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Week 10 Notes

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Week 10 Notes FIN 501


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Financial Economics
Tatyana Deryugina
Class Notes
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This 7 page Class Notes was uploaded by D S on Wednesday November 4, 2015. The Class Notes belongs to FIN 501 at University of Illinois at Urbana-Champaign taught by Tatyana Deryugina in Summer 2015. Since its upload, it has received 25 views. For similar materials see Financial Economics in Finance at University of Illinois at Urbana-Champaign.


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Date Created: 11/04/15
Financial Economics Week 9 Professor Tatyana Derugvina University of Illinois Urbana-Champaign Text - 1 Macroeconomics - Monetary System and the Fed 1.1 Who’s Afraid of a Little De ation Cochrane argues de ation are overblown unexpected and expected de ation if we had a drop of 20 % or more but a steady de ation, we can all adjust to it can’t cut nominal wages, gives workers raises instead of not has to do with contracts written, if its a psychological then he’s just wrong main point - not really that bad perhaps they are trying to hard to void it since you need to print money to prevent it. 1.2 Money talked about de▯nition and purposes of money bonds are better stores are money since they pay you interest but issue is that they are not mediums of exchanges Liquidity - how easy to convert an asset to the medium of exchange types commodity - gold backed money ▯at - money that has value b/c it is backed by the government ▯ bitcoin could be used as money if it was widely accepted ▯ talked about burning man and economy based on baked good or beads ▯ is prisons currency could be cigarettes ▯ ex-Soviet union, you need to pay in dollars and euros which isn’t really the money backed by the government Savings account have a minimum balance - less liquid 3 - 12 month CD where do they fall Empire State Building - storing value but it can’t really be moved 1 1.2.1 Money Supply Types MO currency M1 monetary base, high powered money, reserves currency + commercial banks’ deposits at Fed M2 = M1 + savings deposits, short-term small-amount time deposits, money market mutual funds M3 and M4 do exist The Fed cares mostly about M1 and M2 1.3 Federal Reserve control the money supply in the US. its the central bank and responsible for monetary policy Monetary Policy FOMC federal reserve jobs Fiscal Policy - decision about government spending and taxation congress Purpose f the Fed Fractional Reserve Banking - if you deposit $100, the bank does not need to keep all of that money - it can loan the rest out to make loans reserve-deposit ration (reserve ratio) - fraction of money the bank must keep on hand make way more money from just 100 money multiplier e▯ect- fractional reserve system can increase the money supply without adding more money dark side - Bank Runs - even a perfectly solvent bank may be forced to close Game Theory good equilibria - if people aren’t trying to keep taking money out bad equilibria - everyone keeps trying to take money out of the bank 1930s (dark side occurred) How to prevent this? Deposit Insurance - insured by the Federal Government Lender of last resort through discount lending - Fed provides loans to banks that have di▯cult coming up with enough reserver Change reserve requirements Math for the money multiplier requirement A 2 100 to FNB FNB keeps 10 and loans 90 to Bob who puts it in SNB SNB keeps 9 and loans 81 to Charlie to TTNB created way more deposits P000 total in depo1its1100 in reserves 900 in loans n=11(1 ▯ r) = r= :01 We’re not creating real wealth, only liquidity!!!! Notes in the recessive the money multiplier has dropped to below 1. total money in the economy is less than the base Monetary base - total number of dollars held by the public as currency C and by the banks as reserves Model of Money supply walk through the math on thi. cr+1 M = cr+rr easy to see if you want to change the money supply, then need to change currency deposit (cr) reserve ratio (rr) or monetary base (B) Lower reserve ratio rr banks will lend more. Lower currency-deposit ratio cr consumers will put more money into banks. Increase the monetary base B there will be more money 1 to deposit and subsequently lend if households put all their wealth then it would be:05 115= 5:2 20 2 Why does the Money Multiplier change/collapse - individuals can decide to hold more cash outside of the banking system - banks may stop giving loans and thus put more cash as reserves to maintain M, then you need to increase B by a lot and you can can see this from slide 24 if the fed had not done anything, then it would have created other issues? companies count on getting loans Why can the money multiplier all below 1 reserves re not included in M1, if you put depositors + reserves and then it would be double counting in normal times people get most of their reserves from deposits. and since banks held onto their reserves and thus money multiplier dropped below money demand - how much wealth people want to hold as money high P , a dollar doesn’t buy you very much note this is a conceptual demand curve Money Supply-demand diagram in the short run, the Fed sets Money Supply as some ▯xed value regardless of P P then adjusts so there is an equilibrium value of money Monetary Injection - double the money, prices of things also double Fed’ Dual Mandate focus on maximum employment and price stability (stable in ation 2 %) originally - prevent ▯nancial panics monetary policy does not e▯ective long run growth ( it depends on productivity) counter argument - short run trade o▯ in ation and employment Example: the Feds QE policies are aimed at stimulating the economy, but runs the risk of in ation. Those who oppose the dual mandate also oppose QE. wanted to stimulate the economy 1.4 Fed’s Tools to Control the Money Open - Market Operation takes money out of circulation by selling bonds and puts money into circulation by buying bonds Reserve Requirements higher reserve requirement - lower money supply not really used that much because it takes time to implement and usually only done to prevent a highly disruptive crisis not good for short run people usually just adjust the threshold at which the higher deposit rates kick in Discount Rate - change the rate the Fed charges banks for loans Discount Windows is used by banks that do not have enough cash to meet reserve requirements and this is done on a daily basis lower rate -> more discount lending -> more reserves -.more money only used in a crisis Fed s lender of last resort so they focus way more on Open Market Evolving Emergency Liquidity Toolbox since the fed cut the rates, for the ▯nancial crisis in Aug 2007, put it to 30 days and then 90 days in Mar 2008. Problems with this policy people hold cash more (not really as bad since people have con▯dence and deposit insured) fed doesn’t control what banks lend Bailout Money - help struggling banks and stimulate economy (turns out some didn’t lend as much as was expected) Open Market Operations and Federal Funds Rate interest rate - rate that which banks pay to lend and borrow within each other 3 Federal Funds are loans made from banks with excess reserves to those with insu▯cient reserves, usually on an overnight basis (big banks getting money from smaller banks) So how does the fed control it? OMO look at the logic on how to think about these changes give banks money so they don’t need to get reserves from smaller banks Why is it so important? . Thus FFR is only for lending and it represents an opportunity cost of lending te money to another places these are fairly safe loans - thus you get 5 % so since FFR through OMO, many interest rates move in tandem with FFR lowering FFR through OMO decreases the money supply, which puts upward pressure on prices QE1 - just bough mortgage backed securities and Treasuries (remove toxic stu▯) Quan- titative Easing - not to control in ation - it was to lower longer term interest rates and stimulate the economy 2 Solow Growth Model What determines growth and productivity in the long run? Solow Model characterizes the relationship between output per worker and capital per worker in the steady state note GDP only has Y (output), C (consumption) , and I (investment) Y = C + I t t t F t F(K ;Lt) t what is the production function? K t+1 = (1▯d)K +ItEvert period, capital depreciates at a rate d K (1 ▯ d)K + I 1 unite of labor thus L = population Every period the t+1 t t populations increase at rate n Y = 1F(K;L) = F( ;1)K L L L In the steady state, capital per worker, then each period investment must replenish depreciation and add capital for the new workers Investment that is required to keep the balance I =t(n + d)K t Consumption in steady state C = Y ▯ I = Y ▯ (n + d)K Y y = k savings per worker is also a constant fraction s of GDP s Y = sf(k) L Steady State equation s f(k)* = (n+d)k* = nk* + dk* nk* capital needed for new workers dk* capital needed to replace worn out capital k* steady state level of capital per work investment is just enough to o▯set capital depreciation with no productivity growth, economy reach steady state eventually increase steady state level of capital the steady state level of consumption will increase Determinants of Long Run Living Standards savings rate growth in population produc- tivity saving rate - rises - higher saving allows more investment and larger capital stock n - ▯ll - higher population growth, then more output is needed, so less output is available for consumption productivity (f(k)) - rises - higher productivity directly increase, rises savings and capital stock 4 K S C so increase savings rate -> shift sf(k) upwards and higheL L L So is this a good ideas? higher savings mean higher current consumption K S C population growth n shifts (n+d)k line upward and decreases L L L and so while it will increase consumption per worker, it will reduce total ouput and consumption K S C increase productivity so f(k) goes out increaseL L L saving rate is not inde▯nite increase and not population growth either productivity and innovation can increase the living standards if you’re a policy maker which should you investment more in? what are the di▯erences of impact increasing savings will reduce consumption no tradeo▯ with productivity savings rate is ▯nite in that it can’t be 1. if you really want to grow, you need technological progress 3 The Fed, Long Run Growth Quantitative Easing policies kinda works like OMO expects but its aimed at di▯erent asset classes that the fed typically does not buy note 2 slide; England cares about bringing in ation back up in the long run (doubling the money in the economy doesn’t actually do anything) only in the short term will you see these e▯ects intuition - economy is not smart enough to adjust that fast more money in the economy causes the asset prices to go up wealthier people tend to stimulate the economy cost of borrowing falls because the yield on 10 year treasury bonds will go down and thus banks are less likely to hold these bonds idea is that its stimulating demand (monetary policy) money supply and in ation increase in money leads to higher prices (in ation) Monetary Neutrality - changes in the money supply do not a▯ect real variables if Fed does OMO to lower FFR, then it will increase investment in the short run because OMO does lower FFR which will increase money supply ie leading to in ation third slide - reason people argue that the fed should only focus on in ation \people are dead" is the counter argument after 2008, feds lowered interest rate as much but it wasn’t helping as much as they could so they implemented QE2 QE1: taking toxic assets out of the balance sheets, they fed bought a whole bunch of mortgage goal was stability not stimulation QE2: interest rates low, and banks were reluctant to lend money fed started buying long term treasuries note tells you exactly why - injects reserves into th economy drives down yields on treasuries makes private lending more attractive relative to holding treasuries Know the risks too much money leads to in ation too many dollars drives down value cause ▯scal if you borrow money Operation Twist 2011 What they did: sold short and medium term bonds and used proceeds to buy longer-term bonds Goal: Drive up prices (and down yields) on 10-year treasuries + Not inject additional money into the economy, so avoid in ationary pressure 5 if you buy more of something, you drive up it price, what’s the e▯ect on lending? This depends on the elasticity dependent on the 10 Y Treasury Rate 3.1 Does QE work? people who are against QE will remark that the unemployment is still high and thus just increased the in ation So the fed blamed others: ▯scal policy 2010s bunch of ugliness in debt ceiling debacle (congress didn’t want to reauthorize) sequestration (cutting budget spending) Operation Twist and QE3 expanded Operation Twist by 50 % sharply worsening - not if there is a mildly worsening recession so it truly will be a last resort QE1 -QE3 create more than $3 trillion dollars of base money thus a lot of in ation could occur if the economy suddenly picks up can look at it like MB sharply increased and the money multiplier has a less than 1 range 4 Long Run Growth Production and Growth gdp is a measure of production why do some countries produce more than others? WHy do countries grow at di▯erent rates? slide 15: no clear patter with what the growth and gdp means Rule of 70 if g % its GDP doubls rouchgly every 70/g years so small changes have a major issue implies a poor country does not have to grow that much faster than a rich country to catch up yet we can explain why they have not caught up as fast while not a measure of welfare or wealth but it is correlated with both of these things think of the economy as a whole as having a production function that turns inputs into outputs depend on ▯ L: labor ▯ K: physical capital ▯ H: human capital ▯ N natural resources CRS means we can use ‘ Y = AF(1; K ;H ;N ) L L L L L Determinants of Productivity talked about the actual determinants how do these determinants who actually measure A and K actually get used A - error term assume a cobb douglas function (thing that can’t be explained by things in the production function) solow residual we’ll look primarily at the equilibrium or stead state behavior Growth = increases in output per worker Solow makes a lot of simpli▯cations ignore natural resources, governments, and imports and exports 6 5 Solow Model Class Discussion for countries that start with low capital per worker, then there can be large gains to initial increases in savings but there are diminishing returns to capital, catch-up growth property that poor countries tend to grow more rapidly than rich ones look at the US vs S. Korea if there was a linear production function you would expect equal but there was a huge di▯erence in growthL in Korea was much smaller than US Other Determinants of Growth: Natural Resources and Geographic Condi- tions - some countries are more endowed with natural resources than others reasonably intuitive - geographic conditions also can play a role (tropics bad climate or frequent natural disasters) Pakistan lots of natural disasters Other Determinants of Growth: Investment From Abroad foreign aid either foreign direct investment foreign portfolio investment Other Determinants of Growth: Property Rights and Political Stability many poor countries, the justice system doesn’t work very well African countries and Venezuela has had di▯culties bringing in investment relates to Coase Theorem: Clear property rights and a good legal system can improve economic per- formance warm, fraud, corruption often go unpunished Game Theory - need contracts to enforce stu▯ talked about CPI (corruption perception index) Other Determinants of Growth: Education Government can increase productivity by promoting education-investment in human capital (H). In the U.S., each year of schooling raises a workers wage by 10 % Other Determinants of Growth: Health and Nutrition Health care expenditure is a type of investment in human capital healthier workers are more productive n countries with signi▯cant malnourishment, raising workers caloric intake raises productivity, Over 1962-95, caloric consumption rose 44 % in S. Korea, and economic growth ws huge Nobel winner Robert Fogel: 30 % of Great Britains growth from 1790-1980 was due as due to improved nutrition w Other Determinants of Growth: Research and Development Technological progress is the main reason why living standards rise over the long run. It’s a public good and ideas can be shared freely Other Determinants of Growth: Population Growth Dilutes natural resources per person, But, due to technological progress (e.g., agriculture), this hasn’t been a prob- lem Dilutes the capital stock. BUT Countries with high pop. growth tend to have lower educational attainment., will lower it and shift it to the top left Positive: Promotes technological progress: more people 2 more scientist 2 faster tech 7


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