ECON 4210 Final Exam Review: Exercise Questions

Discuss how asymmetric information can help us understand how US firms finance their operations.

1. Adverse selection = pre-transaction 2. Moral Hazard = post transaction - borrowers engage in activity that is undesirable/riskier than lender wants (principal agent problem)

What does it mean for a central bank to be independent?

Central bank independence is if it makes its own decisions and isn't controlled by any other governing body.

What is the diff between commodity and fiat money?

Commodity money itself has an intrinsic value and is scarce. It can have large fluctuations in value. Examples include gold, silver, cigarettes, sea shells, etc. Fiat money is paper money decreed by the government as legal tender. Therefore, the money itself has no intrinsic value but the value is decreed by the government. The scarcity can be controlled and it is easier to carry.

Difference Between Debt and Equity

Debt instruments are securities that promise to pay fixed amounts at regular intervals until the pre-specified date. Equity is a claim on a net share in the income and assets of a company. Equity doesn't expire and equity holders receive regular dividend payments. Equity holders benefit from the performance of the company and debt holders do not. Debt holders are also considered senior in the case of bankruptcy.

Difference between dynamic OMOs and defensive OMOs

Dynamic OMOs are intended to change the level of reserves and the monetary base while defensive OMOs are intended to offset movements in other factors that affect reserves and monetary base

Consider a situation in which output is above potential. How and why does the economy return to output that is equal to potential?

Economy output will always return to potential level consistent w natural rate of unemployment. This is because without any changes in technology, capital, labor supply, or unemployment rate, any increases in output are not sustainable. this is done by the shifting of the SRAS to intersect with LRAS and AD

What is the Phillips Curve and how is it related to aggregate supply?

Philips curve describes the negative relationship b/w inflation and unemployment π = a - bU idea: when labor markets tight (low unemployment rate) wages tend to increase 3 important conclusions 1. there is no long run trade off between unemployment and inflation 2. there is a short run trade off between unemployment and inflation 3. there is LRPC and SRPC

Difference Between Primary and Secondary Markets

Primary market is where newly issued securities are sold. Investment banks underwrite IPOs which are on the primary market. The secondary market is where previously issued securities are traded and sold.

What is quantitative easing and how does it affect bond yields?

Quantitative easing is a monetary policy in which the central bank buys government securities in order to *increase the money supply* resulting in lower interest rates and lowering bond yields

What is the difference between return on assets (ROA) and return on equity (ROE)?

ROA = net profit after taxes per dollar of assets and ROE = net profit after taxes per dollar of equity if ROE is bigger than ROA then the bank has taken on some financial leverage of sorts

Describe some institutional features that makes the Federal Reserve System different from, say, the Bank of Canada.

US federal reserve system is much more decentralized compared to international counterparts. There used to be no lender of last resort and there is an elaborate system of checks and balances.

Explain the difference between a sterilized and unsterilized foreign exchange intervention. Use the interest rate parity condition to explain how the exchange rate depends on domestic and foreign interest rates.

Unsterilized intervention: intervention that implies a change in the domestic money supply. --> increase in money supply --> lower domestic interest rate (shifts demand curve for dollar assets right) --> depreciation of domestic currency *interest parity condition* ***In equilibrium, the expected return on two assets must be the same = return on holding domestic asset is domestic interest rate and return on holding foreign asset is (foreign interest rate - depreciation of foreign currency) aka "+ appreciation of foreign currency" Sterilized intervention: to counter the effect of the foreign exchange intervention on money supply, an offsetting OMO can be used to sterilize the intervention --> no effect on the monetary base and no effect on the exchange rate

What is diff between a coupon and a discount bond? If both bonds have a face value of $1000, which one costs more today? What's a fixed payment loan?

With a coupon bond, the purchaser of the bond receives regular coupon payments and when the bond matures, receives the face value of the bond back. If the coupon rate and the interest rate are the same, the coupon bond is priced at face value. With a discount bond, which is also called a zero-coupon bond, the bond is bought at a price below its face value and then the face value is then repaid at the maturity date. The discount bond does not make any interest payments If both bonds have a FV of $1000, the coupon bond would cost more today. With a fixed payment loan, the money that is loaned out is paid back to the owner with interest over many increments. These increments, once all paid, will include the repayment of the loan and interest.

Exchange Rate Targeting advantages and disadvantages

contractionary monetary policy --> raise domestic interest rates and strengthen currency = fall in inflation, exports and relative increase in imports expansionary policy will do the opposite = inc in inflation rate and exports and relative dec in imports *advantages* - contributes to keeping inflation under control - automatic rule for conduct of monetary policy - simplicity and clarity *disadvantages* - cannot respond to domestic shocks and shocks to anchor country are transmitted - open to speculative attacks on currency - weakens accountability of policymakers as exchange rate loses value as signal

Derive the aggregate demand curve from the IS curve and the MP curve.

curve axes: Y axis = π and X axis = output has a downward slope: as inflation rises, real interest rate rises, so that spending and equilibrium aggregate output fall IS: Y = Y[fixed] - r MP: r = r[fixed + lambda x π Y = Y[fixed] - r[fixed] - lambda x π put in terms of π!

Lags and Policy Implementation

dif lags prevent policymakers from shifting the aggregate demand curve instantaneously *data lag* = time it takes for policy makers to obtain data indicating what is happening in the economy *recognition lag* = time for policy makers to be sure of what the data are signaling about the future course of the economy *legislative lag* = time it takes to pass legislation to implement a particular policy (not relevant for conventional monetary policy) *implementation lag* = time it takes for policy makers to change policy instruments once they have decided on the new policy *effectiveness lag* = time it takes for policy to actually have an impact on the economy

What is bank capital? What happens if bank capital is negative?

difference bw assets and liabilites and acts as a buffer against insolvency, helping prevent bank failure. in the case of *loan loss*, the high capital bank can sustain the blow without going below required reserves or digging into deposits. if bank capital is negative, assets of the bank must be less than its liabilites and the bank will not be able to pay its debts (insolvent)

Adv and disadv of discount rate policy

discount lending makes fed "lender of last resort", and important during the financial crisis of 2007-2009 volume not controlled by the Fed; decision maker is the bank

Need for Unconventional monetary policy?

during full-scale financial crisis need because 1. financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses and so investment spending and economy collapse 2. negative shock to economy can lead to zero-lower-bound problem zero-lower-bound is when nominal interest rates are close to or at 0 and government can do little to stimulate economy

Was the Fed to blame for the housing price bubble?

economists blamed on low rate interest policies of Fed from 2003 - 2006

How does discount rate affect FFR?

lowering discount rate shifts the supply curve down: - if intersection of d and s is on vertical section, FFR is unaffected - if intersection of d and s is on horizontal section, FFR is lowered

Difference Between Money and Capital Markets

money markets deal in short-term debt instruments while capital markets deal with long-term debt instruments and equity instruments. Money markets are used to manage short term cash flows and are not used to finance investment in production capacity. These shorter term investments have smaller fluctuations in price and therefore have less risk attached to them.

Why was deposit insurance introduced in the US? What are its costs and benefits?

motivated by bank panics -FDIC short circuits bank failures via payoff method, purchase and assumption method (more costly), and lending from central bank to troubled institutions (last resort) Costs: Moral Hazard - financial institutions have an incentive to take on greater risk Adverse Selection - Risk-lovers find banking attractive since they know depositors and creditors will not bother to monitor behavior depositors have little reason to monitor financial institutions

What are the determinants of a stock's price according to the Generalized Dividend Valuation Model?

only the present value of the future dividend stream since payment of the par value is so far in the future that it doesn't matter k = required return on investment in equity

Exchange Rate

price of one currency in terms of another if $1.18 to buy one euro then dollar/euro exchange rate is 1.18 and euro/dollar exchange rate is 1/1.18

Law of One Price

price of similar goods should be the same in both countries aka if a burger is $1.18 in US, it should be 1 euro in the UK

How can the money multiplier formula help us understand the evolution of money supply (M1) during the recent recession?

the increase in monetary base did not effect the money supply during the recession because excess reserves grew dramatically. the effects of a decline in c were immediately canceled by an increase in e

Purchasing Power Parity

the price of similar goods baskets should be the same in both countries. underlying assumptions: - consumption baskets are the same in both countries and contain identical goods - trade barriers and transportation costs are low these are unrealistic though

When does the yield curve slope downward?

the yield curve slopes downwards when the long term rates are below the short term rates. This happens when investors prefer to purchase the long term bonds more than the short term bonds, allowing them to be sold at lower interest rates --> could happen if investors are risk loving

What does it mean that an asset is mispriced?

when there is an asset price boom and then bust when people realize that the asset is not worth as much as originally priced - new financial innovations are often hard to price since we do not understand them as much

What is a repo and how does it affect the amount of high-powered money (monetary base)? What is a reverse repo?

"defensive OMO" a Repo is a repurchase agreement where the fed will purchase a security with an agreement that states that the seller will repurchase it at a future date at a pre-specified price. net effect on the monetary base is basically 0 since the security is repurchased. however, initially, there is an inc in the monetary base. since it is a defensive OMO, it is meant to offset movements in other factors that affect monetary base and reserves. reverse repo = matched sale-purchase agreements

Is $100 today worth as much as $100 a year from now? Why or Why not?

$100 today is worth more than $100 a year from now. Monetarily, if you receive $100 now, you can invest it and gain a return of interest a year from now, making it more valuable than the $100 a year from now. Additionally, people are impatient and would get more utility from having the $100 today as opposed to later. Lastly, there is a factor of uncertainty when people have to wait to get the money that maybe they won't get it or all of it. This factor is eliminated if they receive the money immediately.

Compute present value of being paid $1100 a year from now if interest rates are 10%. Is PV larger or smaller if interest rates are 20%? Why?

$1100 = future value divide the 1100 by (1+0.1)^1 Answer = $1000 if interest rates are larger, the present value is smaller. Mathematically, the denominator would be bigger so the result would be smaller. Practically, if there are higher interest rates, you wouldn't have to invest as much to reach the same 1100 in a year.

Write down the Equation of Exchange. How do we measure the velocity of money?

(Money Supply) x (Velocity of money) = (Price Level) x (Aggregate output) Velocity of money = average number of times per year that a dollar is spent = (P x Y)/M - assumes velocity is fairly constant in short run

Risk Structure of interest rates

*1. Default Risk* = a non-zero probability that the issuer of the bond is unable to make interest payments or pay off the face value - US treasury bonds have NO default risk (b/c government can always just raise more money through taxes or something) - Risk Premium - Corporate bonds have default risk *2. Liquidity Risk* = whether the asset can be liquid or not - cost of selling bond - less liquid bonds are cheaper - difference = liquidity premium *3. Income Tax Treatment* = all bonds have to pay taxes on their interest payments however, muni bonds do not. - therefore, increased demand for muni bonds and decreased demand for treasury bonds

Name three different types of exchange rate regimes. What are the advantages and disadvantages of having a fixed exchange rate regime?

*1. Fixed Exchange Rate Regime* - value of a currency is pegged relative to the value of other currency (anchor currency) and exchange rate is fixed in terms of the anchor currency - Central gov must keep exchange rate at E[par] = if E[1] is less than E[par] --> central gov must purchase domestic currency by selling foreign assets (lowers money supply and base, increasing interest rates, inc the value of domestic assets, shifting demand right BUT loses international reserves OR if cant do this, conducts a devaluation, just dropping E[par] PROS: CONS: no tools for surplus countries, US could not devalue currency *2. Floating exchange rate regime* - value of a currency is allowed to fluctuate against all other currencies. *3. Managed float regime* (dirty float) == a hybrid - attempt to influence exchange rates by buying and selling currencies - smooth out temporary flunctuations - make necessary long term realignment less disruptive - appreciation hurts exporters and employment - depreciation hurts imports and stimulates inflation

Factors that shift the IS Curve

*1. Government Expenditure* - inc in government expenditure --> IS shifts right - when gov purchases are rising, central banks raise interest rates to keep economy from overheating *2. Taxes* - inc in taxes --> IS shifts left - because of decrease in disposable income *3. Autonomous consumption, investment spending, or NX* - autonomous means outside of the model (animal spirits, weather, etc.) *4. Financial frictions* - increase real cost of borrowing/investment --> fall in investment spending and aggregate demand --> IS curve shifts left

In the *Portfolio Theory Framework*, what are the determinants of bond demand? How do they each work?

*1. Wealth* - an inc in wealth causes an *inc* in demand of an asset (in order to store the excess wealth) *2. Expected Return* - If the expected return of an asset increases relative to that of other assets, then the demand for that asset will *increase* *3. Risk* - inc risk in an asset *decreases* the demand for that asset because most people are risk averse. (ex. bond that pays 5% half the time and 15% half the time is riskier than a bond that just always pays 10%) *4. Liquidity* - inc in liquidity relative to other investments *increases* the demand for that asset

What is the role of the coefficients in the Taylor rule for how the economy responds to demand and supply shocks?

*Conclusion = larger lambda, the larger is response of output to supply shocks* recall: lambda is the responsiveness of r to inflation

Summary of the role of expectations

-inflation expectations are important for inflation and output - they depend on expectations of policy: when policy changes, past correlations may be a poor guide to the impact of the policy

Describe the traditional and the credit view of the transmission mechanism of monetary policy. Why do we believe that the credit view is important?

*Monetary policy transmission* mechanism describes a chain of causla links that connects a change in monetary policy with a change in aggregate output *Traditional View: Interest Rate Channel* - works through the effect of real interest rates on investment and expenditure on durable consumption goods - low real interest rate makes borrowing money cheaper and makes it less attractive to save money ***real interest rate depnds on both nominal rates and inflation expectations *Credit View of Monetary Transmission Mechanism* - two types of monetary transmission channels arise as a result of financial frictions in credit markets 1. effects on bank lending - expansionary policy --> inc bank reserves and deposits --> more funds available to lend --> inc demand for goods and services 2. effects on firms' and households' balance sheets "cash flow channel" => lower interest rate payments have a positive effect on firms' cash flow --> more projects can be financed internally "unanticipated price level channel" => inc in price level makes previously agreed credits cheaper to pay off inc firm real net worth which increases firms access to credit *Important Because credit channels have asymmetric effects on large and small firms* 1. empirical evidence suggest that financial frictions are important for how firms finance their operations 2. small firms tend to suffer more from financial frictions than large firms 3. small firms tend to be more affected by monetary policy than large firms *traditional channels should have a symmetric effect on large and small firms

How does an Open Market Operation affect the Federal Funds Rate?

*Open Market Purchase (fed buys back bonds)* = shifts the reserve supply curve to the right, causing the federal funds rate to fall -but- if supply curve initially intersects the "floor" (interest rate paid on reserves) , then a purchase will not affect the FFR *Open Market Sale (fed sells bonds)* = shifts reserve supply curve to the left, causing federal funds rate to rise

What are the pros and cons of an independent central bank?

*Pros* - Political pressure would impart inflationary bias to monetary policy - Political business cycle - Could be used to facilitate treasury financing of large budget deficits - Principal agent problem is worse for politicians due to shorter time horizon *Cons* - Undemocratic - Unaccountable - Difficult to coordinate fiscal and monetary policy - Fed may not have used its independence successfully

Derive the money multiplier. Be careful in describing all the assumptions that you use.

*c = Currency/Deposits* *e = Excess Reserves/Deposits* *r = required reserve ratio* *R = RR + ER* *RR = r x D* *MB = C + R* = C + (r x D) + ER MB = c x D + r x D + e x D MB = D(c + r + e) D = MB/ (c + r + e) *M = C + D* = c x D + (1/(c + r + e)) x MB M = MB x (c/(c+r+e)) + MB x (1/(c+r+e)) M = (1+c)/(c+r+e) x MB *m = (1+c)/(c+r+e)*

Interest Rate and Exchange Rates Statics

*for graphs: X axis = dollar (domestic currency) assets, Y axis = exchange rate (Foreign currency / domestic currency) If domestic real interest rates rise --> domestic currency appreciates if domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates - *due to an increase in expected inflation, shifting the demand for domestic assets to the left* *an increase in money supply leads to lower interest rates and causes domestic currency to depreciate ***EXCHANGE RATES DETERMINED BY DEMAND AND SUPPLY IN MARKETS FOR DEPOSITS IN DIFFERENT CURRENCIES

Inflation targeting pros and cons

*pros* - does not have to rely on one variable to achieve target - easily understood - reduces potential of falling in time inconsistency trap - stresses transparency and accountability *disadvantages* - too much rigity - potential for increased output fluctuations - low economic growth during disinflation but this should be transitory

Response of Financial Regulation

- restrictions on asset holdings - consumer protection - systemic risk regulation - derivatives - to make safer investments

What is duration analysis and how does it relate to interest rate risk?

- uses the weighted average duration of a financial institution's assets and of its liabilities to see how net worth responds to a chance in interest rates (%change in market value of security) = -(%point change in interest rate) x duration in years *if bank has more rate sensitive liabilities than assets* - a *rise* in interest rates will *decrease bank profits* - a *fall* in interest rates will *increase bank profits*

Shifts in MP curve

-An autonomous tightening of monetary policy, shifts MP curve up, increasing r at every value of π -Similarly, an autonomous easing of monetary policy shifts MP curve down

What are the different stages of a financial crisis? Did all of these stages happen in the most recent recession?

1. Initiation of Crisis - financial assets are mispriced due to mismanagement of financial innovation or asset price boom/bust - mispricing becomes obvious when there are spikes in interest rates and increases in uncertainty 2. Banking Crisis - bank panics and fire sale of assets - decrease of value of assets in economy as a whole - financial frictions become more severe due to lower collateral values and inc in uncertainty 3. Debt Deflation - when unanticipated decline in price level due to recession - inc in real value of debt and reduces spending by households and firms and decline in overall production of economy - "Liquidity Trap" = deflation is sufficient make nominal interest rates basically zero and since everyone wants to hold on to their money and doesnt trust any system with it there is no way to change interest rates with conventional tools No. Debt deflation did not occur.

How do the existence of secondary markets for equity affect firms' abilities to raise fund?

1. Secondary markets make securities more liquid by giving consumers options to sell their securities once they buy them in the primary market. This in turn increases demand for securities in the primary market. 2. Firms' are able to use the price of their securities in the secondary market to price newly issued securities in the primary market to maximize funds raised.

Lessons from global financial crisis

1. dev of financial sector can have greater impact on economic activity than was earlier realized 2. zero-lower-bound interest rates can be a serious problem 3. cost of cleaning up after financial crisis is super high 4. price and output stability do not ensure financial stability

Unconventional monetary policy tools:

1. liquidity provision: discount window expansion, new lending programs, term auction facility (to increase liquidity in financial markets) 2. large scale asset purchases: to lower interest rates --> also increasing liquidity in banking system

3 ways government can pay for budget deficit/spending

1. raise revenue by levying taxes 2. go into debt by issuing government bonds 3. government can create money and use it to pay for goods and services. 2 --> no effect on monetary base or money supply 1, 3 --> increased money supply

What are the main facts about US firms' financial structure?

1. stocks are not important source of external financing 2. issuing debt and equity is not how firms finance operations 3. indirect finance is much more important than direct finance 4. financial intermediaries, banks in particular, are the most important source of external funds for a business 5. financial system is one of most heavily regulated 6. only large, well-established corporations have easy access to securities markets to finance their business 7. collateral is a prevalent feature of debt contracts for households and businesses 8. debt contracts are complicated legal documents that put substantive restrictive covenants on borrowers

Zero lower bound

A macroeconomic problem that occurs when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. prevents central bank from lowering interest rate - need Quantitative easing - forward guidance, - liquidity provision

What is adverse slection and how is it relevant to financial markets?

Adverse selection is a subset of asymmetric information where the seller has more information about the product than the buyer. The buyer only wants to spend a value between a good product and a bad product. In the context of financial markets, there are good firms and bad firms. An investor will want the market price which will be a fair price between the good price and the bad price. Mangers of good firms however will prefer not to borrow/issue stock at the market interest rate/price and therefore, only bad firms will be active in the market Can be fixed by the *private production and sale of information*, the *gov regulation to increase information*, *financial intermediation* (assessing borrowers), *collateral* (give skin in the game), and assessing borrowers on *net worth* (only letting borrowers of high net worth)

What does a "liquid" asset mean?

An asset is liquid if it can be converted to cash quickly and at a low cost. Practically, if it is more easily accessible and usable in transactions, then it is more liquid.

How does an autonomous increase in expenditure affect the IS curve?

An increase in autonomous expenditure would raise aggregate demand and equilibrium output at any given interest rate --> shifts IS curve to the right

What happens to demand for bonds when inflation expectiations increase?

An increase in the expectations of inflation cause the expected real return for an asset to decrease and therefore, the demand for that asset will also decrease

Is Bitcoin Money? Why or why not?

Bitcoin is *not* money. First, it is not widely accepted as a means of payment. But also in terms of the functions of money, bitcoin cannot act as a store of value since its value can be destroyed just like how hyperinflation destroys moneys function as a store of value. Also, bitcoin cannot act as a unit of account.

Describe the role played by the credibility of a central bank for how costly it will be in terms of unemployment to pursue a disinflationary policy.

Credibility of a central bank plays the role of securing the public's belief in the policies enacted. if a bank has very little credibility when enacting an anti-inflation policy, then the public will not be convinced that the central bank will stay the course to reduce inflation and they will not revise their inflation expectations. This will make it more painful to reduce the inflation rate, moving the AS to a point where output is lower thna it would be if the central bank had credibility.

Types of asset-price bubbles

Credit-driven bubbles - for example, subprime financial crisis Bubbles driven solely by irrational exuberance - difficult to detect - for example, Dotcom boom and bust

The financial sector nowadays do much morre than intermediate between savers and borrowers. What is Allen and Santomer's explanation for the growth in non-traditional banking activities?

Even though transaction and information costs have declined, financial intermediation has increased. This is primarily due to the need for more risk management because of recent financial innovations, that enable people to make riskier investments. Risk management is important for 4 reasons 1. managerial self-interest 2. non-linear tax system - you pay more taxes if profits fluctuate 3. avoiding costs of financial distress 4. capital market imperfections

What is the Taylor rule and how does it relate to the Taylor principle?

FFR = Inflation + i + 0.5(inflation - fixed inflation) + 0.5(output - fixed output) Monetary Policy Curve is a simplified taylor rule - shows how monetary policy, measured by real interest rate, reacts to the inflation rate: *r = r[autonomous] + lambda x π* lambda is responsiveness of r to inflation MP is upward sloping: real interest rates rise when inflation rate rises in association w taylor principle - MP needs to be upward sloping for central banks to keep inflation stable. Since to stabilize inflation, central banks must raise interest rates by more than any expected rise in inflation

Why may some financial institutions "reach for yield"? What are the consequences for the riskiness of the financial system?

FI's will "reach for yield" because of falling interest rates - pension funds may have made fixed payments commitments during periods of higher interest rates and managers seek higher yields, making riskier investments in order to make their commitments

Advantages of OMOs

Fed has complete control over the volume easily reversed quickly implemented

How do consumers benefit from financial markets?

Financial markets benefit consumers by allowing them to time his/her purchases better and allow them to have nicer amenities. For example, mortgages allow people to buy nicer houses and loans allow people have nicer cars since they can pay it off over a longer period of time.

For what types of shocks must the central bank choose between stabilizing inflation vs stabilizing output?

For AD: either no policy response or policy to stabilize inflation and economic activity (output) in SR For permanent supply shock: no policy response or policy that stabilizes inflation (but no trade-off between stabilizing inflation and output *For temporary supply shock*: - no policy response = AS goes up and then shifts back down over time -policy that stabilizes inflation in SR = tightening of monetary policy responds to inc inflation (from up shift of SRAS) with a shift left of AD. this keeps π constant until AS shifts back (downward) at which point autonomous easing of monetary policy moves AD to the right -policy that stabilizes economic activity in SR = autonomous easing shifts demand right keeping equilibrium output the same, but inflation is at a higher level

How central banks establish credibility

For inflation targeting, need strategy that involves: - public announcement of medium term numerical targets for inflation - institutional commitment to price stability as the primary, long-run goal of monetary policy - an information-inclusive approach in which policy makers use many variables in making decisions about monetary policy - increased transparency of the monetary policy strategy through communication with the public and the markets - increased accountability of the central bank for attaining its inflation objectives could also appoint a conservative central banker who public will think is less tempted to pursue expansionary monetary policy

Name 3 different types of financial intermediaries. What are the functions of financial intermediaries?

Functions: 1. share risk 2. reduce transaction costs and costs of information 3. remove issues of moral hazard and adverse selection (through a screening process) 3 Types: 1. Depository Institutions (commercial banks, savings banks, credit unions) 2. Contractual Savings Institutions (insurance companies and retirement funds) 3. Investment Intermediaries (finance companies, mutual funds, investment banks

What happens to nominal interest rates if there is a one-off increase in the money supply?

Graphically, an exogenous inc in money supply will shift the money supply curve to the right (outwards) and there will be a decrease in short term nominal interest rates, as a result of the liquidity effect. *NOTE* a one off inc in money supply has no effect on long-run real interest rates or real economic activity

What is the difference between a central bank that has a hierarchical mandate vs a dual mandate?

Hierarchical mandate = put goal of price stability first, and then say that as long as that is achieved, other goals can be pursued Dual mandate = aimed to achieve two coequal objectives: price stability and maximum employment (output stability) either one can achieve a stable macroeconomy as long as price stability is the primary goal in the long run! *other goals include:* - economic growth - financial market stability - foreign exchange market stability - interest rate stability

Define high-powered money (or monetary base). Is it different from M1?

High powered money aka the monetary base is the currency in circulation which is in the hands of the public combined with the reserves, which are bank deposits at the Fed and vault cash. This monetary base is controlled through open market operations. Open market purchase increases monetary base and open market sale decreases monetary base. This is different from M1 since M1 is currency in circulation plus checkable deposits. The monetary base times the money multiplier equals the money supply.

What is the IS curve and why does it slope downwards?

IS Curve traces out how aggregate demand depends on the real interest rate. Y[ad] = C + I + G + NX it is downwards sloping because as interest rates rise, planned investment spending and net exports fall and this lowers aggregate demand. In goods market equilibrium, aggregate output must be lower too then Simplified IS Curve: Y = Y[fixed] - r

How does the degree of price stickiness affect how the economy return to a long run equilibrium?

If prices are more sticky, particularly downward, then return to long run equilibrium will be slower and there might be a need for active government policy

Difference Between Direct and Indirect Finance

In direct finance, the borrowers borrow funds directly from the lenders in financial markets by selling securities. In indirect finance, financial intermediaries borrow funds from lenders/savers and lends funds out to entrepreneurs or consumers.

How does interest rate on reserves affect FFR?

Increase in interest rate on reserves --> floor of demand curve shifts up to new i[or] --> can either keep FFR the same (if floor doesnt reach) or increase FFR if equilibrium was on i[or] (the floor)

What is Inflation Targeting? Describe what led countries around the world to adopt Inflation Targeting.

Inflation targeting is when the central bank has the primary goal of smoothing out inefficient fluctuations in inflation. It is important that inflation does not get too high (hyperinflation , also just costly to society since money loses its function as a store of value) also important for inflation to not be too low (zero lower bound can make stimulative monetary policy through lower interest rates impossible) to do this, central banks need an instrument through which they can affect inflation, typically *short term interest rates* Periods of very high inflation in the 1970s and 1980s led the world to adopt inflation targeting. (US example with Nixon and trying to stimulate economy to prevent recessions)

Define "goal" versus "instrument" independence.

Instrument independence is if the central bank has full control over the policy instruments that it has been assigned. Goal independence is if the central bank sets its operational goals itself or whether some other official body does so.

What is Interest rate risk? What types of bonds are subject to the largest interest rate risk?

Interest rate risk is the fact that prices and returns are volatile and interest rates can fluctuate. Prices and returns are more volatile for long term bonds, making them more susceptible to interest rate risk. There is no interest rate risk for any bond held to maturity.

How did Keynes propose to change the classical quantity theory of money? What is the main conceptual difference between Keynes theory and the classical quantity theory?

Keynes changes it by focusing on the demand for real money, using a function for this demand. creating the liqudity preference function M[p]/P = L(i, Y) V = PY/M = Y/L(i, Y) The main conceptual difference between Keynesian Theory and Classical quantity theory is that Keynes theories cast doubt on the view that nominal income is determined primarily by movements in quantity of money! Addiotionally, V is not constant!

What is "Liquidity Preference Framework" for determining interest rates? What happens to interest rates if the price level doubles?

LPF focuses on money's value as a medium of exchange and states that the demand for money is not to borrow money but to keep money liquid. It establishes that the interest rates are therefore, the price of money and so if the *demand for liquid money increases*, *interest rates will also increase.* *4 factors affecting interest rates:* 1. income effect = more money --> people feel wealthier --> inc demand for goods and then money required for transactions --> *inc in interest rates* 2. price-level effect = more money is required to carry out given transactions --> inc demand for liquid money --> *inc in interest rates* 3. expected inflation effect = rising price level will make people expect inflation to be higher over the course of the year --> need more money for transactions --> *inc in interest rates* 4. liquidity effect = increase in supply of money increases demand for bonds --> decrease in interest rates

Explain the Lucas critique of policy evaluation using the US inflation experience in the period 1950-1980 as an example.

Lucas argued that econometric models that did not incorporate rational expectations were unreliable for evaluating the potential effects of policy options. When policies change, public expectations shift as well, which could have a real effect on economic behavior and outcomes. E.g. if Fed changes FFR, the public might change their expectations about where interest rates are headed in the future

Inflationary Monetary Policy

Monetary policy makers can target any inflation rate in the long run by shifting the aggregate demand curve with autonomous monetary policy recall: Autonomous monetary policy easing increases AD (shifting up and right) Can lead to 2 types of inflation: *cost push* = temporary negative supply shock shifts short run aggregate supply curve upward causing output to fall and unemployment to rise. policymakers increase AD in response, leading to a spiraling rise in inflation - caused by a temporary negative supply shock or a push by workers for wage hikes (*suggested by unemployment above the natural rate*) *demand pull* = caused by policymakers pursuing policies that increase AD to for example, hit higher output targets. AS shifts upwards in response to monetary easing policy. leads to spiraling rise in inflation (*unemployment below natural rate leads to demand pull*)

Define "money" in terms of its functions, i.e. in terms of uses. Go in depth on the functions

Money is anything that is generally accepted as payment for goods or services or in repayment of debt. It is the most liquid of all assets. The three functions of money are: *1. Medium of Exchange* - eliminates trouble of finding double coincidence of wants *2. Unit of Account* - used to measure value in the economy. Reduces transaction costs and gives us an agreed upon unit of account in order to express relative prices. *3. Store of Value* - money can be used to save purchasing power over time. Most liquid of all assets is money, however, money *loses* its function as a *store of value* during periods of high inflation (hyper inflation

Quantity Theory in terms of Money and Price level and inflation

Money: as long as prices are sticky, an increase in M will increase Y Price Level: if Y remained at full employment level and is therefore fixed --> P = M x (fixed velocity) / fixed output Inflation: %change in M + %change in V = % change in P + %change in Y %change in P is = to *inflation* %change P = % change M +%changeV - %change in Y *but since V is constant...no change! Therefore, Theory of Inflation: Inflation = %change in M - %change in Y

Why was inflation so high in the 1970s?

Nixon wanted to eliminate high levels of unemployment, which had rose from weak economic growth and so stimulated the economy with a expansionary monetary policy. It worked short-term but Nixon feared another recession since the next presidential election was looming near and so enacted even more expansionary monetary policy. In the long-term, this cause incredibly high levels of inflation not following taylor principle during period of oil shocks

Disadvantages of reserve requirements

No longer binding for most banks Can cause liquidity problems Increases uncertainty for banks takes time to implements

Based on efficient market hypothesis, should you buy or sell stocks based on information you read on the front page of the Wall Street Journal? Why or Why not?

No you should not. efficient market hypothesis = all unexploited profit opportunities will be eliminated since everyone has the same available information, stock prices respond to news incredibly quickly and the information you read in the Wall Street Journal is already in the price of the stock. the information provided is readily available to many market participants

Derive the response of the aggregate economy to supply and demand shocks as a function of the shocks and the parameters in the Phillips curve, the IS curve, the MP curve and Okun's law. Give arguments for and against activist monetary policy.

Okun's law describes the negative relationship between the unemployment gap and the output gap "for each percentage point that output is above potential, the unemployment rate is approximately half a percentage point below the natural rate of unemployment PC: π = π[e] - w(U - U [n]} Okun's: U - U[n] = -0.5 x (Y - Y[p]) combined: AS: π = π[e] + 0.5w(Y - Y[p]) so that gamma = 0.5w combined with AD: Y = Y[bar] - r[bar] - lambda x π *π = (π[e] + (gamma(Y[bar] - r[bar] - Y[P]) + p) / (1 + lambda x gamma)*

Use one period valuation model to determine the current price of a stock that will pay a $50 dividend and can be sold for $100 in the next period as a function of the required return. What happens to the current price if the required return ncreases?

P[0] = D/(1+k) + P[f]/(1+k) if required return increases, the price of the stock will go down. (it is now a riskier investment and so return required needs to be higher)

Define the rate of return and explain how it differs from YTM

Rate of return is the payment to the owner + change in value as a fraction of the purchase price. aka (coupon payment + (P[future] - P[initial])) / P[initial] YTM = yield to maturity is the interest rate that equates the PV of cash flow payments received on a a debt instrument with its value today! *IF* bond is held to maturity, then the rate of return is equal to YTM but if it is called earlier they will most likely be different. This is because interest rates are volatile and therefore, so are bond prices. Calculating YTM: 1. simple loans: YTM = interest rate 2. coupon bond: can be calculated as i if everything else is given 3. perpetuity: i = C/P(C) == yearly payment / price of perpetuity 4. 1 year discount bond: i = (FV - PV)/PV

Define rational expectations. How does rational expectations relate to the efficient market hypothesis theory?

Rational expectations is the concept that rational actors using all available information will create expectations that are identical to the optimal forecast. However, if one rational actor can make this expectation, they all can and if they all act on their expectation at the same time, the stock price will change again. Therefore, changes in price cannot be predicted accurately. In an efficient market, all unexploited profit opportunities will be eliminated. This is what makes it so hard to make money in the stock market.

What are real money balances and what determines the demand for real money?

Real money balances are just quantities of money in real terms. Keynes reasoned that people want to hold a certain amount of real money balances. 3 determinants: *1. Transactions Motive* - as payment technology developed, the transactions motive for money would go down relative to income *2. Precautionary Motive* - people hold money as a cushion against unexpected wants (also proportional to income) *3. Speculative Motive* - people hold money as a store of wealth - opportunity cost of holding money is interest so if interest rates go up, demand for money balances goes down

How does required reserves affect FFR?

Reserve Requirements Increase --> demand for reserves increases (shifts to the RIGHT) --> federal funds rate rises

What is the difference between the short and the long run aggregate supply curve?

SR --> wages and prices are sticky - generates an upward sloping SRAS as firms attempt to take advantage of short-run profitability π = π[expectation] + gamma(Y - Y[P]) + p Y - Y[P] = output gap p = supply/price-cost-push shocks LR --> determined by amount of capital and labor and the available technology - vertical at the natural rate of output generated by natural rate of unemployment

Capital Controls and Speculative Attacks

Speculative attacks = sudden outflows of capital from a country (like a bank run) Controls on outflows = prevent capital from leaving the country. but controls are seldom effective and may increase capital flight and reduce incentives to invest in country. also lead to corruption controls on inflows = if capital cannot flow in, there is less capital that can flow out as well. BUT controls may block funds for productive uses.

Which entity within the Federal Reserve System is in charge of making monetary policy decisions? Who participates in that decision?

The Federal Open Market Committee. Consists of seven members of the Board of Governors, the president of the president of the Fed NY and the presidents of four other Feds. Chairman of board of governors is also chair of FOMC

Explain the Taylor Principle. What historical episode can be explained by the failure of monetary policy to follow this principle?

Taylor Principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation so that real interest rates (r) rise when expected inflation rises (nominal interest rate should respond more than one-for-one to inflation) in the 1970s, there were a series of inflationary oil shocks and the Fed tried to respond to them by raising the nominal interest rates. However, they did not respond strongly enough and the real interest rates continued to fall, stimulating the economy and leading to further increases in inflation.

AS Shocks

Temporary = shifts SRAS Permanent = shifts LRAS and then SRAS shifts to adjust/intersect with AD

What is the Big Mac index and what can we learn from it?

The Big Mac Index is an index comparing the relative price of Big Macs in different countries after controlling for nominal exchange rates. it is a shockingly good measure of over/undervalued currencies same idea as purchasing power parity/law of one price

What tools does the Fed have at its disposal for influencing the Federal Funds Rate?

The Fed controls monetary policy and therefore have the following 4 tools at their disposal 1. Open Market Operations 2. Discount Lending 3. Reserve Requirements (4.) Interest on Reserves = less common tool

What is the main role of financial markets in the economy?

The MAIN role of financial markets is to promote economic efficiency by producing an efficient allocation of capital and therefore, optimizing economic production.

What were the reasons that the US was one of the last countries to set up a central bank? How did those reasons influence the design of the Federal Reserve System?

The US was scared of anything that supported centralization and consolidation of power after living under British rule during the time of the colonies. Therefore, when the federal reserve system was finally created, it was a very decentralized, centralized power with a complex system of checks and balances. In addition to this, there was a diffusion of power along regional lines, between the private sector and the government, and among bankers, business people and the public. *structure* Led to the Fed banks (12), the board of governors of the fed reserve system, the FOMC, the federal advisory council and many other commercial banks. Each has different duties in terms of the policy tools (discount rate, reserve requirements, and open market operations).

Describe the difference between M1 and M2. Can M2 < M1?

The main difference between M1 and M2 is that M1 is much more liquid than M2. M1 contains the most liquid assets including currency, travelers checks, demand deposits, and other checkable deposits. M2 contains M1 in addition to small denomination time deposits, savings and money market accounts, and money market mutual fund shares. Because M2 includes M1, M2 cannot be less than M1

What is the so-called "risk premium" on bonds? How is it affected by the business cycle?

The risk premium on a bond is the spread between the interest rate of the bond that has default risk and a bond that has no default risk (aka treasury bonds). It acts as compensation for investors who tolerate the default risk of a bond. In a contraction, this risk premium goes up since the risk of default increases and in an expansion, the risk premium goes down for the opposite reason.

Consider the market for federal funds. Why is the supply curve horizontal when the federal funds rate equals the discount rate? What about flat part of demand

The supply curve is horizontal when the federal funds rate equals the discount rate because at any FFR higher than the discount rate, the banks will not borrow from each other and will just borrow from the Fed directly at the discount rate. it is vertical for the other part b/c as long as FFR is below discount rate, no funds will be borrowed from reserves and so NonBorrowed Reserves will remain the same at a fixed amount The Flat section of demand represents the interest rate paid on reserves; this flattens out because if the FFR goes below the i[or] then banks will just hold on to reserves and not lend out at a lower interest rate

What are 3 main empirical regularities we can observe regarding the term structure of interest rate?

The three empirical regularities are: *1. Interest rates on bonds of diff maturities move together over time* - explained by "Expectations Theory" - if long term interest rates are an average of the short term interest rates, then as the short term interest rates increase, so must the long term ones and vice versa. *2. when short-term interest rates are low, yield curves are more likely to have an upward slope and vice versa* - explained by "Expectations Theory" - if short term rates are low, mean-reverting short-term rates are required (high) which would bring the average of the short term rates up --> increasing long term rates *3. yield curves almost always slope upwards* - explained by "Segmented Markets Theory" - investors have preference for bonds of one maturity over another - investors generally prefer bonds with shorter maturities that have less risk --> since demand for long term bonds is smaller, the price must be lower and therefore the interest rates must be higher in equilibrium Liquidity Premium Theory combines the two theories and explains all three

What is the Interest Rate Corridor and how is it determined?

This is the range of interest rates that the federal funds rate can fluctuate amongst. The corridor itself is for the purpose of limiting these fluctuations It is determined by the space between the *discount rate* (the ceiling) and the *interest rate paid on reserves* (the floor)

Describe three different types of bonds and explain how and why the average interest rates on these bonds have differed in the past.

Three types of bonds are US government bonds, Muni bonds, and corporate bonds. The average interest rates on these bonds have differed in the past because of the risk and term structures of the bonds are different.

What determines foreign exchange rates in the (a) long run? (b) short run?

a. Long Run exchange rates determined by: - *relative price levels* (non-traded goods are more expensive in rich countries) = law of one price and purchasing power parity - trade barriers - preferences for domestic versus foreign goods - productivity b. Short run exchange rates determined by shifts in demand for domestic assets which are initiated by changes in the domestic interest rate, foreign interest rate, or expected future exchange rate. --> in short: *exchange rates depend on expected returns of currencies* --> interest rate parity condition

In context of Gordon Growth Model: (a) what happens to asset's current price if (expected) dividend growth decreases? (b) what happens to asset's current price if the required return decreases? (c) name some factors that in reality may influence stock prices that are not captured by Gordon Growth Model

a. expected dividend growth decreases, asset price also decreases b. required return decreases, asset price then increases. the investment is less risky now (since the return required is less) c. Any form of unexpected news could influence stock prices, whether it is a natural disaster or an announcement of a new breakthrough. These are not captured in the Gordon Growth model

What determines the LRAS curve?

amount of capital and labor and available technology autonomous factors of production

Shifts in Aggregate Demand

any shift in IS curve shifts the aggregate demand curve in the same direction MP: autonomous monetary policy tightening = rise in real interest rate at any given inflation rate and shifts the aggregate demand curve LEFT autonomous monetary policy easing shifts aggregate demand right for opposite reason (opposite shift of MP)

What are the main components on banks' balance sheets?

assets, liabilities, bank capital assets = liabilities + bank capital

Why do net exports depend on interest rates?

b/c of interest rate parity condition when a currency appreciates, net exports decrease when a currency depreciates, net exports increase

What are capital requirements regulation and what is its purpose?

basically a minimum capital requirement that the banks must keep - minimum leverage ratio for banks (leverage ratio = bank capital/total assets) - gives stockholders more "skin in the game", reducing moral hazard - "Basel Accord": risk based capital requirements

Why is the SRAS curve upward sloping?

because price and wage stickiness and firms attempts to take advantage of this stickiness

Asset price channels

bond prices, foreign exchange rates, and prices of equities

What is the expected return on US dollar denominated assets from the perspective of a European investor? What is the interest parity condition?

for an american economic agent, the expected return on dollar-denominated assets is equal to the domestic rate of interest for a foreign economic agent, the expected return on dollar-denominated assets is equal to the rate of interest associated with those same assets, adjusted for an expected appreciation or depreciation in the value of the USD relative to the Euro *if* foreign and american bank deposits are perfect substitutes and capital mobility exists, *then* absence of arbitrage implies that expected return on both assets should be the same i[d] = i[f] - (expected Exchange rate [t+1] - Exchange rate [t]) / Exchange rate [t] *the last term is the depreciation of foreign currency*

Why do banks hold reserves? What are the trade-offs involved?

good to have excess reserves to protect against bank runs. by having excess reserves, it provides a low cost way of paying off (protects against) *deposit outflows* without changing anything else in the balance sheet which could be costly. the cost of holding these extra reserves, however, is the interest that could have been made making loans therefore, having more reserves negatively impacts returns

What does too-big-to fail mean? How may the fact that some banks are considered too-big-to-fail distort incentives?

gov guarantees repayment of large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee because the Financial institution failing would have a catastrophic effect on the economy -uses purchase and assumption method - increases moral hazard incentives for bulge bracket banks

Describe incentive why financial managers might "herd" and explain why that increases systemic risk.

herding would occur because managers are evaluated relative to their peers and so taking similar positions to each other provide them w a level of security against people who take contrarian positions, especially if herded position is a profitable one - "herding" = when managers take similar positions to other managers to provide them w/ "insurance" - this makes it difficult to take contrarian positions for long periods as funds under management tend to flow through managers that make profits - mispricing persists and many firms tend to get in trouble at the same time!

Describe how banks make a profit.

in short, banks make a profit by borrowing short and lending long. The banks will borrow money or people will make deposits to a bank and then the bank will take (typically) as much of this money as they can and make loans with it, gaining interest on their loans. This way, banks are making more money from their money. Simply put, asset transformation occurs so that a bank turns its reserves into loans

Dollarization

is the adoption of another country's money as legal tender - solution to lack of transparency and commitment - avoids possibility of speculative attack on domestic currency occurs when lost control of independent monetary policy and increased exposure to shocks from anchor country also when country is unable to create money and act as a lender of last resort

Assume that the expectation hypothesis holds. What are investors expectations of interest rates in period t, t+1, t+2, t+3 if i = 1%, i(2t) = 1.5%, i(3t) = 2%, and i(4t) = 2.5%? What's the yield curve look like?

t = 1% t+1 = 2% t+2 = 3% t+3 = 4% yield curve is upward sloping since long term rates are above short term rates

What additional assumption is used in the Gordon Growth Model to derive the price of a stock? Is this assumption realistic? Give example of when Gordon Growth Model may be a poor guide to the price of a stock? What is the simplified equation?

the assumption is that dividends grow at a constant growth rate, g. This is not a realistic assumption; it is an idealized concept for the purpose of making things easier. during a recession or period of negative inflation (where dividends could shrink), this would be a particularly bad assumption P = D[1]/(r - g)

What is the expected real interest rate? What is the ex-post real interest rate?

the expected real interest rate is the interest rate that has been adjusted for expected changes in price-level and therefore, is a more accurate representation of the cost of borrowing/lending than nominal interest rate. The ex-post real interest rate is the interest rate that has been adjusted for inflation and *actual* changes in price - level i[r] = i[n] - [expected inflation rate]

The Policy Trilemma

the idea that a country cannot pursue the following three policies at the same time: free capital mobility, a fixed exchange rate, and an independent monetary policy