Finance 381 Textbook - Exam 1

Capital markets

are where capital goods are financed with stock or long-term debt instruments.

Capital Markets

less marketable (Capital or Money markets?)

bank runs

occurs when a large number of depositors simultaneously want to convert their deposits into cash.

asymmetric information

occurs when buyers and sellers do not have access to the same information; sellers typically have more information than the buyers.

Toxic Securities

Subprime mortgages were called ____________ because of their toxic effect on a firm's capital and ultimately its solvency

price stability

for some large market basket of goods, the average price change of all the products is near zero

Private Placements

transactions in private markets

Alternative fisher equation

(1+i)=(1+r)(1+∆P(e)) i= r + ∆P(e)+(r∆P(e))

natural rate of unemployment

4%... full employment unemployment rate

∆P(e)

= (P(t+1)-P(t)/P(e)

∆P(a)

= (p(t+1)-P(t))/p(t)

M2 money supply

is the definition of money that includes the role money plays as a store of value as well as a medium of exchange

M1 money supply

is the definition that focuses on money as a medium of exchange

Fed Funds Rate

is the interbank lending rate and represents the primary cost of short-term loanable funds. the rate on these overnight interbank loans is highly volatile

Deferred Availability Cash Items (DACI)

represent the value of checks deposited at the Fed by depository institutions that have not yet been credited to the institutions' accounts

Excess Reserves

reserves greater than the required amounts

Required Reserves

reserves that the bank is required to hold by law

Systemic Risk

risk of the failure of the entire financial system resulting from interdependencies among financial institutions

discount rate

the interest rate a financial institution must pay to borrow reserve deposits from its regional federal reserve bank

Dealers

"Make markets" for securities by carrying an inventory of securities from which they stand ready to either buy or sell at quoted prices.

19. Explain the adverse selection problem. How can lenders reduce its effect?

Adverse selection arises from asymmetric information and, in the context of debt markets, refers to borrowers of poor credit quality applying for loans (perhaps because such borrowers need the loans the most in order to survive financially). The lender may reduce adverse selection by requiring loan applicants to supply detailed financial statements and other additional information, to use differential loan pricing for borrowers of different credit quality, or to reject loan applications if the risk appears too high. To process the information they collect, lenders often develop or acquire from third party credit scoring models that help determine borrowers' creditworthiness.

commercial paper

An unsecured, short-term promissory note issued by a corporation for financing accounts receivable and inventories. It is usually issued at a discount reflecting prevailing market interest rates. Maturities range up to 270 days and denominations of $1 million or more.

financial markets

Are just like any market you have seen before, where people buy and sell different types of goods and haggle over prices.

11. Why are banks singled out for special attention in the financial system?

Banks are the dominant type of depository institutions. As such, they deal with consumers (depositors), and consumers' trust in the banking system is extremely important for the flow of funds and ultimately the well-being of the economy. Also, banks, like other depositories, are highly leveraged (liabilities are often around 90% of total assets, with capital being the other 10%), which makes them much more vulnerable to credit and liquidity risks than other businesses.

8. What steps should bank management take to manage credit risk in the bank's loan portfolio?

Banks manage credit risk of their loan portfolios by (1) diversifying the portfolios across regions, industries, and types of loans, (2) conducting a careful credit analysis of potential borrowers, and (3) continually monitoring the borrowers over the life of the loan or investment. Banks develop and follow lending policies which set guidelines for lending officers.

Financial Claims (IOU)

Claims against someone else's money at a future date. Also go by securities or financial instruments

2. Explain the economic role of brokers, dealers, and investment bankers. How does each make a profit?

Brokers, dealers, and investment bankers make markets at both primary and secondary stages. Funds are raised and claims issued in primary markets with the help of investment bankers, who purchase securities from issuers at one price and sell them to the investing public at a higher price, earning the underwriter's spread. In secondary markets brokers help bring buyers and sellers of financial claims together, charging commissions, and dealers trade claims in volume, providing liquidity and price discovery and earning the difference between ask and bid price (the bid-ask spread).

17. Why do corporations issue commercial paper?

Commercial paper is short-term corporate debt; it is issued to meet corporate short-term cash obligations.

13. Explain why direct financial markets are wholesale markets. How do consumers gain access to these important markets?

Direct financial markets are dominated by institutions that want to avoid the costs of registering securities with the SEC and transact large amounts of securities between each other. Only wealthy individuals, so called "accredited investors" (one must have high income and/or net worth to be considered an accredited investor) may participate in direct financial transactions such as private placements. Small individual investors access financial markets indirectly through intermediaries such as commercial banks or mutual funds.

10. Explain how the Fed changes the money supply with an open-market purchase of Treasury securities.

Every Fed transaction with the private sector clears through the "bank reserve account". When the Fed buys securities, it pays for them in a way no other financial system participant can: It unilaterally creates new money by crediting new reserves in the amount of the purchase to the reserve account of the depository bank of the securities dealer. Thus, open market purchases increase total reserves in the banking system directly, immediately, and dollar-for-dollar. During the financial crisis of 2007-2009, the Fed expanded open market operations from using only Treasury securities to buying large amounts of federal agency debt and mortgage-backed securities. The importance of open market operations is illustrated in Exhibit 2.6: The Fed's portfolios of these securities are by far its largest asset categories.

Deficit spending units (DSU)

Expenditures for the period exceed revenues

18. With respect to the financial system, what is meant by "too big to fail"? Why is it an important issue?

Failure of a large financial firm may cause irreparable damage to the economy, resulting in a banking panic, recession, or even depression. To prevent the possible catastrophic consequences, the federal government may step in to bail out such firms, as it did in the fall of 2008. While a bailout may be the lesser evil than letting such firms fail, moral hazard may lead to wealth transfers from taxpayers to owners of these firms. That is, if a financial institution believes it is too big to fail, it may take excessive risks and, if these risks do not pay off, fail and end up being bailed out by the government (i.e., taxpayers). Minimizing the likelihood of having to bail out large financial institutions that are "too big to fail" calls for more stringent controls of capital positions, leverage, and risks taken by such firms.

Primary markets

Financial claims are sold by DSUs in ________. All financial claims have _______. An example of a ________ transaction is IBM corporation raising external funds through the sale of new stock or bonds.

financial intermediaries

Financial institutions are called ________ because they are middlemen, facilitating transactions between SSUs and DSUs

5. Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?

Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient.

4. Explain how you believe economic activity would be affected if we did not have financial markets and institutions.

Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings. The "production possibilities frontier" of the society would be smaller.

Investment banks

Firms that specialize in helping businesses sell new debt or equity in the financial markets

Does it make sense that the typical household is a surplus spending unit (SSU) while the typical business firm is a deficit spending unit (DSU)? Explain.

Households are ultimately SSUs, but have deficit periods when a home or other "big ticket" item is purchased. Businesses usually invest more in real assets than they receive in current operating cash flow.

12. Explain why households are the principal SSUs in the economy.

Households in the U.S. are more likely to have their income exceed their expenditures than businesses, which either look to expand and thus are DSUs or pay out the extra cash to shareholders in the form of dividends or share repurchases, or governments, which are often plagued by political agendas and run deficits.

6. How do financial intermediaries generate profits?

Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy 3 sources of comparative advantage: Economies of scale —large volumes of similar transactions; transaction cost control—finding and negotiating direct investments less expensively; and risk management expertise—bridging the "information gap" about DSUs' creditworthiness.

15. What is the difference between marketability and liquidity?

Marketability is the ease with which a security can be sold and converted into cash. Liquidity is the ability to convert an asset into cash quickly without a loss of value. While the two concepts are similar, marketability does not carry the implication that the security's value is preserved.

14. What are money center banks and why were they not allowed to engage in investment banking activities following the Great Depression?

Money center banks are large commercial banks located in major financial centers. The Glass-Steagall Act of 1933 separated commercial banking and investment banking because it was believed that excessive risk taking by commercial banks resulted in large number of bank failures after the 1929 stock crash followed by a depression. Commercial banks were again allowed in investment banking activities (and vice versa) in 1999.

7. Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why?

Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or "capital goods" are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to "store" cash in money market securities, which are generally, safe, liquid, and short-term.

16. Municipal bonds are attractive to what type of investors?

Municipal bonds are long-term debt of state and local governments. Their coupon income is exempt from federal income tax. Therefore, they are attractive to individuals and businesses in high income tax brackets.

20. Why does the Fed want the ability to pay interest on reserve accounts?

Paying interest on reserves allows the Fed to influence not only the supply of reserves (which it does by buying or selling securities via open market operations) but also the demand for reserves. Increasing the interest rate on reserves provides banks with an incentive to keep more excess reserves with the Fed rather than to lend to other banks or customers. Decreasing this rate or eliminating interest on reserves altogether would encourage banks to keep less excess reserves and lend more, all else equal.

21.If the country went into a recession, would you expect banks to increase or decrease its holdings of excess reserves? Explain.

Recessions are characterized by declines in economic activity. Demand for loans falls during such times while deposits levels tend to remain fairly stable. As a result, banks tend to make less loans and hold more excess reserves.

16. Why is the Federal Reserve Bank of New York granted special status? What is the special status?

The New York Fed's special status is in its responsibility to conduct open market operations for the Fed on a daily basis. The New York Fed Trading Desk buys and sells securities on the open market to carry out the decisions of FOMC. The New York Fed also houses the foreign exchange desk which trades currencies on behalf of the Fed and the U.S. Treasury. The president of the NY Fed has a permanent spot on FOMC, while the remaining eleven FRBs have four of their presidents on the committee on a rotating basis.The reason for the special status of the New York Fed is its location in the heart of the financial district in Manhattan - the home to some of the largest commercial banks and other financial firms in the world. The ability of the New York Fed officials to stay in close contact with these key market players is very important, especially in times of crises.

19.What are the arguments that support having a strong and independent Federal Reserve Bank?

The independence of the Fed relieves it from day-to-day political pressures and affords it to take unpopular measures beneficial for the economy in the long run. An example is contracting money supply to increase interest rates, which would likely dump inflation but cool of the economy in the short run.

Nominal Rate of interest

The interest rate we observe in the marketplace at any given time

3. Why are direct financing transactions more costly or inconvenient than intermediated transactions?

The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale.

20. Why is the financial system so highly regulated?

The regulation is needed to protect consumers from abuses by unscrupulous financial firms and to ensure economic stability. People should have confidence in the financial system for it to function well, and a well-functioning financial system is critical for ensuring the flow of funds and, in turn, economic growth.

Interest Rate

The rental price of money

17. What were three important regulatory powers that the Fed gained from the passage of the Financial Regulatory Reform Act of 2010? Explain each briefly.

The three regulatory powers the Fed gained are:1)The power to intervene in the business activities of large nonbank firms to better control systemic risk across the economy. In extraordinary circumstances, it has the power to break up firms or require them to divest of certain assets.2)Increased focus on strengthening firms considered "too big to fail", i.e., posing systemic risks to the economy. The Fed may impose tougher capital, leverage, risk-taking, and other standards for such firms.3)Focus on regulating larger financial firms: The Fed no longer oversees small bank-holding companies and state-chartered banks and will only regulate large financial institutions, banks, and thrift holding companies with total assets in excess of $50 billion.

15. Explain the fiscal policy stance that you would deploy if the economy were in a recession. How would you implement the policy?

The two basic fiscal policy stances are expansionary and contractionary. To combat a recession, a government can decrease taxes and/or increase expenditures to help create jobs and stimulate economic activity. It will cause the government budget deficit to increase or surplus to fall. This stance was first proposed by the British economist John Maynard Keynes.

10. Explain the statement, "A financial claim is someone's asset and someone else's liability."

There are always two sides to debt. To the issuer of the debt, it is a liability. To the holder of the debt, it is an asset. A financial asset always appears on two balance sheets; a real asset on just one.

18. Explain what is meant by moral hazard. What problems does it present when a bank makes a loan?

When it comes to loans, moral hazard occurs if borrowers engage in activities that increase the probability of default. A firm that has taken a bank loan may take on very risky investment projects which, if successful, would result in large profits, but which have high probabilities of failure. The reason for such behavior is that lenders do not share the upside with shareholders of the firm. To reduce moral hazard, the bank may impose some restrictions on the borrower stipulated in the loan contract (e.g., to maintain certain financial ratios at a certain level or better, to not acquire certain assets, or to reduce expenses), and continually monitor the borrower.

Goal of Fed today?

a Dual mandate to maintain maximum employment and stable prices

Federal funds

are bank deposits held with the Federal Reserve Bank.

Treasury bills

are direct obligations of the US government and thus are considered to have no default risk. Sold weekly and have maturities that range from 3 months to 1 year.

Money center banks

are large commercial banks usually located in major financial centers who are major participants in financial markets. EX: Jp Morgan, Citicorp, Bank of America, and Wells Fargo

Negotiable certificates of deposit (NCDs)

are large-denomination time deposits of the nations' largest banks. Unlike other time deposits of most commercial banks, _______ may be sold in the secondary market before maturity. Only the larger banks sell ______.

Secondary markets

are like used car markets; let people exchange "used" or previously issued financial claims for cash at will. ______ provide liquidity for investors who own primary claims. Ex: NYSE

Public Markets

are organized financial markets where securities registered with the Securities and Exchange Commission are bought and sold to individual institutional investors.

Municipal bonds

are the long-term debt obligations of state and local governments.

Corporate Bonds

are thus long-term IOUs that represent a claim against the firm's assets

Financial institutions (financial Intermediaries)

firms such as commercial banks, credit unions, insurance companies, pension funds, mutual funds, and finance companies that provide financial services to consumers, businesses, and government units

Direct financing

funds flow directly through financial markets

Indirect Financing

funds flow indirectly through financial institutions in the financial intermediation market

Brokers

help bring buyers and sellers together by acting as "matchmakers". If sale occurs _____ receive commission for their services

Surplus Spending Units (SSU)

income for the period exceeds expenses

Political risk

is the fluctuation in value of a financial institution resulting from the actions of the US or foreign governments.

bank panic

is the simultaneous failure of many banks during a financial crisis

Mortgages

long-term loans secured by real estate

moral hazard

problems occur after the transaction takes place

adverse selection

problems occur before a financial transaction takes place

Common Stock

represents an ownership claim on a firm's assets.

Liquidity

the ability to easily convert financial assets into cash without loss in value

Marketability

the ease with which a security can be sold and converted into cash

Foreign exchange risk

the fluctuation in the earnings or value of a financial institution that arises from fluctuations in exchange rates

Over the Counter Market (OTC)

the market where securities that are not listed on exchanges are traded. _______ has no central trading place. EX: Blomberg Tradebook or Citi Cross

Financial intermediation (Indirect financing)

the purchase of direct claims (IOUs) with one set of characteristics from DSUs and the transformation of them into indirect claims (IOUs) with a different set of characteristics.

interest rate risk

the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates

credit risk (default risk)

the risk that a borrower may not repay on a timely basis

actual reserves

total reserves of the bank

Quantitative Easing

Purchasing bonds and creating more reserves even when interest rates are near zero

4 goals of Federal Reserve Act of 1917

1. a MONETARY AUTHORITY that would expand and contract the nation's money supply as needed to stabilize the economy 2. a LENDER OF LAST RESORT that could furnish additional funds to banks in times of financial crisis 3. an EFFICIENT PAYMENT SYSTEM for clearing and collecting checks at par throughout the country 4. a more VIGOROUS BANK SUPERVISION system to reduce the risk of bank failures.

2. What is a call loan? How did call loans contribute to economic recessions?

A call loan may be "called in"—declared due and payable—by the lender at any time. Call loans were once a common form of bank financing for agriculture and business. Until the Fed was created in 1913, there was no "lender of last resort" to keep banks liquid. After the federal government began taxing state banknotes in the 1860s, demand deposits—essentially "call loans" to banks from depositors—became highly popular. If too many depositors demanded their money back at once, banks would be forced to call in loans, usually causing borrowers to default, often causing their farms or businesses to fail, and not necessarily raising enough cash to pay off the depositors. The ensuing economic slowdown and financial uncertainty would provoke more depositors to try to withdraw funds from banks, forcing more banks to call in loans, triggering more defaults and business failures, dragging the economy into recession.

Regulation Q

A historical Federal Reserve regulation that set a maximum interest rate that banks could pay on deposits. All interest rate ceilings on time and savings were phased out on April 1, 1986, by federal law.

19.Explain what is meant by the term negative interest rate. Why can interest rate never be negative?

A negative interest rate on investment means that the investor (lender) pays the borrower rather than the other way around. Theoretically, interest rates cannot be negative because investors are better off not investing at all and earning zero percent interest than investing at negative interest rates.

Troubled Asset Relief Program (TARP)

A program established in 2008 that allows the U.S. Treasury to purchase or guarantee mortgage-related assets of banks and other financial institutions.

7.What is the track record of professional interest forecasters? What do you think explains their performance?

Accurate forecasters will not likely publish their forecasts, but will use their ability to extract profits from the markets. This adjustment process, which incorporates all available information in an efficient market will adjust the current rate structure to reflect the consensus forecast. Studies of public forecasts indicate a very poor forecasting ability.

1.Explain why the banking system was so unstable prior to establishment of the Fed in 1914.

After termination of the Second Bank of the United States in 1836, the U.S. was without a central bank until passage of the Federal Reserve Act in late 1913. Thus there was no overall control of the size or quality of the money supply. Until the National Banking and Currency Acts (1862-64), banks were largely unregulated and free not only to engage in unsound lending practices, but to issue banknotes—IOUs against themselves—without restraint. Over-issue of this "private currency" prompted hoarding of gold and silver, causing the money supply to be "inelastic"—unevenly distributed and not easily adjustable. Frequent bank failures exacerbated downturns in the normal business cycle. The National Banking apparatus was a step forward, but the need for a central bank became more evident as the post-Civil War economy cycled through boom, bust, and financial panic.

Positive Time Preference

All things being equal people prefer to consume goods today rather than tomorrow. this is called a _____

2.If the money supply is increased, what happens to the level of interest rates?

An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates.

Discount Window

An operation of the Federal Reserve System whereby banks may borrow temporary reserves from the Federal Reserve System as an alternative to selling secondary reserves or borrowing federal funds to cover legal reserve deficiencies; the discount window is part of the mechanism for adjusting short-term required reserve deficiencies

4.If a country named Lower Slobovia decided to use U.S. dollars as a medium of exchange and therefore withdrew $10 billion in cash from its transaction deposits in the U.S., what would happen to the U.S. monetary base? What would happen to depository institutions' actual reserve holdings? What would happen to U.S. financial institutions' net excess reserves if the Lower Slobovians withdrew their money from bank deposits subject to a 10 percent reserve requirement? What would probably happen to the U.S. money supply?

Assuming the banks replenish their cash at the Fed, the monetary base will not change. FRN will increase by $10 billion and bank reserve deposit accounts will decrease by $10 billion. With the withdrawal of $10 billion in bank deposits, the banks' required reserves would decline by $1 billion (10% of $10 billion), but their actual reserve balances would decline by $10 billion, assuming replenishment of cash. Assuming no excess reserves, the destruction of bank reserves would reduce the money supply. The Fed is likely to replenish the reserves, assuming no policy changes.

11. What are technical factors? How do they affect the implementation of monetary policy?

Cash drains are "leaks" between changes in the monetary base and changes in actual reserves. These "leaks" occur as the public chooses to hold cash outside of banks, making it unavailable to use as actual reserves. Because cash drains reduce actual reserves, the Fed tries to anticipate when people are likely to withdraw cash. The Fed then tries to expand the money supply commensurately, to maintain the desired level of reserves. When people put cash back in, the Fed acts to decrease the monetary base back to the level consistent with monetary policy. Open-market operations are ideal for this kind of "fine-tuning". Similarly, the Fed must engage in open-market operations to offset the effects of float, the difference between deferred availability cash items (DACI) and cash items in process of collection (CIPC). A third technical factor is changes in Treasury deposits at the Fed. Large payments into or out of Treasury balances at the Fed cause large shifts in depository institutions' reserves as the checks are deposited and collected. Thus, the Treasury tries to coordinate any large fluctuations in its deposits with the Fed.

Federal Open Market Committee (FOMC)

Consists of the members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents.

11.Explain what the nominal rate of interest is and how it is related to the real rate of interest.

Nominal rates are the quoted interest rates we observe in the marketplace. A nominal rate includes the real rate plus expected inflation over the investment period.

14. What is fiscal policy? How does fiscal policy compare to monetary policy?

Fiscal policy is the control over government spending and taxes over the business cycle. Congress and President determine, and the Treasury Department carries out fiscal policy in the U.S. Monetary policy, on the other hand, boils down to the control of money supply; it is determined and carried out by central banks such as the Federal Reserve System in the U.S. or the European Central Bank in the Euro-zone.

9. Explain the concepts of frictional unemployment, structural unemployment, and the natural rate of unemployment. How do these affect what is considered full employment?

Full employment implies that every person of working age who wants work is working. It is a desirable goal, but not necessarily a practicable one. A certain amount of unemployment in the economy is frictional unemployment—a portion of those that are unemployed are in transition between jobs. Another reason for people not working is structural unemployment, meaning that there is a mismatch between a person's skill levels and available jobs or there are jobs in one region of the country but few in another region. Policy makers tolerate a certain level of unemployment—the natural rate of unemployment—a sort of "full employment unemployment rate." However, the politically acceptable rate of unemployment varies directly with the actual rate.

Real GDP

GDP expressed in constant, or unchanging, prices; adjusted for inflation

16. What is the government expenditure equation? Explain the three budget positions.

Government can finance its expenditures (G) with money raised by taxation (T) or incurring debt (B, for bonds):. G = T + ΔB. The three possible budget positions are:1)Balanced budget (G = T);2)Deficit (G > T): when expenditures exceed taxes collected, new debt is issued to finance the shortfall;3)Surplus (G < T): when expenditures are less than tax revenues, debt can be retired.

18. Explain why stable prices are so important to an economy.

High rates of inflation present two problems. First, it is hard to adjust to price level changes. It means that those market participants who underestimate inflation lose purchasing power. The second problem is that high inflation rates increase uncertainty regarding long-term investment decisions. To avoid these risks, many potential investors may withdraw from the financial markets altogether, causing a decline in economic activity.

13. Why is the concept of a liquidity trap important in the conduct of monetary policy?

If money supply is expanded so much that any extra money would be hoarded (rather than lent or invested), further injections of money have no effect on interest rate and the economy overall. This state is known as a liquidity trap. This is important when money supply is already high and interest rates low, such as after the 2007-2009 financial crisis in the U.S. and some other developed countries. It means that the economy should be stimulated by other means.

20.In financial markets, we occasionally observe negative interest rates. Reconcile the contradiction between the statement "The nominal rate of interest will never decline below zero" with the negative interest rate that occurred in the Japanese Treasury bill market in November 1998.

In some situations, investors seek safe storage for their money. In November 1998 in Japan many large investors did not want to keep money at banks, as they worried about the banking system's health, and preferred to store the money in government bills; the overwhelming demand for the bills, coupled with an already very low interest rate environment, drove the T-bill yields below zero. The desire to preserve capital trumped the desire to grow it.

9. Why does the Fed not use the discount rate to conduct monetary policy? How does the Fed use the discount rate?

In the early 20th century, long before modern money markets evolved, "discounting" was a common way to retrieve liquidity from financial instruments (e.g., factoring accounts receivable), and commercial banks did not have many "non-deposit" funding choices. When the Fed was formed, the discount rate was the primary tool of monetary policy because it was the cost of member banks' main non-deposit source of funds—loans at the Discount Window. The Fed would discount (lend less than the face value of) loans and other financial instruments held by member banks, providing liquidity. Because the banking industry had few other funding choices but was the primary source of operating credit to farms and businesses, Fed discount policy was a reasonably effective direct control on the money supply. As money markets evolved, the Fed Funds market in particular developed, and the FOMC developed its processes, "discounting" in its foundational sense faded into history. Today changes in the discount rate merely signal policy intent; open market operations directly increase or reduce the money supply. Loans "at the Window" are still available, but depository institutions have many funding choices and are wary of "Window scrutiny"—questions regulators might have about early or regular trips to the Window. Discount Window loans outstanding are now just a tiny fraction of the Fed's total assets.

The fed is likely to raise interest rates by the open-market sale of Treasury securities (reduce the money supply)

Inflation rate is above the Target Rate

The Fed is likely to lower interest rates by the open-market purchase of Treasury securities (increase the money supply)

Inflation rate is below the target rate

14.Explain how the market rate of interest is determined applying the loanable fund interest rate model.

Interest rates depend on the supply of and demand for funds, which in turn depend on thrift and productivity. The sources of supply of loanable funds are consumer and business savings, government budget surpluses, and Federal Reserve increases in the money supply. The sources of demand are consumer credit purchases, business investments, and government budget deficits, and Federal Reserve decreases in money supply.

16.Explain why it is important to adjust financial contracts for inflation. What is the relevant inflation factor?

It is important because investors want to realize a positive real rate of returns, in other words, to beat inflation. The relevant inflation factor is the average annual inflation rate anticipated over the period of investment.

Allocative Function

Like other prices, interest rates serve an _______ in our economy. They allocate funds between SSUs and DSUs among financial markets.

M2 money supply

M1 + savings deposits, money market deposit accounts, noninstitutional money market mutual funds, and small time deposits

1.What is the difference between M1 and M2? Why are there different measures of money?

M1 focuses on money as a medium of exchange—demand deposits and currency. M2 expands the meaning of money to include its use as a short-term store of value. To the elements of M1 it adds savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, noninstitutional money market mutual funds, and small time deposits. The Fed wants to know what definition of money has the greatest impact on interest rates, unemployment, and inflation.

M x V = Y

M= Money Supply V= velocity Y= GDP

MB = C + TR

MB= Monetary Base C= currency in circulation TR= Total reserves in the banking system

Real Rate of Interest

One of the most important economic variables in the economy. It is the rate of interest determined by the returns earned on investments in productive assets in the economy and by individuals' time preference for consumption

6.What is the essential difference between the Keynesian and the Monetarist view of how money affects the economy

Monetarists believe the key financial variable is the money supply. They assume the propensity to consume rises or drops as people perceive they have "more" or "less" money. Thus the money supply can be used to influence aggregate demand, and short-term interest rates merely indicate monetary policy's effects. Keynesians believe the key financial variable is interest rates: Real sector economic growth is stimulated by falling rates as economic activity costs less to finance, or slowed by rising rates as economic activity costs more to finance. To Keynesians, money supply changes reflect reactions to interest rates

10. What are some of the potential conflicts between goals of monetary policy? Explain.

Most of the goals are relatively consistent with one another. The goals often perceived in conflict are full employment and stable prices, at least in the short run. The conflict revolves around the perception that, as employment increases, so does inflation. This argument holds that high levels of unemployment mean substantial unused industrial capacity. As the economy begins to expand, unemployment starts to decline as workers are called back to work, and capacity utilization increases as more goods and services are produced. As the expansion continues, demand for labor and materials rises, putting upward pressure on price and wage levels.

12.Explain what is meant by the term positive time preference for consumption. How does it affect the rate of interest?

Most people prefer to consume goods sooner rather than later. This is known as a positive time preference for consumption. The higher this time preference is, the higher interest rate a person should be offered to forgo consumption and make an investment.

Humphrey-Hawkins Act

Passed in 1978, this legislation specifies the primary objectives of monetary policy- full employment, stable prices, and moderate long-term interest rates. In addition, it requires that the Board of Governors of the Federal Reserve System submit a report on the economy and the conduct of monetary policy to Congress by February 20 and July 20 of each year.

too big to fail

Policy adopted by federal regulators that the failure of certain financial institutions would have too much of an adverse effect on the economy and so those institutions will not be allowed to fail.

TR = RR + ER

RR = Required Reserves ER = Excess Reserves

6. Explain why Regulation Q caused difficulties for banks and other depository institutions, especially during periods of rising interest rates.

Reg Q, one of many "lettered" Fed regulations, originally prohibited banks from paying interest on demand deposits, prohibited thrifts from offering demand deposits, and imposed interest rate ceilings on interest-bearing deposits. These provisions served to limit price competition for deposits in a period when stability was the primary objective. When market rates rose above Reg Q ceilings, deposit withdrawal (disintermediation) would drain liquidity from depository institutions. Ultimately, Reg Q was phased out by the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Depository Institutions Act of 1982. Today, the Fed depends on market forces to allocate flow of funds.

6.Under what conditions is the loss of purchasing power on interest in the Fisher effect an important consideration?

Retired individuals or foundations with fixed interest rate returns on long-term CD or bond investment portfolios are hurt with actual or anticipated inflation. With expected inflation, market interest rates increase, and the value of the investment declines. With inflation and fixed interest income, less can be purchased each period.

17.Explain when the market rate of interest is equal to the real rate of interest.

Since market rates are nominal rates, the market rate is equal to the real rate when inflation is zero during a period.

4.Explain why the Board of Governors of the Federal Reserve System is considered so powerful. What are its major powers and which is the most important?

The 7 members of the Board make up a majority of the 12-member FOMC, which sets monetary policy (the Fed's most important power). The Board also promulgates all the financial system regulations listed in Exhibit 2.4, enacts the policies and procedures by which the Federal Reserve System is internally governed, and appoints 3 of the 9 directors of each Federal Reserve Bank. Governors, though appointed by the President and confirmed by the Senate, have a 14-year nonrenewable term of office and may thus discharge their duties with considerable political independence.

5. Explain why the FOMC is the key policy group within the Fed.

The Federal Open Market Committee, comprising the 7 Governors, the president of the New York Fed, and 4 of the remaining 11 presidents of Federal Reserve Banks, sets monetary policy for one of the world's largest and most powerful countries, affecting interest rates, exchange rates, and economic growth. The Chairman of the Board of Governors sets the FOMC's agenda, runs its meetings, and is the Fed's face and voice to the outside world. Consequently, the Chairman is one of the world's most powerful figures.

3.What is the "Fisher effect"? How does it affect the nominal rate of interest?

The Fisher effect, espoused by Irving Fisher, theorizes that expected inflation is embodied in current nominal interest rates. Assuming the ability to forecast expected inflation, nominal rates should vary directly with expected inflation.

10.If the realized real rate of return turns out to be positive, would you rather have been a borrower or a lender? Explain in terms of the purchasing power of the money used to repay a loan?

The answer depends upon whether the lender (borrower) earns (pays) their expected real rate on the loan? If inflation were originally underestimated, borrowers would benefit at the cost of the lender for their realized real cost of borrowing would be less. If inflation were overestimated the lender would benefit at the cost of borrower for realized real returns (borrowing costs) would higher than originally anticipated. If a 3% real return (cost) were the agreed upon at the beginning of a $1000, one-year loan, and inflation expectations were 4%, lender and borrower would have been satisfied at the beginning of the loan with a 7% nominal rate. If inflation realized is 5%, the lender (borrower) only earns (pays) 2%. If realized inflation is 3%, the lender (borrower) real return (cost) is 4%.

13.Explain how the equilibrium real rate of interest is determined.

The equilibrium rate of interest is the point where the desired level of borrowing by deficit spending units (DSUs) equals the desired level of lending by surplus spending units (SSUs).

12. Why do security traders pay so much attention to the fed funds rate? Why is the fed funds rate so important?

The fed funds rate is the interbank lending rate. It is of interest to many market participants for three reasons: (1) it measures the return on the most liquid financial asset - bank reserves, (2) it is closely related to monetary policy, and (3) it measures the available reserves in the banking system, which influences banks' decisions on making loans.

20. In your opinion, what were the three most important factors that caused the 2008 financial crisis?

The first of the most important factors was the U.S. housing price bubble that burst. Asset price bubbles occur when demand is over-inflated. The U.S. housing price bubble became possible due to the combination of low mortgage interest rates and lax lending standards. When many mortgages made during the housing price run-up started defaulting, it caused deterioration in the balance sheets of financial institutions that held these mortgages or mortgage-backed securities. It was the second major factor contributing to the crisis. The third major factor was the bankruptcy of the investment bank Lehman Brothers in September 2008. It signaled that the government was willing to allow large financial institutions to fail and caused major concerns about the U.S. financial services industry, bringing the financial system to the brink of collapse.

2.What would happen to the monetary base if the U.S. Treasury collected $4 billion in taxes, which it deposited in its account at the Fed, and the Fed bought $2.5 billion in government securities? Do you know now why the Fed and Treasury try to coordinate their operations in order to have minimal effects on the financial markets?

The first transaction would lower bank reserves and increase Treasury deposits at the Fed by $4 billion. The second transaction would restore $2.5 billion in bank reserves. The net reduction of $1.5 billion in reserves would put upward pressure on the Fed Funds rate. The Treasury will probably spend its deposits down quickly, increasing bank reserves by the total of the clearing checks. The Fed may then have to sell government securities to return reserves to their intended level.

3. What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?

The goals of the Federal Reserve Act of 1913 were to create: (1) a reliable mechanism for adjusting the money supply to the needs of the economy;(2) a lender of last resort that could furnish liquidity to banks in times of financial crisis(3) an efficient payment system for clearing and collecting checks at face value throughout the country(4) a more vigorous bank supervision system to reduce the risk of bank failures.Relatively low rates of inflation since the early 1980s are evidence of success with goal #1. The Fed was a true lender of last resort (goal #2) to financial institutions (including non-banks) and even some non-financial companies during the 2007-2009 financial crisis. The U.S. payment system—goal #3— operates so reliably as to be taken for granted. The financial services industry faced a major challenge during the 2007-2009 crisis, with numerous bank failures and near failures. The Fed worked hard to prevent failures of systemically important banks (goal #4) and other financial institutions and restore confidence in the financial markets..

1.What factors determine the real rate of interest?

The real rate of interest is determined by: (a) individual time preference for consumption, and (b) the return that firms expect to earn on their real capital investments. In equilibrium, the real rate of interest is determined when desired saving equals desired investment.

18.Explain what is meant by the realized rate of return. How does it differ from the real rate of interest?

The realized rate of return is the actual real rate to the lender at the conclusion of the loan contract. It depends on the actual inflation during the period. The real rate of interest is the base interest rate for the economy and is closely related to the productivity of capital investments and the people's time preference for consumption.

17. What are the six goals the Fed is required by government legislation to achieve? Which two goals are the most important? Why?

The six goals of the Fed are: price stability, full employment, economic growth, interest rate stability, stability of the financial system, and stability of foreign exchange markets. The most important goals are high employment and stable prices. High inflation (unstable prices) is destructive because it causes unintended transfers of purchasing power between parties of financial contracts and discourages people from engaging in economic activity due to high uncertainty. Full employment is important because it is critical to the well-being of the economy and the society, as well as its individual members.

15.What is the value of money? How does the value of money vary with aggregate price-level changes?

The value of money is its purchasing power, or goods and services that can be bought with it. Price increases (decreases) decrease (increase) the value of money because a dollar can buy less (more).

Technical Factors

There are a number of the so-called ______ that affect the monetary base

7. Explain the sense in which the Fed is independent of the federal government. How independent is the Fed in reality? What is your opinion about the importance of the Fed's independence for the U.S. economy?

There are no direct channels of bureaucratic, fiscal, or political pressure on the Fed. It is a creature of Congress, but not directly under its authority. The Board is appointed by but not answerable to the President. The Fed funds itself, thus Congress has no "power of the purse" over it. Ultimately, however, it may be more correct to say that the Fed is independent within, not of the government. What Congress creates, Congress can modify or destroy. Congress has from time to time established guidelines or objectives for the Fed (e.g., the Humphrey-Hawkins Act of 1978). The Fed remains independent because most politicians want it that way. They mostly agree that monetary policy is not a partisan issue. An independent Fed can also absorb blame if the economy falters, and take necessary but unpopular steps to combat various economic ills. Critics argue that the Fed's independence is elitist and undemocratic. Supporters argue that elected politicians cannot be fully trusted to handle the money supply. The underlying argument is as representative government itself: Should popular will decide public policy, or merely decide who decides? There is evidence (see Exhibit 2.5) that countries with more independent central banks have less inflation. However, there is no evidence that central bank independence correlates with employment or national income levels.

8.Explain how forecasters using the flow-of-funds approach determine future interest rate movements.

Using the loanable funds theory, forecasters predict funds flow through sectors looking for significant supply/demand variations, which may signal changes in interest rates.

Return on investment

Usually measured as a percentage. It is the output generated by a capital project

19. Assume the Fed undertakes open-market operations and buys Treasury securities. Explain what should happen to interest rates. What is the expected change in nominal GDP?. How is nominal GDP then partitioned off between inflation and real GDP?

When the Fed buys securities, money supply expands. In response, consumer and business spending increase, increasing nominal GDP. Nominal GDP changes occur due to changes in real GDP (that is, amount of goods and services produced) and due to changes in the price level. When inflation is relatively high, most of a GDP increase is due to price changes rather than changes in the real output.

structural unemployment

a mismatch between a person's skill levels and available jobs

Frictional unemployment

a portion of those who are unemployed are in transition between jobs

Cash Items in Process of Collection (CIPC)

an account that is the value of checks drawn on other banks but not yet collected

Realized real rate of return

can be defined as the actual rate of return to the lender at the conclusion of the loan contract

market economy

consumers have a free choice to buy or not buy whatever goods or services they want

M1 money supply

currency + checking deposits + Traveler's checks

APR

e(1)/e(0)=[1+(i(U.S.)/m)]

Approximate Fisher Equation

i = r + ∆P(e) Is named after economist Irving Fisher

i = r + ∆P(e)

i= nominal rate of interest (contract rate) r = real rate of interest ∆P(e)= expected annualized Price Level Change

Full Employment

implies that every person of working age who wishes to work can find employment

crowd out

in a closed economy without foreign sources of capital, government spending can _____ private spending because the government's demand for funds may increase interest rates and make some private investment unprofitable

8. Given your answers to Question 7, what, if anything, would you expect to happen to housing investment, plant and equipment investment, intended inventory investment, government expenditures, consumption, exports, imports:

increase, increase, increase, increase, increase, increase, decrease. As market interest rates decline, loans become readily available, money supplies expand, the public's liquid asset holdings increase, and the market value of financial assets rises. In addition, disintermediation pressures may diminish. As a result of the decline in interest rate, increase in liquidity, and increase in credit availability more expenditures will be undertaken in all segments of the economy.

liquidity trap

is a keynesian concept where increasing the money supply does not lead to lower interest rates and thus does not stimulate the economy

Inflation targeting

is an economic policy where a central bank estimates and makes public a projected or target inflation rate then steers the actual rate of inflation in the economy toward the target rate through use of monetary policy tools.

Inflation

is defined as a continuous rise in the average price level

7. What effects are decreases in reserve requirements likely to have on bank reserves, federal fund rates, bank lending, T-Bill rates, the bank prime rate:

none, reduce them, increase it, reduce them, reduce. Reductions in reserve requirements will provide depository institutions with additional excess reserves. As they lend or invest these excess reserves to earn an interest return, Fed Funds rates and other short-term rates will fall, stimulating demand for loanable funds.

r(r) ≈ i - ∆P(a)

r(r)= realized real rate of return on a loan contract i= observed nominal rate of interest ∆P(a)= actual rate of inflation during the loan contract

Open-Market Operations (OMOs)

the purchase and sale of U.S. government bonds by the Fed. _____ are used to increase or decrease bank reserves and the monetary base. When the Fed purchases securities, the monetary base expands

velocity of money

the relationship between the money supply and economic activity

Total Reserves

the reserve amount computed by a bank by summing its holdings of vault cash with its holdings of reserve deposits at federal reserve banks over a 2-week reserve maintenance period.

monetary base

the sum of currency in circulation and bank reserves plus the total reserves in the banking system