ECON 319 FINAL

Macro theory - short and long-term equilibrium

Short-run equilibrium is when the aggregate amount of output is the same as the aggregate amount of demand. Long-run equilibrium is when prices adjust to changes in the market and the economy functions at its full potential.

Illustrate and explain why TARP resulted in a profit for the federal government as applied to the investment banks but a loss as applied to the auto manufacturers.

TARP resulted in a profit for the federal government as applied to the investment banks but a loss as applied to the auto manufacturers. The government was able to sell its equity, debt, and warrants for a profit when the investment banks recovered, but was unable to do so when the auto industry recovered.

Bayesian updating

The Bayesian method is a method of thought (named for Thomas Bayes) whereby one takes into account all prior relevant probabilities and then incrementally updates them as newer information arrives. This method is especially productive given the fundamentally non-deterministic world we experience: We must use prior odds and new information in combination to arrive at our best decisions. This is not necessarily our intuitive decision-making engine.

Bank Runs and Failures

a financial crisis in which a large number of customers simultaneously attempt to withdraw their money from a bank out of fear that the bank will close

confirmation bias

a tendency to search for information that supports our preconceptions and to ignore or distort contradictory evidence

money theory

change in money supply is a key driver of economic activity

momentum trading

occurs when investors buy stocks whose prices have been rising and sell stocks whose prices have been falling

Assume that B and C tranches of MBS's lacked demand. Illustrate and explain how a CDO that is the securitization of those tranches from a pool of MBS's can make economic sense but may have contributed to the Great Recession.

- Because the tranches of THE MBSs lack demand, issuing a collateralized debt obligation allow for both B and C tranches to be pooled together and sold as a new financial product generating revenue and new investment opportunities - A CDO is a financial instrument that pools together various types of debt into a new security - However, this may have contributed to the great recession as these tranches are generally risky and the least valuable part of the MBSs pool - The issuer of the CDO is basically transferring the risk by selling these transches which led to a build-up of risky assets - on paper the sale of these tranches through a CDO make sense for portfolio diversification (reducing risk). However, during the recession these CDOs were backed by subprime mortgage loans which were poor and at high risk of default.

Illustrate and explain how the failure of a money market fund containing commercial paper of one investment bank nearly shut down the markets for money market funds and commercial paper.

- Moneys market fund is a mutual fund that invests in short-term and lower risk assets like commercial paper, t-bills etc - money market funds have strict regulation so are very safe and stable investments - the money market fund held a ton of assets (almost billi) from lehman brothers - when the brothers filed for bankruptcy then value of paper to 0 and triggered a run on the fund as investors withdrew money in a panic - created a liquidity crisis but us guaranteed the Money market funds and averted the crisis

Illustrate and explain how quantitative easing is equivalent to monetary policy.

- Quantitative easing is a non-conventional monetary policy where a central bank can purchase securities and assets from OMOs to reduce interest rates and inc. money supply (economic growth broadly) - This can help stimulate investment too - New bank reserves created so more liquidity - This is a key tool used by the central banks to influence to economy especially during a crisis (like the pandemic)

Illustrate and explain why a risk-averse home buyer would purchase a subprime mortgage in the run-up to the Great Recession.

- Risk-averse home buyer may have decided to purchase a subprime mortgage in the run of of the great recession because they were unaware of the risks (higher interest rates and payments) - Subprime mortgages are marketed as a way for those w/ poor credit to buy a home (people are lured into it w/o knowing the drawbacks) - During the run-up of the great recession, the housing market was booming, so there was pressure to buy a home quickly before prices inc. further (led to risky and rash decision making)

Illustrate and explain how a long period of monetary easing could have created conditions for the Great Recession.

- Though monetary policies can actually help grow the economy, heavy engagement with policies can also be negative which happened during the recession - During a period of QE, central banks engages in large-scale asset purchases of bonds which inc money supply and lowered interest rates - However, overtime this can have many risks like inflation, rapid expansion of credit, and build up of debt + lead to bubbles in asset prices - can also lead to the misallocation of capital with investment going into the wrong sectors that are not sustainable in LR (economy susceptible to shocks like inc in interest and demand drops) - another condition to the recession is that it can decrease the value of money aka inflation also domestic currency down so imports more expensive and production too.

Illustrate and explain why a risk-averse home buyer would purchase a home in the middle of the real estate bubble.

- a real estate bubble is a run-up in housing prices fuelled by demand, speculation, and spending - A risk-averse home buyer would do so because of the overvaluation or potential for quickly increasing property values - this creates a sense of urgency so as to not miss out on the opportunity for investment returns - Risk-averse buyers have a preference for expected value over the utility as it is lower in risk but also it is lower in returns - Subprime mortgages have high default risk for lenders but allow buyers to get a mortgage w/o adequate credit (high interest) - Risk-aversion leads to buys a subprime mortgage pre-bubble as the utility of the mortgage is less than the expected value of the house

Illustrate and explain how credit default swaps created moral hazard, and how this may have contributed to the Great Recession

- credit default swaps are financial instruments that provide protection against the risk of default on a security (periodic payment) - Create moral hazard by providing a financial incentive for the buyer of a CDS to take on more risk than normal (bc they know they have a protection from default risk) - what went wrong? Many CDSs were sold as insurance to cover those financial instruments that created the subprime housing crisis, As those MBSs and CDOs became nearly worthless, that low-risk event-an actual bond default-was happening daily. - The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out big money

Illustrate and explain why monetary policy may have contributed to inflation post— COVID but not post-Great Recession.

- monetary policy is how the central bank controls economic activity and the main goal is the keep inflation low - during recession int rates cut by central bank and quantitative easy used (didnt lead to inflation) - after pandemic, aggressive action to cut interest and qe, This provided liquidity however money supply increased so did inflation (dec orir and then value down) - diff conditions between recession and pandemic (recession economy was fragile to begin with so cautious policy - covid pandemic led ti decline in global demand so prices drop (which offset some inflation)

Illustrate and explain whether quarantines for positive COVID tests early in the pandemic may or may not have been the result of base rate fallacy.

- possible - base rate fallacy is a cognitve bias that occurs when people make judgments based on specific info rather than taking into acc context or the base rate - during the beg of pandemic more panic and little was known, so quarantine were based on judgments with out context -eg: someone quarantined without considering risk - fallacy bc it doesnt take into acc the overall prevelance of the cirus and the likelihood of individuals at risk

Illustrate and explain why mask and vaccine mandates were necessary in the pandemic.

- public goods game (masks and vaccines are public goods bc you cant exclude people from the benefits of them) basically, how even though there are people who do not wear masks or get vaccines, they still benefit from the herd immunity

Illustrate and explain how the consumer non-durable and asset experiments run in class can provide evidence as to necessary conditions for an economic bubble.

- the consumer non-durable goods experiment run in class give evident to the conditions for an economic bubble by stimulating the dynamics of asset prices and consumer behaviour - involved created market for a specific asset like stocks and allowing the participants to trade the assets at prices determined by supply and demand - show how factors like availability of credit, expctation abt future price movments, and risk aversion can affect the development of a bubble - if the experiment shows that an increase in the availability of credit leads to a rapid increase in asset prices, it can provide evidence that credit availability is a necessary condition for the development of a bubble - psychological factors (herd and overeconf) - excitement and speculation that pricing will keep rising which lead to bubble Bubble explained by momentum trading (in exp. 2) → people trading based on the expectations of what they think everyone will do (which drives prices up/creates mkt price). Bubble is generated from the difference between the decreasing expected value and the unrealistic market valuation.

Inflation

A general and progressive increase in prices

Monetary policy

Government policy that attempts to manage the economy by controlling the money supply and thus interest rates.

Money transmission

the process through which monetary policy decisions affect the economy in general and the price level in particular.