral finance field of study that applies concepts from social sciences such as I 39 39 g and s i I g to help 39the behavior of security prices 0 short selling mkt participant believes stock price is irrationally high so they borrow stock from brokers to sell in the mkt and make a profit by buying the stock back again after the stock falls in price 0 loss aversion people are more unhappy when they suffer losses than when they gain 0 explains why very little shortselling actually takes place overconfidence and social contagion provide an explanation for stock market bubbles 0000 I l Chapter 8 17 in full text The Foreign Exchange Mkt 81 Foreign Exchange Mkt 0 Foreign exchange rate price of one currency relative to another 0 determined in the foreign exchange mkt 0 most trades involve the buying and selling of bank deposits denominated in diff currencies 0 forward transaction agreement to exchange dollar bank deposits for euro bank deposits in one month I example agreement to exchange dollars for euros in three months at a price of 90 per euro spot exchange rate I 1 euro purchased for 110 When the value of british pound changes from 125 to 150 the pound has APPRECIATED and the US dollar has DEPRECIATED and vice versa 0 new currency exchange rate X your currency 82 Exchange rates in the long run 0 law of one price if two countries produce an identical good the price of the good should be the same throughout the world no matter which country produces it o theory of purchasing power parity exchange rates between any two currencies will adjust to reflect price levels of the two countries 0 if one country s price level rises relative to another s its currency should depreciate cannot fully explain exchange rate movements bc some goods are not traded between countries 0 exchange rates between two currencies will adjust to reflect changes in the price lvls of the two countries 0 example if the real exchange rate between the US and Japan is gt 10 then it is cheaper to buy goods in Japan than in the US 0 the real exchange rate between two countries will always equal 10 0 factors that affect exchange rates in the long run 0 if a factor increases the demand for domestic goods relative to foreign the domestic currency will appreciate and vice versa 0 relative price lvls I rise in country s price lvl causes its currency to depreciate o trade barriers tariffs and quotas I increasing trade barriers appreciate currency preferences for domestic vs foreign goods I increase demand for country s exports appreciate currency productivity I more productive appreciate currency 0 O O O O 83 Exchange rates in the short run supply and demand analysis 0 theory of asset demand the most important factor affected the demand for domestic and foreign assets is the expected return on theses assets relative to one another Real Exchange Rate NCO o 0 NCO 0 supply is xed bc quantity supplied at any exchange rate is the same 0 excess demand increase value of dollar exchange rate goes down from eq 0 excess supply decrease value of dollar exchange rate goes up from eq 84 Explaining changes in exchange rates Relative Expedth Priceltevel epreciate R liative Expected Productivity Appreciate RelativeuExpeCfed frades Barniers Appreciate RelatiVe Expe ct d llmpoft b mahd Depreciate Relative Expected Export Demand Appreciate domestic inmates rate Appreciate Foreig nt interet rate Depreciate Expected xture eXChanlge rate Appreaiatei Chapter 9 22 m mu text AggregateDemand and Supp y A a ysws a 1 Aggregate demand dwffprwce Ms mc rease raa spendmg e duanmy medry uf mnney derived frum eduauun Elf exchange I L demand a su hErEaSE mnney supp yxnreasaagg demand e fudredmpunentpams Eunsumerexpendnures manned mvestmantsp en dmg guv t spendmg Lexpun v eunsumppun expendn d re investme m g guv tpumhases t taxes nx netexpdn s msquot mun y SuppN a 2 Aggregate supp y agg ypw Luv e mum qudmu m pnee Eve s e shunvs relatmnsmp bn pnee M and M uf agg uutput supphed ung run agg su curve e natura rate uf unemp uyment Where Ecunumy grawtates m the ung rgn e vemm hne Waugh the natura rate M uf Dutput z p ta merease m tuta arm u abursupphed mcrease m ava ab etemnu u dechne m natura rate ufunemp uyment shurt run agg supp y Iqu m lt 93 Equilibrium in agg demand and supply analysis self correcting mechanism economy always returns to the natural rate lvl of output short run equilibrium moves to the long run equilibrium over time increase in agg demand 0 increase price lvl short run 0 increase output short run 0 increase price lvl long run long run increase money supply increase price lvl I I I I l I I I of new a 0 decrease unemployment rate short run 0 decrease agg price lvl short run 0 no change unemployment rate long run 0 no change agg price lvl long run increase consumerbiz confidence 0 increase real GDP short run 0 increase agg price lvl short run 0 no change real GDP long run 0 increase agg price lvl long run open market purchase of bonds by Fed 0 increase real gdp short run 0 increase agg price lvl short run 0 no change real gdp long run 0 increase agg price lvl long run depreciation of US dollar 0 increase real gdp short run increase agg price lvl short run no change real gdp long run increase agg price lvl long run 000 Chapter 10 23 in full text Monetary Policy Theory 101 Response of monetary policy to shocks 0 main goal of central banks is price stability 0 try to maintain inflation target slightly above zero 0 minimize inflation gap difference bn inflation and inflation target 0 response to aggregate demand shock o no policy response I agg demand curve remains at lower point moved to left I agg output fails I short run agg supply curve shifts down to put output back to normal I inflation rate is lowered o policy stabilizes economic activity and inflation in short run by lowering int rate I agg demand curve moves back to original point I short term agg supply curve does not move 0 response to permanent supply shock o no policy response I long run agg supply curve shifts left I output lowers I short run agg supply curve shifts upward until economy returns to equilibrium I inflation rises o policy stabilizes inflation I long run agg supply curve still shifts left I short run agg demand curve shifts left until inflation stabilizes I short run agg supply curve shifts up small amount to reach equilibrium 0 response to temporary supply shock o no policy response I short run agg supply curve shifts upward I inflation temporarily increases and output decreases I inflation and output stabilize in long run 0 policy stabilizes economic activity in short run I short run agg supply curve still shifts upward I agg demand curve shifts to decrease output but keep inflation stable I short run agg supply curve shifts downward I agg demand curve is shifted back to stabilize output and inflation 0 bottom line the relationship bn stabilizing inflation and stabilizing economic activity 0 if most shock to the economy are agg demand shocks or permanent agg supply shocks then policy that stabilizes inflation will also stabilize output even in short run 0 if temp supply shocks are more common than central bank must choose between two stabilization objectives in short run 0 in long run no conflict bn stabilizing inflation and output in response to shocks 102 How actively should policymakers try to stabilize economic activity 0 lags prevent policies from being immediately implemented 0 data lag time it takes for policymakers to obtain data indicating what is happening in the economy 0 recognition lag time it takes for policymakers to be sure of what the data is signaling about the future course of the economy legislative lag time it takes to pass legislation to implement policy implementation lag time it takes for policymakers to change policy instruments once they have decided on new policy 0 effectiveness lag time it takes for policy to actually have an impact on economy 103 lnflation always and everywhere a monetary phenomenon o monetary authorities can target any inflation rate in the long run with autonomous monetary policy adjustments 0 potential output is independent of monetary policy 104 Causes of inflationary monetary policy 0 high employment targets and inflation 0 high employment can bring high inflation I cost push inflation from temporary negative supply shock or push by workers for wage hikes beyond what productivity gains can justify o temp negative supply shock shifts short run agg supply curve up 0 output falls and unemployment increases 0 policy makers increase agg demand 0 inflation rises dramatically I demand pull inflation policymakers pursuing policies that increase agg demand 0 policy makers increase agg demand to reach higher output 0 short run agg supply shifts up bc rising wages o inflation rises dramatically O O Chapter 11 13 in full text Central Banks and the Federal Reserve System 111 origins of the federal reserve system I public s fear of centralized power and distrust of moneyed interest led to demise of first two experiments in central banking 0 first bank of the US was disbanded in 1811 when its charter was not renewed 0 second bank of the US had its charter renewal vetoed in 1832 112 Structure of Fed Reserve System Wis three Elect six directors Io durum to awn Pym mm FEB B i x E S x S 39 Establish f Hanlaws and I 1 Mommas D mcts 0 federal reserve banks 0 3 largest fed reserve banks New York Chicago San Francisco I hold more than 50 of assets in Fed reserve system I quasi public institutions since they are owned by private commercial banks where the reserve bank is located 0 each fed reserve bank has 9 directors I 6 appointed by member banks I 3 appointed by board of governors O 0 split into 3 categories 0 3 professional bankers o 3 leaders from industry 0 3 represent public interest 0 not allowed to be officers employees or stockholders dividend paid by stock limited to 6 annually New York bank houses open market desk president always has vote in fed open market committee 0 Monetary policy functions establish discount rate decide which banks obtain discount loans select one commercial banker from each bank s district to serve on Fed advisory council 5 of 12 bank presidents each have vote in federal open market committee which directs open mkt operations 0 other functions clear checks issue new currency and withdraw damaged currency from circulation administer and make discount loans to banks in their districts evaluate proposed mergers and applications for banks to expand their activities act as liaisons bn the biz community and the fed reserve system examine bank holding companies and state chartered member banks collect data on local biz conditions use professional economists to research monetary policy 0 member banks 0 37 of commercial banks belong to fed reserve system 0 prior to 1980 member banks left fed bc high cost of required reserves 0 ALL banks are subject to reserve requirements set by fed member and not 0 board of governors of the federal reserve system 0 7 members appointed by president of US and confirmed by Senate as members resign serve one full nonrenewable 14 year term plus part of another term 0 chairman chosen from 7 and serves 4 yr term 0 monetary policy functions all 7 are members of FOMC and vote on conduct of open market operations sets reserve requirements within limits of legislation approves or disapproves discount rate established by fed reserve banks chairman advises president of US on economic policy testifies in congress and speaks for fed reserve system in media 0 other functions I sets margin requirements fraction of purchase price of securities that has to be paid for with cash rather than borrowed funds I sets salary of president and all officers of each fed reserve bank I reviews each fed reserve bank s budget I approves bank mergers and applications for new activities I specifies permissible activities of bank holding companies I supervises activities of foreign banks in US I has staff of professional economists to provide economic analysis used for decision making 0 Federal Open Market Committee FOMC I meets 8 times a year I makes decisions regarding conduct of open market operations I 7 members of board of governors and 5 presidents of regional fed banks 0 each fed bank president attends FOMC meetings but only 5 presidents vote and all provide input I makes decisions concerning reserve requirements and the discount rate but does not officially set them I beige book research document given to the FOMC containing info on state of economy in each fed reserve district I green book research document given to FOMC containing forecast of national economic variables for next 2 years I blue book research document given to FOMC containing forecasts of money aggregates conditional on diff monetary policy stances I balance of risksquot assessment of whether its primary concern will be higher inflation or a weaker economy 113 How independent is the Fed o instrument independence ability of the central bank to set monetary policy instruments 0 goal independence ability of central bank to set monetary policy goals 0 members of congress influence monetary policy by proposing legislation that would force fed to submit budget requests to Congress 0 case for independence 0 political pressures put inflationary bias on monetary policy I could produce a political biz cycle 0 expansionary policies pursued right before an election to lower unemployment and int rates 0 fed can be used to facilitate treasury financing of large budget deficits by its purchases of treasury bonds I leads to more inflation in economy 0 control of monetary policy is too important to leave to politicians 0 case against independence 0 undemocratic to have monetary policy controlled by an elite group responsible to no one I lack of accountability 0 fed has not always used its freedom successfully 0 not immune to political pressures I could encourage pursuit of a course in self interest rather than public interest 114 Structure and Independence of European Central Bank 0 Similarities to Fed 0 executive board like board of governors o governing council like FOMC 0 national central banks have same role as fed reserve banks 0 differences bn Euro and fed 0 national central banks control their own budgets and the budget of the of the ECB in Frankfurt I ECB has less power 0 monetary operations are conducted by national central banks in each country not centralized 0 not involved with supervision and regulation of financial institution 0 governing council 0 meets 12 times per year 0 decision of what policy to implement is made by consensus o 12 countries with representation 0 ECB is regarded as the most independent in the world bc its charter cannot be changed by legislation 115 Structure and independence of other foreign central banks 0 Bank of Canada 0 less instrument independence 0 less goal independence 0 bank of england o oldest central bank founded in 1694 0 makes monetary policy decisions separate of ECB 0 was least independent of central banks until 1997 0 bank ofjapan 0 not formally independent until 1998 o ministry of finance still has control over part of bank s budget that is unrelated to monetary policy 0 both theory and experience suggest that more independent central banks produce better monetary policy 0 more and more govts have been granting greater independence to central banks Chapter 12 14 in full text The Money Supply Process 121 three players in money supply process 0 central bank government agency that oversees the banking system and is responsible for monetary policy Fed reserve system 0 banks depository institutions financial intermediaries that accept deposits from individuals and institutions and make loans 0 commercial banks 0 savings and loan associations 0 mutual savings banks 0 credit unions r I 122 The fed s balance sheet 0 Liabilities o currency in circulation I fed issues currency I currency held in depository institutions but counted as part of reserves I fed reserve notes but they are paid off with more fed reserve notes 0 reserves I all banks have an account at the fed for deposits 0 banks can demand payment on them at any time I required reserves fed requires banks to hold 0 required reserve ratio percentage of deposits required to go to fed I excess reserves banks choose to hold 1quot L39 and 39 that hold deposits in banks 0 assets 0 securities I holds securities issued by US treasury and unusually other securities 0 primary way fed provides reserves to banking system I increase in govt or other securities leads to increase in money supply 0 loans to financial institutions I borrowed reserves I increase in loans increase in money supply I during normal times fed only makes loans to banking institutions 0 discount rate int rate charged 0 during recent financial crisis fed made loans to other financial institutions 123 Control of the monetary base 0 monetary base currency in circulation reserves 0 Federal reserve open market operations purchases or sales of securities in open market 0 open market purchase from bank I fed reserves increase liability I fed securities increase asset I fed monetary base increase I bank securities decrease asset bank reserves increase asset 0 open mkt purchase from the nonbank public if fed p money I if fed p I ays with check and check is deposited in bank which puts the in their account with the fed fed securities increase asset fed reserves increase liability fed monetary base increase bank reserves increase asset bank checkable deposits increase liability nonbank public securities decrease asset nonbank public checkable deposits increase asset ays with check and check is cashed for currency fed securities increase asset fed currency in circulation increase liability nonbank public securities decrease asset nonbank public currency increase asset fed monetary base increase but not reserves note the effect of open market purchase on reserves depends on whether the seller of bonds keeps the proceeds from the sale in currency or deposits 0 open mkt sale nonbank public securities increase asset nonbank public currency decreases asset fed se fed cu if kept in currency monetary base increases but reserves do not if kept in deposits monetary base and reserves increase curities decrease asset rrency in circulation decreases liability fed monetary base decrease reserves unchanged note e certain ffect of open market operations on monetary base is much more than the effect on reserves 0 shifts from deposits into currency 0 public withdraws currency from bank nonbank public checkable deposits decrease asset nonbank public currency increase asset bank r eserves decrease asset bank checkable deposits decrease liability fed cu rrency in circulation increase liability fed reserves decrease liability fed monetary base unchanged but reserves fall 0 loans to financial institutions 0 loan is made from fed to bank bank r eserves increase asset bank loans increase liability I fed loans increase asset I fed reserves increase liability I fed monetary base increase 0 loan is paid back to fed from bank I bank reserves decrease asset I bank loans decrease liability I fed loans decrease asset I fed reserves decrease liability I fed monetary base decrease 0 other factors that affect monetary base 0 float temporary net increase in the total amount of reserves in banking system from fed s check clearing process I decrease in float leads to equal decrease in monetary base 0 US treasury deposits at fed us treasury moves deposits from commercial banks to account at fed causing deposit outflow at banks I decrease in reserves in banking system I decrease in monetary base 0 both float and us treasury deposits affect monetary base but are not controlled by the fed 0 overview of fed s ability to control monetary base 0 fed does not tightly control monetary base bc does not completely control borrowed reserves 0 nonborrowed monetary base monetary base borrowed reserves from fed 0 float and treasury deposits affect the monetary base in the short run but do not prevent fed from accurately controlling it 124 Multiple deposit creation a simple model 0 multiple deposit creation a process where the fed supplies the banking system with an extra dollar of reserves and deposits increase by more than one dollar 0 deposit creation the single bank 0 when a bank makes a loan from its excess reserves it creates money by the act of lending I a bank cannot safely make a loan for an amount greater than the excess reserves it has before it makes the loan I reserves increase I loans increase I checkable deposits increase 0 when the borrower makes purchases by writing checks the checks will be deposited at other banks I the original reserves will now leave the bank to go to another bank I loans increase I reserves and checkable deposits are gone o deposit creation the banking system Q if required reserve ratio is 10 bank must keep 10 of reserves and cannot loan out that amount each time another loan is made to another bank required reserve ratio must be kept in reserves and only the excess can be loaned out again process repeats and checkable deposits increases with the original amount of each loan before required reserve ratio is taken out whether a bank uses excess reserves to make loans or to purchase securities effect on deposit expansion is the same simple deposit multiplier I change in total checkabl39e deposits in banking system o 1required reserve ratio X change in reserves for banking system Same 1 70079 0039O Another 9009000 Yet Another 81931900 istilllAinothar 77292006 You Get the Figure 65100 31 0 million Tote ls o deriving the formula for multiple deposit creation O same as simple deposit multiple see above or pg 294 o critique of simple model O decisions by depositors to increasetheir holding of currency or of banks to hold excess reserves results in smaller expansion of deposits than simple model predicts decisions by depositors about their holdings of currency and by banks about their holdings of excess reserves affect the money supply 125 factors that determine the money supply Player Variable change in money supply reason variable response federal reserve nonborrowed up up more monetary system monetary base base for depos creation required up down less multiple reserve ratio deposit expansion banks borrowed up up more monetary reserves base for depos creation excess up down less loans and reserves deposit creation depositors currency up down less multiple holdings deposit expansion 127 Money Multiplier 0 models describing the determination of money supply and the feds role in this process normally focus on the monetary base rather than reserves since fed s actions have a more predictable effect on monetary base money mulitplier ratio that relates the change in the money supply to a given change in the monetary base 0 money supply money multiplier x monetary base 0 shows effect on money supply of change in factors OTHER THAN monetary base 0 deriving the money multiplier see pg 298300 sorry impossible to type it out I 1 currency ratio required reserve ratio excess reserve ratio currency ratio 0 currency ratio currency in circulation checkable deposits 0 excess reserve ratio excess reserves checkable deposits Chapter 13 15 in full text Tools of Monetary Policy 131 market for reserve and the federal funds rate 0 3 policy tools to manipulate money supply I open market operations affect reserves and monetary base I changes in borrowed reserves affect monetary base I changes in reserve requirements affect money multiplier 0 federal fund rate int rate on overnight loans of reserves from one bank to another I primary indicator of fed s stance on monetary policy 0 demand and supply in the market for reserves I demand curve 0 quantity of reserves demanded required reserves excess reserves fed funds rates gt int rate on reserves qd increase when fed funds rate decrease o negatively sloped opp cost of holding excess reserves fed funds rate int raid paid on excess reserves fed funds rate int rate paid on excess reserves demand curve horizontal argument for fed paying int on excess reserve holdings o paying int reduces the effective tax on deposits 0 paying int helps implementation of monetary policy 0 paying int increases capacity of fed s balance sheet I easier to address financial crises o excess demand cause fed funds rate to rise I supply curve 0 q of reserves supplied nonborrowed reserves borrowed reserves fed funds rate lt discount rate supply curve vertical fed funds rate discount rate supply curve horizontal fed funds rate gt int on excess reserves 0 open market sale decreases supply of reserves raising fed funds int rate 0 open mkt purchase increases supply of reserves fed funds int rate falls 0 excess supply causes fed funds rate to fall I see next pg for graph I equilibirum Federal Funds Rate id RS ii i 391 ff Rd Rn Quantity of Reserves R 0 how changes in tools of monetary policy affect fed funds rate 0 open mkt operations I fed funds rate gt int on excess reserves 0 open market sale decreases supply of reserves raising fed funds int rate 0 open mkt purchase increases supply of reserves fed funds int rate falls I if excess demand and fed wishes to keep fed funds rate at its current lvl fed should take defensive open market purchase I if fed funds rate gt target rate fed makes dynamic open mkt purchase I if excess supply and fed wishes to keep fed funds rate at its current lvl defensive open mkt sale I if fed funds rate lt target rate fed makes dynamic open mkt sale 0 discount lending I lower discount rate shortens vertical section of supply curve I most changes in the discount rate have no effect on fed funds rate 0 reserve requirements I fed raises reserve requirements fed funds rate rise I fed funds rate between discount rate and int rate paid on excess reserves increase in reserve requirement 0 increases demand 0 increase fed funds rate 0 interest on reserves I when fed funds rate is at int rate paid on reserves rise in int rate on reserves rise in fed funds rate I unless fed funds rate is at int rate paid on reserves int rate increases and decreases have no effect on fed funds rate 132 Conventional monetary policy tools 0 discount policy and lender of last resort 0 operation of discount window I discount window facility at which banks can borrow reserves from fed I primary credit discount lending that plays the most imp role in monetary policy 0 healthy banks are allowed to borrow all they want at very short maturities from standing lending facility primary credit facility int rate is discount rate back up source of liquidity for sound banks so taht fed funds rate never rises too far above fed funds target I secondary credit banks in financial trouble and experiencing severe liquidity problems 0 int rate is 05 above discount rate I seasonal credit meet limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits 0 lender of last resort I borrowing from fed is a last resort for banks I meant to prevent bank failures from spinning out of control I prevent bank and financial panics 0 relative advantages of diff tools 0 open mkt operations occur at initiative of fed which has complete control over their volume open mkt operations are flexible and precise and can be used to any extent open mkt operations are easily reversed open mkt operations can be implemented quickly and involve no administrative delays other tools have advantages over open mkt operations I when fed wants to raise int rates after banks have accumulated lg amts of excess reserves I when discount policy can be used by the fed to perform its role of lender of last resort 0 O O 133 Nonconventional monetary policy tools during global financial crisis 0 liquidity provision 0 discount window expansion I lowers discount rate closer to fed funds rate target 0 term auction facility I made loans at rate determined through competitive auctions usually lower than discount rate 0 new lending programs 0 asset purchases 0 quantitative easing vs credit easing o quantitative easing expansion of balance sheet I leads to huge increase in monetary base I expansion of money supply I stimulates economy in short term I raises inflation long term 0 credit easing altering the composition of the feds balance sheet in order to improve the functioning of particular segments of the credit mkts o commitment to future policy actions Chapter 14 16 in full text The conduct of monetary policy strategy and tactics 141 The price stability goal and the nominal anchor 0 price stability low and stable inflation o desirable bc inflation creates uncertainty making it difficult to plan for the future 0 inflation results in difficulty interpreting relative price movements role of nominal anchor nominal variable such as inflation rate or money supply which ties down the price lvl to achieve price stability 0 limits time inconsistency problem monetary policy conducted on a discretionary day by day basis and leads to poor long run outcomes I monetary policy is time inconsistent bc policymakers are tempted to pursue discretionary policy that is more expansionary in short run 142 Other goals of monetary policy 0 high employment and output stability 0 high unemployment I loss of output I frictional unemployment works voluntarily leave work why they look for better jobs structural unemployment unemployment from mismatch of workers skills and job requirements goal natural level of unemployment 0 economic growth 0 supply side economic policies I increase saving and investment using tax incentives o stability of financial mkts 0 fed was created to promote financial stability 0 interest rate stability I allows for less uncertainty about future planning 0 foreign exchange rate stability I decline in value of domestic currency will increase inflation rate I increase in value of domestic currency makes domestic industries less competitive with foreign 143 lnflation targeting public announcement of medium term numerical targets for inflation institutional commitment to price stability as primary long run goal of monetary policy and commitment to achieve inflation goal info inclusive approach in which many variables are used in making decisions about monetary policy advantages 0 reduces likelihood that central bank will fall into time inconsistency trap of trying to expand output and employment in short run by pursuing over expansionary policy 0 readily understood by public and highly transparent 0 increased accountability of central bankfor attaining its inflation objectives disadvantages o delayed signaling I inflation outcomes only revealed after substantial lag 0 too much rigidity 0 potential for increased output fluctuations 0 low economic growth 144 The fed s monetary policy strategy advantages of fed s just do itquot approach 0 central bank uses many sources of info to determine best monetary policy 0 forward looking behavior and stress on price stability discourage over expansionary policy 0 demonstrated success disadvantages 0 lack of transparency 0 low accountability 0 strong dependence on preferences skills and trustworthiness of individuals in charge of central bank 0 inconsistencies with democratic principles 145 Lessons for monetary policy strategy from the global financial crisis developments in the financial sector have a far greater impact on economic activity than was earlier realized zerolowerbound on int rates can be serious problem cost of cleaning up after a financial crisis is very high price and output stability do not ensure financial stability 146 Tactics choosing the policy instrument o policy instrument variable that responds to the central bank s tools and indicates the stance of monetary policy 0 linked to intermediate target 0 criteria for choosing policy instrument 0 observability and measurability o controllability o predictable effect on goals 147 Tactics the Taylor Rule 0 sorry you re on your own for this one Chapter 15 Banking and Mgmt of financial Institutions 151 bank balance sheet 0 liabilities o checkable deposits I has shrunk over time I lowest cost source of bank funds I payable on demand I NOW accounts 0 nontransaction deposits 0 borrowings I discount loans 0 bank capital 0 assets 0 reserves 0 cash items in process of collection 0 deposits at other banks 0 securities 0 loans 0 other assets I physical capital 152 Basic banking 0 banks earn profits by selling liabilities with attractive combinations of liquidity risk and return 0 use proceeds to buy assets with a diff set of characteristics 0 sell short term liabilities and buy long term assets 0 when a bank receives additional deposits it gains an equal amt of reserves 153 General Principles of bank mgmt o liquidity mgmt and role of reserves 0 bank manager maintains sufficient reserves to minimize the cost to the bank of deposit outflows o if bank has ample excess reserves a deposit outflow does not necessitate changes in other parts of its balance sheet o liquidity mgmt bankers concerns regarding the optimal mix of exces reserves secondary reserves borrowing from fed and borrowing from other banks to deal with deposit outflows I when a deposit outflow occurs holding excess reserves allows the bank to escape the costs of o borrowing from other banks or corps 0 selling securities 0 borrowing from the fed 0 calling in or selling off loans 0 asset mgmt 0 when a bank has insufficient reserves it calls in loans 0 banks would prefer to acquire funds quickly by borrowing from the fed rather than reducing loans 0 calling in loans may antagonize customers and thus can be a very costly way of acquiring funds to meet an unexpected deposit outflow 0 goal purchasing securities with high return and low risk 0 liability mgmt 0 will most likely meet a reserve shortfall by borrowing fed funds 0 resulted in increased sales of certificates of deposits to raise funds 0 insolvent liabilities exceed assets 0 capital adequacy mgmt 0 how bank capital prevents bank failure I it can be used to absorb the losses resulting from bad loans I lessens chance it will become insolvent 0 how the amt of bank capital affects returns to equity holders I the lower the bank capital higher the return for owners of bank 0 there is a trade off between safety and returns to equity holders 0 bank capital requirements I banks hold capital because they have to according to regulatory authorities 154 Managing credit risk 0 screening and monitoring 0 screening I avoids adverse selection 0 specialization in lending I easier for banks to collect credit info on local firms than far away ones 0 quot 39gand of quotquot I reduces moral hazard 0 long term customer relationships 0 keeps bank from having to redo monitoringscreening process 0 loan commitments o bank s commitment to provide a firm with loans up to a given amt at an int rate that is tied to some mkt int rate o collateral and compensating balances o collateral if loanee defaults o compensating balances loanee must keep certain amt of money in acct at bank in order to receive loan and that amt can be taken if default 0 credit rationing refusing to make loans even though borrowers are willing to pay the stated int rate or even a higher rate 0 lender refuses to make a loan of any amt to a borrower o lender is willing to make a loan but restricts the size of a loan to less than a borrower would like 155 managing int rate risk 0 if a bank has more rate sensitive liabilities than assets a rise in int rates will reduce bank profits 0 gap and duration analysis 0 gap analysis amt of rate sensitive liabilities is subtracted from the amt of rate sensitive assets I maturity bucket approach measure gap for several maturity subintervals 0 duration analysis examines sensitivity of the mkt value of the bank s total assets and liabilities to changes in int rates 156 off balance sheet activities 0 loan sales contract that sells all or part of the cash stream from a specific loan and thereby removes the loan so that it no longer is an asset on the bank s balance sheet 0 generation of fee income 0 trading activities and risk mgmt techniques Chapter 16 Financial Crises 161 What is a financial crisis financial crisis occurs when info flows in financial mkts experience a particularly lg disruption with the result that financial frictions increase sharply and fin mkts stop functioning 162 dynamics of financial crises in advanced economies stage 0 stage 2 O O O O ne initiation of financial crisis mismgmt of financial innovationliberalization deterioration in financial institutions balance sheets asset price decline increase in uncertainty adverse selection and moral hazard problems worsen and lending contracts banking crisis economic activity declines banking crisis adverse selection and moral hazard probs worsen and lending contracts economic activity declines stage 3 debt deflation O O 0 causes 0 O 0 effects 0 O O O O unanticipated decline in price lvl adverse selection and moral hazard probs worsen and lending contracts economic activity declines of 20072009 financial crisis financial innovation in mortgage mkts agency problems in mortgage mkts asymmetric information and credit rating agencies of 20072009 financial crisis residential housing prices boom and bust deterioration of financial institutions balance sheets run on the shadow banking system I shadow banking system composed of hedge funds investment banks and other nondepository financial firms which are not as tightly regulated as banks global financial mkt issues failure of high profile firms 163 dynamics of financial crises in emerging mkt economies stage 1 O O O O O initiation of financial crisis deterioration in financial institutions balance sheets increase in int rates asset price decline increase in uncertainty adverse selection and moral hazard probs worsen and lending contracts stage 2 currency crisis 0 fiscal imbalances 0 foreign exchange crisis 0 adverse selection and moral hazard probs worsen and lending contracts 0 stage 3 full fledged financial crisis 0 economic activity decline banking crisis adverse selection and moral hazard probs worsen and lending contracts economic activity declines OOO


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