Money and Banking Part II

State the equations and explain the economic intuition for Phillips Curve

- π = πe + α (Y-Y*) /Y* + v (α>0) - When unemployment is high, many people are seeking jobs, so employers have no need to offer high wages. It's another way of saying that high levels of unemployment result in low levels of wage inflation. Likewise, the reverse would also seem to be intuitive. When unemployment rates are low, there are fewer people seeking jobs. Employers looking to hire need to raise wages in order to attract employees.

What are the main objectives of monetary policy? Explain the concept of "dual mandates" with respect to monetary policy.

-Federal reserve controls monetary policy in order to make sure the money supply doesn't grow neither too quickly, causing excessive inflation, nor too slowly, hampering economic growth -The Goals of Dual Mandate: 1)maximum employment, stable prices, and 2) moderate long-term interest rates

After the conversion, will you then withdraw a portion of Biermarks to slow down the economy? Why or why not?

It may be a good idea to withdraw some money out of circulation, which leads to higher interest rates and lower consumptions and investments

State the equations and explain the economic intuition for Okun's Law

-(Y - Y*)/Y* = c * (U - U*) -investigates the statistical relationship between a country's unemployment rate and the growth rate of its economy. "is intended to tell us how much of a country's gross domestic product (GDP) may be lost when the unemployment rate is above its natural rate. 1% decrease in unemployment will occur when the economy grows about 2% faster than expected

What is a liquidity trap? Why does it exist and why are conventional monetary policy tools NOT effective in a liquidity trap?

-The liquidity trap is the situation in which the current interest rates are low and savings rates are high, rendering monetary policy ineffective. -The more sensitive to interest rates the demand for money is, the more unpredictable velocity will be, and the less clear the link between the money supply and aggregate spending becomes. Indeed, there exists an extreme case of ultrasensitivity o f the demand for money to interest rates called the liquidity trap in which conventional monetary policy has no direct effect on aggregate spending because a changer in the money supply has no effect on interest rates.

Explain the phrase "(time) dynamic inconsistency" in the context of monetary policy. Apply the concept and explain why it is difficult for central banks to implement "forward guidance."

-Time Dynamic Inconsistency is the tendency of policymakers to deviate from good long-run plans when making short-run decisions. When workers and firms see a central bank pursuing discretionary expansionary policy, they will recognize that this policy is likely to lead to higher inflation. They will therefore raise their expectations of inflation, driving wages and prices up which will lead to higher inflation without higher output. -Central banks use the term forward guidance to communicate what their future monetary policy will be. It is difficult to set a monetary policy in the future and stick to it while under Time Dynamic Inconsistency considering what I previously explained.

State the equation and explain the economic intuition for the Taylor Rule

-inflation rate +[(.5)inflation gap+(.5) output gap] -The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate is known as the Taylor principle.

Describe the asymmetric information dynamics of financial crises. How should the government intervene when a crisis happens according to this dynamics?

Characterization: sharp drop in asset prices and failures of financial institutions. Policy responses include crisis management, fiscal stimulus and monetary stimulus. Crisis management: bailing out/taking control of institutions, guaranteeing debts, suspending markets. Fiscal: cutting taxes and increase spending. Monetary: cutting interest rates and "printing" money.

What is a zero lower bound? Why does it exist and why are conventional monetary policy tools NOT effective at the zero lower bound?

Conventional monetary policies aim to lower the federal funds rate. At zero lower bound, this is not possible due to cash holding. To stimulate the economy, the Fed tried QEs, which are long-term assets purchase programs that aim to lower long term interest directly. The Fed also tried Forward Guidance, promising to keep QE 3 in place until unemployment is sufficiently low. This helps the market plan for the medium term, hence consuming and investing more.

Using the Uncovered Interest Rate Parity (and maybe Mundell's trilemma), explain why you cannot raise Biermani's interest rates to "cool" down the economy.

Fixed rate+Capital mobility rule out monetary autonomy

Suppose you have withdrawn 2% of Biermarks out of the economy. By how much do you expect the money supply to decrease? Knowing the uncovered Interest Rate Parity, do you expect the Biermark to appreciate or depreciate relative to the EuFa?

Money supply decreases by 5%, using the money multiplier. Appricates: money supply goes down, hence long term deflation, hence expected future exchange rate goes down. At the same time, interest rates goes up. Altogether, making the current exchanges rate goes down by more than 5%

In class, we have discussed the "luncheon meat" model of securitization. According to this model, what are Collateralize Debt Obligations (CDOs)?

Reducing the adverse selection problem requires the banks to acquire information to screen bad credit risks from good credit risks. It is easier for banks to obtain information about local businesses. Also if the bank lends to firms in a few specific industries they will become more knowledgeable about those industries and a better judge of creditworthiness in those industries.

What is systemic risk? Why does it attract so much attention during the most recent Financial crisis .

Systemic risk also referred to as, volatility, is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered a systemic risk are called "too big to fail." These institutions are large relative to their respective industries or make up a significant part of the overall economy.

Explain the "trilemma of policy objectives" in monetary policy from an international perspective.

The Fed does not completely control the level of bank deposits and loans because banks can hold excess reserves and the public can change it's currency holdings. A change in either factor changes the deposit expansion process. An increase in either excess reserves or currency reduces the amount by which deposits and loans are increased.

Explain two reasons why the Fed does not have complete control over the level of bank deposits and loans. Explain how a change in either factor affects the deposit expansion process

The Fed does not completely control the level of bank deposits and loans because banks can hold excess reserves and the public can change its currency holdings. A change in either factor changes the deposit expansion process. An increase in either excess reserves or currency reduces the amount by which deposits and loans are increased

What two key factors trigger speculative attacks leading to currency crisis in emerging market countries?

The deterioration in bank balance sheets and severe fiscal imbalances are the key factors. To counter a speculative attack, a country might try to raise interest rates. Raising interest rates, however, would worsen the problem of banks that are already in trouble. Speculators recognize this and seize the opportunity. When their are severe fiscal imbalances, there is concern that government debt will not be paid back. Funds are pulled out of the country and domestic currency is sold leading to a decline in the value of the domestic currency. Speculators will once again seize the opportunity.

Explain the time-inconsistency problem. What is the likely outcome of discretionary policy? What are the solutions to the time-inconsistency problem?

With policy discretion, policymakers have an incentive to attempt to increase output by pursuing expansionary policies once expectations are set. The problem is that this policy results not in higher output, but in higher actual and expected inflation. The solution is to adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint on discretionary behavior.

Explain the "impossible trinity" as put forth by Robert Mundell

country cannot achieve the free flow of capital, a fixed exchange rate and independent monetary policy simultaneously. By pursuing any two of these options, it necessarily closes off the third. According to the trilemma model, a country has three options. It can A - set a fixed exchange rate between its currency and another while allowing capital to flow freely across its borders, B - allow capital to flow freely and set its own monetary policy, or C - set its own monetary policy and maintain a fixed exchange rate. However it can not do all three at the same time!