Money and banking test 1

What is the difference between financial instruments bought and sold in primary markets from those bought and sold in secondary markets?

Newly-issued instruments are bought and sold in the primary market. Previously-issued instruments are bought and sold in the secondary market. Business and governments will only receive funds from primary market sales.

What is a debt instrument? What is the claim to income on a debt instrument?

Debt instruments represent a type of loan arrangement and like a loan, they pay interest over time. The claim to income would be a bond. A person who buys a debt instrument would be paid back the original amount and then whatever the annual interest payment was on the debt instrument.

What is a depository institution? What are the three types of depository institutions in the US?

Depository institution maintains deposits from savers and makes loans to businesses and individuals. The three types of depositories are commercial banks, savings institutions, credit unions.

Be able to identify the country associated with different stock exchanges: Dow Jones S&P 500 Nikkei (i.e. Nikkei 225) FTSE 100 (e.g. Footsie) Hang Seng SSE (Shanghai) Composite

Dow Jones (US) S&P 500 (US) Nikkei ( Japan) FTSE (UK) Hang Seng (Hong Kong) SSE(Shanghai)

Has QE become a temporary or regular policy tool for major central banks? How has the QE response from major central banks to the COVID crisis compared to previous rounds in response to the 2007-09 financial crisis? (HW#4)

The article states that QE programs have become a "staple" of central banks, suggesting that it is now a tool used with some regularity. The numbers presented in the article suggest that current QE activity is more intense than in previous years.

What is the required reserve ratio? What is the difference between required reserves and excess reserves?

The required reserve ratio is 10 percent. The required reserve is set up by the government. The excess reserve is additional money in the reserve.

Calculate M1

M1 = currency + total checkable deposits + traveler's checks

How are the monetary aggregates of M1 and M2 defined? Know what assets are included in each measure. Which aggregate has the higher liquidity?

M1 includes currency in circulation, transactions deposits and travelers checks. Currency in circulation includes government backed paper money and coins. M2 includes all M1 plus near money: saving deposits, small denomination time deposits, and retail funds. M1 is more liquid than M2

What distinguishes the behavior of M1 and M2 before 2008 versus post-2008? (HW#2)

M1 money showed alternating periods of stability and modest increases up to 2008. After 2008, M1 money showed a sharp acceleration that has continued until the last couple of years.

Calculate M2

M2 = M1 + savings deposits + small-den time deposits + retail money funds

Calculate monetary base

MB = monetary base = R + C.

Debt instrument:

a contract that promises to pay a given amount of money to the owner of the instrument at specific dates in the future

Transaction deposit:

a deposit at a depository institution that can be used for immediate transactions; that is, deposits that have full liquidity

Time deposit:

a deposit that requires either advanced notice of withdrawal or has a fixed maturity before withdrawal can be made; a common example is a certificate of deposit (CDs)

Primary dealers:

a firm, typically a large investment firm, that agrees to buy/sell government securities with the government or central bank; primary dealers in the US are used to execute open market operations

Treasury bond:

a long-term debt instrument issued by the US government

Monetary aggregate:

a measure of the total money supply in the economy based on a standard of liquidity

Financial markets:

a mechanism by which savers, borrowers, and financial intermediaries exchange financial resources

M2:

a monetary aggregate that includes M1, savings accounts, small-denomination (<$100,000) time deposits, and non-institutional money market mutual funds

M1:

a monetary aggregate that includes coin and currency outstanding, total transactions/checking accounts, and traveler's checks

Do all countries have reserve requirements? How can governments guide the flow of money and credit in their economies if there are no reserve requirements? (HW#4)

Many countries do not have reserve requirements. Without reserve requirements, all reserves are effectively "excess reserves". Banks' demand for these reserves will depend on the extent to which they want to make loans. This is partly influenced by trends in economic activity, but can also be influenced through regulations on bank lending by the government.

How is money defined in economics? What are the four functions of money and how are they defined?

Money is any item that individuals are willing to accept in exchange for goods or services. -Medium of exchange. Money reduces transactions costs (as in #1 above). -Unit of account. Money allows the value of goods and services to be denoted in terms of a common unit. -Store of value. Money can retain its value if not spent. -Standard of deferred payment. Money is accepted as future payment for current consumption; that is, money allows loans to be made.

What are the maturity lengths for financial instruments in money markets? What are the maturity lengths for those in capital markets?

Money market instruments are mature in less than one year. For capital markets they mature in one year or more.

What institutions created the greatest immediate concern in the 2007-2008 financial crisis?

created lending facilities for non-depository financial institutions, which extended the Fed's conventional role as a lender of last resort for banks to a lender of other types of financial institutions;

Depository institution:

financial institutions that pool the deposits of savers and make loans to businesses and individuals; include commercial banks, savings institutions, and credit unions (in the US)

Liquidity:

how easy an asset can be transformed into cash on short-notice and at low-risk

Monetary base:

includes bank reserves and public-held currency; is directly influenced by the central bank

What was the response to leverage problems in the financial system? (Bailout of Bear Stearns)

leverage problems are addressed with bailouts. Bailouts occur when the government provides funds to prevent an insolvent institution from failing.

Capital market:

market for intermediate- and long-term (over one-year maturity) financial instruments; includes all types of stock (equity) and notes/bonds (debt)

Money market:

market for short-term (less than one-year maturity) financial instruments; major money market instruments include US Treasury bills and commercial paper

Federal funds market:

market where banks loan/borrow reserves with each other at the market determined federal funds rate

Open market operations:

the activity by which the Federal Reserve buys and sells securities with its primary dealers

Federal Reserve:

the central banks of the United States

Bank failure:

the closing of an insolvent bank by a state or federal regulating body

Money multiplier:

the factor by which the money supply changes as a result of a change to the monetary base; conceptually takes values > 1.0

Required reserve ratio:

the legal ratio (q) of cash reserves that depository institutions must hold relative to transactions deposits; set by the Federal Reserve

Board of Governors:

the main governing body of the Federal Reserve; consists of seven Presidentially-appointed and Senate-confirmed governors that have 14-year staggered terms

Federal funds rate:

the market rate determined by bank lending/borrowing in the federal funds market.

Discount window:

the process of depository institutions requesting short-term loans from the Fed at the determined discount rate

Systemic risk:

the risk posed to one financial institution's credit agreements by the potential failure of transactions by other institutions that are otherwise unrelated

Leverage risk:

the risk that losses in asset values cannot be offset with reduced liabilities

Liquidity risk:

the risk that short-term assets cannot meet short-term liabilities

Direct finance:

when borrowers obtain funding directly from savers, e.g. when savers buy instruments direct from borrowers

Indirect finance:

when borrowers obtain funds from intermediaries who collect and pool the resources of savers

Relation between changes in the money supply (M1), total lending (L), and the monetary base/reserves (MB) (see HW#4):

∆𝑀1 = ∆𝐿 + ∆𝑀B

Calculate Money Multiplier

∆𝑀1 = 𝑐 + 1/ 𝑟 + 𝑐 + 𝑒 × ∆𝑀B

How do businesses benefit from financial markets?

-Businesses can borrow funds that will pay for capital such as equipment, buildings, and other infrastructure. -This capital allows the business to be more productive and generate more revenue/profit.

Describe the differences between debt instruments and equity instruments?

-Debt instruments are issued by both government and businesses. They represent an obligation by the issuer to pay certain amounts of money at specific dates. -Equity instruments are issued only by businesses. They give the holder a share of ownership in the business. However they do not represent an obligation by the business to pay some future money.

What is the difference between a primary market and a secondary market? In which market do businesses and governments obtain funds?

-Primary markets exist for newly-issued financial instruments. -Secondary markets exist for instruments that have already been purchased once. They are analogous to a used car market. -Governments and business only receive funds when they sell their instruments for the first time, in primary markets.

Describe the two sides of financial markets.

-Savers have unused financial resources. This represents the supply-side of the market. -Borrowers want financial resources to pay for productive activities. This represents the demand-side of the market.

What is a central bank? Other than the Federal Reserve, what are considered the other major central banks of the world?

A central bank is an institution charged with controlling the money supply nation. Other central banks are: Banks of England, bank of Japan, People's bank of china, and the european central bank

What is a financial crisis? Are they rare or relatively common?

A financial crisis is generally defined as a sudden and large reduction in a financial system's value. Globally, financial crises are not rare and occur with some frequency. In the US we had the 1929 financial crisis that precipitated the Great Depression of the 1930s, a savings and loan crisis that resulted in the mass failures of savings institutions in the 1980s and 1990s, and of course the most recent crisis in 2007-2008 that was associated with subprime mortgage lending. Crises in other countries include the UK Secondary Banking Crisis of 1973-75, the Japanese asset bubble of 1986-1991, and the Swedish banking crisis of the 1990s. This is just a short list to highlight the fact that crises occur throughout the world and with frequency.

What are negative externalities? How can they create systemic risk in the financial system?

A negative externality occurs when uncompensated costs are imposed on a third party by the activities of other parties. Consider three banks. Bank A owes funds to Bank B, and Bank B owes funds to Bank C. Bank B is waiting for his payment from Bank A before he can pay Bank C. Suppose Bank A gets into trouble and cannot pay what he owes to Bank B. Then Bank C suffers a cost as a result of Bank A's actions. This reflects a systemic risk in the banking system.

What are the usual events that describe an asset price crash?

Asset price crashes result in reduced wealth and uncertainty in financial markets, both of which result in lower consumer/business spending and lending activity that puts downward pressure on economic activity. Institutional problems result in fewer institutions and reduce lending which also hurt economic activity. The lower economic activity puts further pressure on asset prices and institutional problems, reinforcing the cycle.

What is the typical pattern of bank lending (to businesses) during and after recessions? Why might banks tighten lending standards during recessions? Why might people and businesses have lower demand for loans during recessions? (HW#2)

Banks tighten their lending standards to adjust for increased risk during recessions. People and businesses may be less likely to pay back loans during recessions because of higher unemployment and lower business revenues. High unemployment and lower spending result in lower income and profit for people and businesses. These act to reduce overall desired spending on big-ticket items for which loans are used, such as cars, appliances, and business equipment. Recessions also create more uncertainty about the economic environment, which makes people and businesses less willing to borrow money.

What is meant by endogenous money? How can monetary policy still influence bank lending and the money supply in an environment of endogenous money? (HW#4)

Endogeneous money is a term that suggests that the amount of money flowing through the banking system is determined by the banks themselves (in reaction to economic conditions and subject to any government regulations). Even in an environment of endogenous money, central banks can still exert monetary policy through regulations on bank lending and, most prominently, by influencing the level of interest rates in the economy. (We will detail the second point in later classes.)

What is an equity instrument? What is a claim to income on an equity instrument?

Equity instruments represent shares of ownership. Only business can issue equity instruments because a government cannot sell "themselves" Equity instruments pay dividends over time: periodic cash payments that are based on the performance of the business. Equity instruments are not a guaranteed payment.

How does the behavior of excess reserves after 2008 compare to historical standards? How does this translate to changes in the monetary base? (HW#3)

Excess reserves sharply increased between 2008 and 2014. There was another major increase in early-2020. If you look closely you can see accelerations in 2009, 2011, 2013, and 2020. These represent policy actions (executed through open market operations) that we will discuss in the future.

What are financial intermediaries? What are the functions and benefits attributed to financial intermediaries?

Financial intermediaries are institutions that pool the funds of savers and reallocate those funds to borrowers. They have two functions: first they collect and pool the funds of many savers. Second, they gather and process information on where the funds are coming from and who will receive the funds. They yield several benefits to savers, borrowers, and the economy in general. Such as diversification, large loans, reduce transaction costs, increase efficiency.

Equity instrument:

a contract that gives a share of ownership in the firm to the owner of a instrument

What was the key asset of the 2007-2008 financial crisis?

In summary, the key asset of the financial crisis was the mortgage-backed security and the key institutions were the large investment firms (such as Bear Stearns and Lehman Brothers). The asset-price crash in the MBS market resulted in liquidity and leverage problems among financial institutions. Personal and business wealth was reduced and access to lending/credit was severely restricted. The crisis cycle was apparent.

Why does the Fed (and other central banks in higher-income countries) tend to operate independently from the government? (HW#3)

Independence is important to avoid short-term political motives from interfering with long-term economic stability.

How is direct finance distinguished from indirect finance? How are savers and borrowers related in indirect finance?

Indirect finance takes place through financial intermediaries. (Like a bank) Direct finance is done with financial instruments like bonds. The difference is indirect, has someone in the middle and direct does not have a intermediary.

What is the concept of liquidity?

Liquidity describes how fast something can be used to make a transaction. Cash is very liquid because it can be spent anywhere any time.

What does it mean for a bank to have liquidity problems? What does it mean for a bank to have leverage problems?

Liquidity problems occur when short term assets cannot meet short term liabilities. For example "a bank cannot access enough cash to meet the demand for withdrawals by its depositors. Leverage problems occur when overall assets values fall below liability values

What will be the ultimate addition to money in the economy from the original $85B open market operations if the reserve ratio is 10%, the currency-to-deposit ratio is 50%, AND banks hold 5% excess reserves? Is this amount more or less than what you found in part b? What behavior explains the difference?

Now we have the full M1 money multiplier with r = .1, c = .5, and e = .05: ∆𝑀1 = 𝑐 + 1 𝑟 + 𝑐 + 𝑒 × ∆𝑀𝐵 ∆𝑀1 = . 5 + 1 . 1 + .5 + .05 × $85𝐵 ∆𝑀1 = 2.31 × $85𝐵 = $196.15𝐵 This is a smaller amount than part b because not only are individuals and businesses pulling money out of the banks when they hold currency, but the banks themselves are also holding money back when they keep excess reserves. This results in smaller loan amounts and therefore a smaller overall money expansion.

What is monetary policy?

Policy implemented by central bank that influences the flow of money and credit in the economy.

Treasury bonds issued for the first time New commercial paper issued by a corporation A 6-month Treasury bill being sold by its second owner First-time stock issued by a corporation Previously-issued stock traded on the New York Stock Exchange

Primary Primary Secondary Primary Secondary

What is quantitative easing? What potential consequence created concern about that policy? (HW#4)

QE is described by the Fed undertaking two large-scale asset purchase programs in 2008 and 2010. (NOTE: A third QE started in early 2013 and ended in early 2014. The Fed also embarked on a QE program in 2020 in response to financial conditions stemming from the COVID-19 pandemic.) The potential consequence created is The potential consequence is a large increase the money supply and much higher inflation.

In what year was the Federal Reserve established? What are the two broad components of the Federal Reserve? In which component does the Chairman belong? Who is the current Chairman?

The FED was established by congressional legislation in 1913. It is divided into two main components. The first is the board of governors and the second is the 12 district banks. The chairman belongs to the board of governors. The current chairman is Jerome Powell

What is the Federal Open Market Committee?

The FOMC is a gathering of all seven governors and all 12 presidents of the district bank. The FOMC is charged with discussing and executing monetary policy.

What financial instruments are involved in the 2020 QE activity of the Federal Reserve? (HW#4)

The Fed is purchasing US Treasury bonds and agency mortgage-backed securities (MBS). Agency MBS are financial instruments that are based on the pooling of home mortgages. MBS pay interest just like bonds. The term "agency" means that the MBS come from quasi-government agencies, including: The Government National Mortgage Association (Ginnie Mae), which finances housing projects. The Federal National Mortgage Association (Fannie Mae), which finances mortgages for the Federal Housing Administration and the Veterans Administration. The Federal Home Loan Mortgage Corporation (Freddie Mac), which finances federally chartered thrift institutions.

What is the discount window? How does it address liquidity problems in the banking system?

The Fed offers short-term lending to depository institutions through its discount window program. A troubled bank can apply for a short-term loan and the Fed will evaluate the risk of the bank. It is important to note that the discount window is meant to address short-term liquidity problems with banks. It is not meant to save banks with longer-term leverage problems

What are the ways that the Fed is accountable to Congress? (HW#3)

The Fed provides a semi-annual Monetary Policy Report along with Congressional testimony. These provide an outlet to inform Congress and the public on Fed activities

What are open market operations? How are reserves and the monetary base affected by open market purchases? How are reserves and the monetary base affected by open market sales?

The Fed uses open market operations to more reserves into the banking system. OMOs involve the buying or selling of financial instruments between the fed and large investment firms.In an open market purchase the Fed buys financial instruments from the primary dealers and transfers funds in payment. The funds are eventually deposited into commercial bank accounts. Before the banks allocate the funds from these deposits, they will represent an increase in the bank's reserves. In an open market sale, the Fed sells financial instruments from the primary dealers and the dealer makes payment to the Fed by withdrawing from commercial bank accounts. This results in lower reserves at the banks

Assume that people do not hold any currency, there are zero excess reserves, and that the $85B was initially deposited into a single bank. How much of the $85B might we expect the bank to lend out? Make a table like that on page 9 of your reading handout that traces the behavior of deposits, loans, and reserves through four banks.

The bank must keep $8.5 billion ($85 billion x 10%) as required reserves. It can lend out the remaining $76.5 billion. Additions (bil$) Bank Deposits: Loans: Reserves A 85: 76.5: 8.5 B 76.5: 68.85: 7.65 C 68.85: 61.965: 6.885 D 61.965: 55.7685: 6.1965

What are the key assets categories for a bank? What are the key liability categories? What is the largest asset category and largest liability category?

The key assets are loans, financial instruments, reserves, other smaller categories. The key liabilities are deposits, borrowing, and other. The largest asset category is loans they represent 60 percent. The largest liability category is deposits at 60 percent.

What is the monetary base? Is it more or less liquid than M1 and M2?

The monetary base is all the currency and bank reserves in the economy, it is less liquid than m1 and m2

From your answer to part b, what would be the expected change in total lending associated with the $85B open market operations? What would be the expected change in the monetary base?

The money multiplier process suggests that the change in the M1 money supply will equal the sum of the changes in lending and the monetary base: Δm1 =ΔL + ΔMB Substituting our values we have: $212.5B =ΔL + $85B ΔL = 212.5 - 85 = $127.5B

What has been the trend in the number of banks in the US and the size of bank in the US over the past 40 years? (HW#2)

The number of banks in the US has been decreasing over the past 40 years, from about 14,500 in the early-1980s to fewer than 4,500 today.

Discount rate:

The rate charged by the Federal Reserve on loans made to banks through the discount window; though influenced by other market rates, the discount rate is officially set by the Fed

What is the discount rate? What was the behavior of the discount rate in response to the financial crisis/recession of 2008 and the pandemic/recession of 2020?

The rate charged to banks by the Fed is called the discount rate and is set by the Fed.

How are savers and borrowers related in financial markets? What is the benefit to savers of participating in financial markets? What is the benefit to borrowers of participating in financial markets, in particular business and government?

They are mechanisms for a financial market. Savers are owners of financial resources in an economy. They receive a monthly income and use that money to spend on goods and services. With the unspent money, they deposit into a savings account where it becomes a resource. A borrower then uses that unspent resource to create economic growth by making a factory or store. Then the saver has a job. Borrowers benefit from this because a business or government is always looking to be more productive and generate more profit and with "financing" it makes this process faster.

What were the two broad actions by the Federal Government (i.e. the President and Congress) in response to the financial crisis?

Troubled Asset Relief Program (TARP). The total estimated payments for this program were around $430 billion but by now the funds have been paid back to the government. And help from the FED

What are the two common elements/events of most financial crises? What are the three economic consequences of these events?

Two common characteristics of financial crises are asset price crashes and institutional problems. The value of some asset is expected to increase. This can happen for any number of reasons, but the consequence is a substantial increase in the demand for the asset that results in a substantial increase in the price of that asset. 2. The trend of an increasing price reinforces the expectations of rising value. This continues to put upward pressure on the asset's price. 3. At some point the price increase pushes beyond the expected value of the asset. As savers become worried that the price of the asset is no longer sustainable, there is a rapid sell-off that results in a sharp price decrease. The worst case is that the demand for the asset goes to zero and the market for that asset collapses. The asset would then have an indeterminate value.

Instrument: money/capital: Debt/ Equity US Treasury bond US Treasury bill Common stock Corporate bond Preferred stock Commercial paper US Treasury note

US Treasury bond: Capital: Debt US Treasury bill: Money: Debt Common stock: Capital: Equity Corporate bond: Capital: Debt Preferred stock: Capital: Equity Commercial paper: Money: Debt US Treasury note: Capital: Debt

Now suppose we include currency in the money supply and that the currency-to-deposit ratio is 50%. Use the M1 money multiplier to calculate the ultimate addition to money in the economy from the original $85B open market operations.

With currency we must use the full M1 money multiplier with r = .1, c = .5, and e = 0: ∆𝑀1 = 𝑐 + 1 𝑟 + 𝑐 + 𝑒 × ∆𝑀𝐵 ∆𝑀1 = . 5 + 1 . 1 + .5 + 0 × $85𝐵 ∆M1 = 2.5 × $85𝐵 = $212.5𝐵 The open market purchases will create $212.5 billion in new M1 money, in the form a checkable deposits in the banking system.

Federal Open Market Committee:

a committee of Fed governors and district bank presidents that discusses and votes on open market operations that pursue a given monetary policy objective

Barter:

a system of exchange where goods/services are traded for other goods/services

Common stock:

an equity instrument that gives the holder a share of ownership in the corporation and a right to vote; does not guarantee dividend payments

Financial intermediary:

an institution that collects and pools the funds of savers and reallocates the funds to borrowers

Central bank:

an institution whose primary function is to control a nation's money supply

Money:

any items that individuals are willing to accept in exchange for goods and services

Negative externality:

occurs when a transaction imposes uncompensated costs onto parties not involved in the transaction

Asymmetric information:

occurs when one party to a transaction has superior information relative to the other party

Adverse selection:

occurs when the highest-risk borrowers are also those most likely to seek financing

Monetary policy:

policy that influences the flow of money and credit in an economy

Retail money fund:

professionally-managed portfolios of short-term instruments

How did the Federal Reserve address liquidity problems during the financial crisis? (Lowered the discount rate, created lending facilities outside the discount window, purchased bad assets from financial institutions)

reduced the discount rate from 6.25% to 0.5% in an effort to encourage banks to use the discount window; created the Term Auction Facility (TAF) where depository institutions could anonymously bid for short-term lending from the Fed; created lending facilities for non-depository financial institutions, which extended the Fed's conventional role as a lender of last resort for banks to a lender of other types of financial institutions;

Excess reserves:

reserves held by banks in excess of their statutory requirements