Econ Exam 2
What actions does a central bank need to have the independence to say "no" to? A central bank needs to be able to say no to actions that would harm the economy, like excessive inflation from buying government bonds. The statement above is
true
An economist makes the following statement: "There is a principal-agent problem with respect to the relationship between the president and the Fed. But that's a good thing—it's how we can avoid a political business cycle." In general, what do economists mean by a "principal-agent problem"? By a "principal-agent problem," economists mean ________.
when the goals and priorities of those in charge do not match the goals and priorities of the people they oversee
Why might a fund's dumping its positions cause prices to be destabilized? Prices of what? Because such large positions are being sold, it ____________ the prices of ___________.
decreases, assets the fund holds.
f nominal interest rates remain unchanged during a period of deflation, then when inflation rates are _____________, the real interest rate in the economy will ____________.
decreasing; increase
A representative of the British government's Treasury Department is present at every meeting of the Bank of England's Monetary Policy Committee. The representative can participate in the discussion but is not allowed to vote. In the United States, since Congress revised the Federal Reserve Act in 1935, no member of the Treasury Department is present during meetings of the Federal Open Market Committee. What are the advantages and disadvantages of the British approach compared with the U.S. approach? Compared to the United States, an advantage of the British approach is ________. A disadvantage is ________.
greater coordination of economic policy between the government and central bank; less central bank independence in conducting monetary policy
The financial writer Sebastian Mallaby observed about hedge funds that: ... leverage also made hedge funds vulnerable to shocks: If their trades moved against them, they would burn through thin cushions of capital at lightning speed, obliging them to dump positions fast—destabilizing prices. Source: Sebastian Mallaby, More Money Than God, New York: Penguin Press, 2010, p. 10. What does a hedge fund's trades "moving against it" mean? "Moving against it" means that
if a hedge fund bets one way and the price moves another away, it has to exit the position fast.
What does Greenspan mean that "the added risk had not been compensated by higher capital"? In order to compensate for the risk, Greenspan believes that nonbank financial institutions should have voluntarily
increased their capital.
The debt-deflation process is the process of ______________that can increase the severity of an economic downturn.
increasing bankruptcies and defaults or falling asset prices
What is the connection between a fund's being highly leveraged and its having a "thin cushion of capital"? Leverage ___________ a trading position, ____________ the ratio of capital to assets. This _______________ both gains and losses and ______________ the capital "cushion" for losses.
magnifies, reducing, magnifies, reduces
When a bank's capital improves, what must have happened to the value of the bank's assets relative to the value of its liabilities? A bank's capital is defined as the value of a bank's assets _________ the value of its liabilities. Therefore, if a bank's capital improves, we know that the bank's assets must have _____________ the value of its liabilities.
minus; risen relative to
Which from the following are off-balance-sheet activities? (Check all that apply.)
A. Trading activities. D. Standby letters of credit. E. Loan commitment. F. Loan sales.
When was TARP created?
2008
An article in the Wall Street Journal notes that: "Higher capital requirements effectively limit how much SIFIs can borrow, and can crimp profitability." Source: Ryan Tracy, "What You Need to Know about SIFIs," Wall Street Journal, March 30, 2016. Part 2 What is a SIFI?
A firm whose failure would potentially cause a financial crisis.
David Wheelock of the Federal Reserve Bank of St. Louis describes the following episode at the beginning of the Great Depression: Following the stock market crash [of October 1929], the Federal Reserve Bank of New York used open market purchases [of Treasury securities] and liberal discount window lending [to commercial banks] to inject reserves into the banking system. . . . The Federal Reserve Board reluctantly approved the New York Fed's actions ex post, but many members expressed displeasure that the New York Fed had acted independently. Source: David C.Wheelock, "Lessons Learned? Comparing the Federal Reserve's Responses to the Crises of 1929-1933 and 2007-2009," Federal Reserve Bank of St. Louis Review, Vol. 92, No. 2, March/April 2010, pp. 97-98. What are the arguments for a Federal Reserve Bank operating independently?
A regional Federal Reserve Bank acting independently can act quickly to address regional issues.
What is the public interest view of the Fed's motivation?
A theory of central bank decision making that holds that officials act in the best interests of the public.
What is the principal-agent view?
A theory of central banking that holds that officials maximize their personal well-being rather than that of the general public.
What is a lender of last resort?
A. A lender of last resort is an institution that serves as an ultimate source of credit to which banks can turn during a panic. B. The Federal Reserve acts as a lender of last resort. C. Is an entity that seeks to stop a bank failure from turning into a bank panic by making sure solvent institutions can meet their depositors' withdrawal demands. D. All of the above.
What are the arguments against a Federal Reserve Bank operating independently? (Check all that apply.)
A. A regional Federal Reserve Bank would be circumventing the checks and balances built into the system. C. A regional Federal Reserve Bank's actions might exacerbate a crisis.
In 1960, federal regulations prohibited banks from paying interest on checking accounts. Today, banks are legally allowed to pay interest on checking accounts, yet the value of checking accounts has shrunk from more than 50% of commercial bank liabilities in 1960 to less than 12%. Because checking accounts now pay interest, shouldn't they have become more popular with households rather than less popular?
A. All else constant, this would increase the popularity of checking accounts. However, at the same time that interest became payable on checking accounts, banks were creating several new savings instruments, including certificates of deposit and money market deposit accounts. B. As wealth increases over time, households hold less money in checking accounts relative to other financial assets. C. Both A and B are correct.
How do banks manage credit risk?
A. Banks can manage risk by creating long-term business relationships by which the bank could acquire information about the creditor. B. Banks can manage credit risk by diversifying their assets. C. Banks can manage credit risk by performing credit risk analysis, requiring borrowers to put up collateral, and using credit rationing. D. All of the above are correct.
Why would a fund's trade moving against it cause it to burn through its capital?
A. Hedge funds are highly leveraged, and a margin is generally required for their trades. B. Capital serves as margin, so capital is used as a cushion between losses. C. Both A and B are correct.
What are the main arguments for the Fed's independence? (Check all that apply.)
A. Monetary policy is too important to be left to politicians, who are not economists and have their own political interests at stake. C. An independent Fed makes a political business cycle less likely.
Adam Posen, a member of the Bank of England's Monetary Policy Committee, was quoted as arguing in a speech that: Central banks' purchases of government debt . . . far from undermining their independence . . . should enhance their credibility. . . . Mr. Posen said, . . . "What matters for our independence is our ability to say no and to mean it, and to be responsible about when we choose to say yes." Source: Natasha Brereton, "BOE's Posen Defends ECB's Actions," Wall Street Journal, June 15, 2010. Why might purchasing government debt be seen as undermining a central bank's independence?
A. Purchasing government debt is almost like printing money. B. If the Bank of England starts purchasing government debt, it may be interpreted as a sign that the government is forcing the Bank of England to monetize the debt. C. When the central bank purchases government debt, it serves as a way for the government to spend money without having to pay for it. D. *All answers are correct.*
How is the European Central Bank (ECB) organized? (Check all that apply.)
A. The ECB has an executive board of six members, with one of its members serving as president. B. The governance of the ECB includes the governors of each of the member national central banks. C. Board members are appointed by member countries' governments, based on the recommendation of the council of Ministers of Economics and Finance, after consulting the European Parliament and the Governing Council of the ECB.
Why was it established?
A. The FDIC was established in 1934 after a series of bank failures. C. The FDIC was established to ameliorate bank runs.
Suppose that the U.S. Constitution were amended to include the following: "Congress shall establish a central bank that will be responsible for conducting the monetary policy of the United States." What effect would such an amendment be likely to have on the Fed? (Check all that apply.)
A. The amendment would likely have little effect on the Fed and would simply quiet dissenters who don't believe the Fed is constitutional. C. The Fed already serves the role described in the hypothetical amendment.
Why might a central bank sometimes want to say "yes" to the above actions?
A. These actions may be positive in times of extreme economic circumstances. For instance, in the fall of 2010 the Federal Reserve undertook "quantitative easing," which was the purchase of government debt. The action flooded banks with excess liquidity. B. *All answers are correct.* C. When these actions can lower the cost of government borrowing in bad economic times. D. When these actions can put downward pressure on exchange rates, increasing exports to spur recovery.
How is being a lender of last resort connected to the too-big-to-fail policy? (Check all that apply.)
A. The too-big-to-fail policy and the lender of last resort have to provide liquidity to banks during bank panics. Your answer is correct. C. The too-big-to-fail policy and the lender of last resort strive to prevent systemic risk, where the failure of a few firms leads to the widespread failure of solvent banks.
According to economist Alan Meltzer of Carnegie Mellon University, who has written about the history of the Federal Reserve: Tension between the [Federal Reserve] Board and the reserve banks began before the System opened for business. . . . [Paul] Warburg described the problem. Dominance by the Board would allow political considerations to dominate decisions about interest rates. Dominance by the reserve banks "would . . . reduce the Board to a position of impotence." Paul Warburg was one of President Wilson's initial appointments when the Federal Reserve Board began operations in 1914. Source: Allan H. Meltzer, A History of the Federal Reserve, Volume I: 1913−1951, Chicago: University of Chicago Press, 2003, p. 75. Why did Congress set up a system that had this tension between the Reserve Banks and the Federal Reserve Board? (Check all that apply.)
A. This was all part of the organizational plan to prevent one faction of the banking system from having too much power. D. Tension was created to ensure that various interests would have input into the conduct of monetary policy.
Does Bernanke's observation help to explain the role bank panics played in the severity of the Great Depression?
A. When thousands of banks failed, it became difficult for their customers to obtain credit, thus exacerbating the severity of the Great Depression. C. Yes, Bernanke's observation helps to explain the role bank panics played in the severity of the Great Depression. D. Both A and C are correct.
An article in the New York Times published just after the Fed helped to save Bear Stearns from bankruptcy noted: If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions. Source: Gretchen Morgenson, "Rescue Me: A Fed Bailout Crosses a Line," New York Times, March 18, 2008. Why did Bear Stearns almost fail? (Check all that apply.)
A. because lenders lost faith in Bear's ability to pay back short-term loans Your answer is correct. B. because Bear liquidated assets in order to pay back short-term loans E. because lenders declined to renew Bear's short-term loans
Does this process provide any insight into why the Federal Reserve rescued Bear Stearns? (Check all that apply.) A debt-deflation process
A. pushes down the price of those assets which other investment banks hold, thus worsening their balance sheets, which in turn can accelerate bankruptcies. B. would occur if Bear Stearns goes bankrupt and has to sell its assets.
In the first volume of his history of the Federal Reserve System, Allan Meltzer titled one of his chapters "Under Treasury Control, 1942-1951." Source: Allan H. Meltzer, A History of the Federal Reserve, Volume I: 1913-1951, Chicago: University of Chicago Press, 2003, Ch. 7. Which of the following statements are true and help explain why Meltzer considered the Fed to have been under Treasury control during those years (Select all that apply)
A. The Treasury assumed some control over the Fed to help finance wartime deficits. B. The Treasury encouraged the Fed to actively buy bonds that private investors would not. D. The Treasury wanted the rate on government securities to be held at a low level.
The key accounting equation on which balance sheets are based is given by
Assets = Liabilities + Shareholders' Equity.
In his memoirs, Herbert Hoover described the reaction of his Treasury Secretary to the Great Depression: First was the "leave it alone liquidationists" headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." Source: Herbert Hoover, The Memoirs of Herbert Hoover: Volume 3: The Great Depression, 1929-1941, New York: Macmillan, 1952, p. 30. What does "liquidate" mean in this context?
A.Liquidate means to let prices fall to their equilibrium level.
Why might Fed officials have believed that low nominal interest rates were a good indicator that policy was easy?
ANS on HW: Low nominal interest rates would indicate to the Federal Reserve that it did not need to intervene in the banking system. Low nominal interest rates would indicate to the Federal Reserve that it did not need to intervene in the banking ANS on Quiz: B.In the Fed's view, low nominal interest rates indicated that there was an adequate supply of excess reserves to be used for losses or loans. In the Fed's view, low nominal interest rates indicated that there was an adequate supply of excess reserves to be
"A bank that expects interest rates to fall will want the duration of its assets to be greater than the duration of its liabilities - a positive duration gap." Do you agree with this statement?
Agree. A fall in interest rates with a positive duration gap will increase a bank's capital.
"A bank that expects interest rates to increase in the future will want to hold more rate-sensitive assets and fewer rate-sensitive liabilities." Do you agree with this statement?
Agree. Rate-sensitive assets will increase in value thus holding more of them as assets, while reducing them as liabilities, will increase bank profits.
Why might a politically independent Fed give a greater weight to low and stable inflation than Congress and the president would if they controlled monetary policy directly?
An independent Fed is more focused on long-run costs than short-term gains.
[Related to the Making the ConnectionLOADING...] In their book This Time Is Different, Carmen Reinhart and Kenneth Rogoff conclude: "An examination of the aftermath of severe postwar financial crises shows that they have had a deep and lasting effect on asset prices, output, and employment." Source: Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press, 2009, p. 248. Part 2 Why should a recession connected with a financial crisis be more severe than a recession that did not involve a financial crisis?
Ans on HW A recession that includes a financial crisis is generally more complex and has more severe consequences, such as decreasing asset prices and lending, which affects the economy for a longer time period than a traditional recession. Ans on Quiz When financial institutions fail, credit markets can be damaged comma and the amount of borrowing comma and hence economic activity comma can decrease comma further affecting real output. When financial institutions fail, credit markets can be damaged, and the amount of borrowing, and hence economic
Suppose First National Bank has $280 million in assets and $28 million in equity capital. If First National has a 2% ROA, what is its ROE? ROE = ________% Now suppose First National's equity capital declines to $14 million, while its assets and ROA are unchanged. What is First National's ROE now? ROE= _______%
Assets =$ 260 Million, Equity = $ 26 Million ROA = 2% = 0.02 Hence ROA = Return/ Assets 0.02 = Return/ 280 M Return = $ 5.6 Million Therefore Return on Equity = ROE = Return/Equity = 5.6/28 = 0.20 = 20 % ROE = 20 % Equity Capital declines by 14 Million, New Equity, = $14 Million Since ROA and Assets are unchanged, Return remains the same $ 5.6million Hence , New ROE = return/ Equity = 5.6/14 = 0.4 New ROE = 40 %
What is the difference between a bank's return on assets (ROA) and its return on equity (ROE)?
A bank's return on assets (ROA) is the ratio of a bank's after-tax profit to the value of its assets. Return on equity (ROE) is the ratio of the value of a bank's after-tax profit to the value of its capital.
How do banks manage liquidity risk? (Check all that apply.)
B. Banks manage this risk by keeping some funds very liquid, such as in the federal funds market. Your answer is correct. C. Banks manage this risk by keeping some funds very liquid, such as a reverse repurchase agreement. Your answer is correct. D. Banks can increase their borrowings to cover liquidity risk.
What are the changes to the Fed under the Dodd-Frank Act? (Check all that apply.)
B. Making the Fed a member of the new Financial Stability Oversight Council. D. Designating a Fed vice chairman for regulatory supervision. E. Ordering the Government Accountability Office to audit the emergency lending programs the Fed carried out during the financial crisis.
How do banks manage interest-rate risk? (Check all that apply.)
B. Interest-rate swaps can reduce interest-rate risk exposure. D. Banks can reduce interest-rate risk by making more floating rate loans, or ARMs.
Why might people knowing what was causing an economic downturn affect the length and severity of the downturn?
Knowing the cause may help reduce the uncertainty that households and firms have about their future incomes, thus decreasing the severity of an economic downturn.
What are the main arguments against the Fed's independence? (Check all that apply.)
C. It would be more democratic for elected officials to control monetary policy. D. The public is unable to hold Fed officials accountable for their policies, unlike elected officials.
[Related to the Chapter Opener] In a paper written in April 2010, looking back at the financial crisis, former Fed Chair Alan Greenspan argued: At least partly responsible [for the severity of the financial collapse] may have been the failure of risk managers to fully understand the impact of the emergence of shadow banking that increased financial innovation, but as a consequence, also increased the level of risk. The added risk had not been compensated by higher capital. Source: Alan Greenspan, "The Crisis," April 15, 2010, p. 21. How did the emergence of shadow banking increase the risk to the financial system? (Check all that apply.)
C. Nonbank financial institutions are not required to maintain the equivalent of reserve requirements even though, like traditional banks, they borrow short and lend long. D. In the event of a nonbank financial institution run, there is no equivalent of the FDIC.
What does a fund's "dumping its positions" mean? (Check all that apply.)
C. Selling before capital runs out. D. Selling before a margin call.
Suppose that Bank of America sells $30 million in Treasury bills to PNC Bank. Use T-accounts to show the effect of this transaction on the balance sheet of each bank.
Bank of America: Reserves $ +30 mil Securities $ −30mil PNC Bank: Reserves $ -30 mil Securities $ +30mil
In academic research published before he entered government, Fed Chairman Ben Bernanke wrote: [In] a system without deposit insurance, depositor runs and withdrawals deprive banks of funds for lending; to the extent that bank lending is specialized or information sensitive, these loans are not easily replaced by nonbank forms of credit. Source: Ben S. Bernanke, Essays on the Great Depression, Princeton, NJ: Princeton University Press, 2000, p. 26. What does it mean to say that bank lending is "information sensitive"?
Banks acquire information to decide if borrowers are creditworthy.
Why would bank lending being "information sensitive" make it difficult to replace with nonbank forms of credit?
Banks have economies of scale or some other advantage in evaluating the riskiness of loans.
history of deposit insurance on the Web site of the FDIC notes that: "Some have argued at different points in time that there have been too few bank failures because of deposit insurance, that it undermines market discipline, ... and that it amounts to a federal subsidy for banking companies." What does it mean to describe deposit insurance as undermining "market discipline"?
Because (most )depositors are fully insured, they have (little) incentive to withdraw their money and cause their bank to fail. This encourages(risk-taking) by bank managers as depositors are protected(regardless of) how the bank actually performs.
Was Fed Chairman Bernanke justified in evading the requirements of this act during the financial crisis of 2007-2009?
Because the financial crisis was unfolding so quickly, one could argue that Bernanke was justified in evading the Sunshine Act.
If Congress agreed that the Fed was acting to "thwart the policies of elected officials," what actions could Congress take?
Congress could amend the Federal Reserve Act to change how the Fed operates or it could even abolish the Fed.
Nonbank forms of credit
refer to credit from providers other than banks.
What is the main problem with having a central bank that is not independent of the rest of the government?
Less independent central banks tend to lead to higher inflation. An independent central bank can more freely focus on keeping inflation low.
Why was TARP created?
TARP was created to restore the market for mortgage-backed securities and other toxic assets to provide relief to financial firms that held these assets on their balance sheets.
"If a bank manager expects interest rates to fall in the future, he should increase the duration of his bank's liabilities." Do you agree with this statement?
Disagree. Higher duration of its liabilities will reduce the value of the bank's capital.
The following entries (in millions of dollars) are from the balance sheet of Rivendell National Bank (RNB): U.S. Treasury bills $21 Demand deposits $43 Mortgage-backed securities $33 Loans from other banks $5 C&I loans $46 Discount loans $5 NOW accounts $45 Savings accounts $6 Reserve deposits with Federal Reserve $8 Cash items in the process of collection $9 Municipal bonds $6 Bank building $3 If RNB's assets have an average duration of four years and its liabilities have an average duration of two years, what is RNB's duration gap? Duration gap = ___________
Duration gap = average duration of assets - average duration of liabilities --> 4-2 = 2
In what sense might deposit insurance be considered a federal subsidy for banks?
FDIC insurance is backed by the full faith and credit of the United States government.
Despite these potential drawbacks, economists and members of Congress overwhelmingly support deposit insurance for all of the following reasons, except:
FDIC protects every dollar a customer has in a bank.
How did the Federal Reserve rescue Bear Stearns? The Federal Reserve arranged a buyout of Bear Stearns by
JP Morgan Chase.
[Related to Solved Problem 13.1] Suppose that Bank of America pays a 2% annual interest rate on checking account balances while having to meet a reserve requirement of 10%. Assume that the Fed pays Bank of America an interest rate of 0.2% on its holdings of reserves and that Bank of America can earn 6% on its loans and other investments. How do reserve requirements affect the amount that Bank of America can earn on $1,000 in checking account deposits? Ignore any costs Bank of America incurs on the deposits other than the interest it pays to depositors. The 10% reserve requirement reduces the amount Bank of America can earn on $1,000 by $___________
First step: How much the bank is currently earning:(900 x .06) + (100 x .002) = 54.2 Second step: How much you could be earning:= (1000*.06) = 60 Third step: 60-54.2= $5.8
Does Greenspan's analysis provide insight into why the Fed during his tenure may have been reluctant to take action against asset bubbles?
If Greenspan believes that most bubbles burst without severe economic consequences, then, yes, it would explain the Fed's actions.
The classic account of bank panics was published in 1879 by Walter Bagehot, editor of the Economist, in his book Lombard Street: "In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them." Source: Walter Bagehot, Lombard Street: A Description of the Money Market, New York: John Wiley, 1999 (first published 1873), p. 51. Part 2 All of the following are reasons why one bank failure might lead to many bank failures, except: What are the two main ways in which the government can keep one bank failure from leading to a bank panic?
If multiple banks have to sell the same assets, the prices of those assets are likely to rise. A central bank can act as a lender of last resort, and the government can insure deposits.
Which of the following could be a negative implication if "the maturity of the debt is less than the maturity of the assets it funds"?
If the debt is not renewed, or rolled over, the asset side of the balance sheet becomes unsustainable.
Why would holding more capital limit how much a financial firm can borrow and reduce the firm's profitability?
It decreases the amount of funds available to invest in riskier, potentially higher-yielding assets.
Is it easier for a central bank to be independent in a high-income country or in a low-income country?
It is often difficult for a central bank to act independently in a low-income country.
Was deflation during the early 1930s good or bad for firms?
It was bad for firms that were borrowers because it effectively raised interest rates.
Why would long-term interest rates have a closer connection to house prices than overnight interest rates?
Multiple questions with diff answers: C. The average holding of a house is 10 years. D. Mortgage companies generally markup mortgages 2 minus 3 % above the 10 minus year Treasury bond yield.
Suppose that National Bank of Guerneville has $34 million in checkable deposits, Commonwealth Bank has $42 million in checkable deposits, and the required reserve ratio for checkable deposits is 10%. If National Bank of Guerneville has $4 million in reserves and Commonwealth has $5 million in reserves, how much in excess reserves does each bank have? National Bank of Guerneville has $_________ million in excess reserves. Commonwealth Bank has $ ___________million in excess reserves. Now suppose that a customer of National Bank of Guerneville writes a check for $3 million to a real estate broker who deposits the check at Commonwealth. After the check clears, how much in excess reserves does each bank have? National Bank of Guerneville has $ __________ million in excess reserves. Commonwealth Bank has $ ___________ million in excess reserves.
National Bank of Guerneville: required reserve= 10% x 34 = $3.4 M excess reserves = 4 - 3.4 = $0.6 M Commonwealth Bank: required reserve= 10% x 42 = $4.2 M excess reserves = 5 - 4.2 = $0.8 M National Bank of Guerneville: 34 - 3 = $31 M remaining balance = 4 - 3 = $1 M required reserve= 10% x 31 = $3.1M excess reserves = 1 - 3.1 = -$2.1 M Commonwealth Bank: 42 + 3 = $45 M remaining balance = 5 + 3 = $8 M required reserve= 10% x 45 = $4.5 M excess reserves = 8 - 4.5 = $3.5 M
In the context of the early 1930s, were low nominal interest rates a good indicator that policy was easy?
No. Because of deflation, real rates were high.
In the modern Fed, would it be possible for a Reserve Bank to act as the New York Fed did in 1929?
No. In the modern Fed a Reserve Bank cannot conduct monetary policy independent from the FOMC and the Board of Governors.
How are they related?
ROE is equal to ROA multiplied by the ratio of bank assets to bank capital.
From this perspective, why might there be too few bank failures as the result of deposit insurance?
Rather than let banks fail, the FDIC steps in to minimize the amount of money it will have to pay out.
The most important bank assets are
Real estate loans and U.S. government/agency securities.
What implications does your answer have for what the average inflation rate is likely to be in high-income countries as opposed to low-income countries?
Research has shown that the more independent a central bank is, the lower the inflation rate will be. Thus, one would expect the average inflation rate in less-developed countries to be higher than in industrial countries.
Suppose that Lena, who has an account at SunTrust Bank, writes a check for $140 to Jose, who has an account at National City Bank. Use following the T-account for SunTrust Bank to show how it is affected after the check clears. Use following the T-account for National City Bank to show how it is affected after the check clears
SunTrust Bank: Assets Reserves: -140 Liabilities Checkable deposits: -140 National City Bank: Assets Reserves: 140 Liabilities Checkable deposits: 140
In what sense is the Federal Reserve System both accountable to the government and independent of it?
The Board of Governors is a federal government agency, while the Federal Reserve Banks are legally the equivalent of private corporations.
What is the "Constitutional question" involved here? Is the existence of the Fed constitutional?
The Constitution does not directly discuss a central banking system; however, the Fed's constitutionality was confirmed by the Supreme Court.
What difficulties did the ECB encounter during the financial crisis of 2007
The ECB encountered difficulty conducting a common monetary policy for countries experiencing different economic conditions.
What difficulties did the ECB encounter during the 2020 Covid-19 pandemic?
The ECB realized the effectiveness of monetary policy was limited and urged member countries to employ more expansionary fiscal policy.
Why is the issue of whether Bear Stearns and AIG held sufficient collateral important legally?
The Fed can only make loans to firms provided that the loan being made is secured by adequate collateral.
What is the purpose of the Government in the Sunshine Act?
The Government in the Sunshine Act, which required government agencies to post meetings before they happened, was created to promote public awareness.
At the beginning of the 2020 recession, real GDP declined by even more than it had over a comparable period at the beginning of the Great Depression. An article on barrons.com quoted economist Price Fishback of the University of Arizona as saying, "I understand why people are thinking about the Depression. But it's not similar in the following sense—we know why this is happening. In the Great Depression, we really didn't know what was going on." Why were people less likely to understand what was causing the Great Depression while it was happening than were able to understand what was causing the recession of 2020 while it was happening?
The Great Depression was caused by a variety of factors that were difficult to disentangle, while the 2020 recession was the result of lockdowns due to the Covid-19 pandemic.
Has the tension been resolved in the modern Fed?
The board has much more power today, but the tension remains.
What special problems does the ECB confront?
The decentralized organization of the ECB, with the governors of the national central banks holding a majority of the votes, makes it harder to achieve a consensus during a crisis.
Defending the presence of bankers on the boards of directors of the Federal Reserve Banks, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond argued that: "This hybrid governance model has come to play an important role in the independence of monetary policy. ... Political independence allows monetary policy to place greater weight on the long-term benefits of low and stable inflation." Source: Jeffrey M. Lacker, "The Fed-Bank Relationship Under Scrutiny," Federal Reserve Bank of Richmond Econ Focus, Fourth Quarter 2015, p. 1. Part 2 What does Lacker mean by a "hybrid governance model"?
The economic power within the Federal Reserve System is divided between bankers and business interests, states and regions, and between the government and the private sector.
An article on forbes.com during the Covid-19 pandemic noted that: "In the days and weeks after the pandemic hit, U.S. corporations drew on over $500 billion in credit, much of it from America's four biggest banks." The article also noted the "banks' strong capital and liquidity heading into the pandemic." Are the loans the banks made to corporations an asset or a liability to the banks doing the lending? Are they an asset or a liability to the firms borrowing the funds?
The loans are assets to the banks and liabilities to the corporations since the money must be paid back to the bank in the future.
Is the opportunity cost to banks of reserve requirements likely to be higher during a period of high inflation or during a period of low inflation?
The opportunity cost to banks of reserve requirements would likely be higher during a period of high inflation when nominal interest rates on loans are high.
How are the principal-agent view and the public interest view connected to the theory of the political business cycle?
The political business cycle would be more likely with the principal-agent view where the Fed lowers interest rates to stimulate the economy before an election to avoid conflict with groups that could limit its power and influence.
Former Federal Reserve Chair Ben Bernanke has observed that; "Even a bank that is solvent under normal conditions can rarely survive a sustained run." Source: Ben S. Bernanke, The Courage to Act: The Financial Crisis and Its Aftermath, New York: W.W. Norton, 2015, p. 45. Part 2 What does Bernanke mean by "solvent under normal conditions"? What does he mean by a "sustained run"? Why can't a bank by itself survive a sustained run?
The value of a bank's assets is more than the value of its liabilities, so its net worth, or capital, is positive. By "sustained run," Bernanke means a bank run that lasts for a significant period of time. A bank cannot by itself survive a sustained run because it does not have enough reserves to match the deposit withdrawals and its assets are long term and not easily liquidated.
Why would it matter to Greenspan whether low long-term interest rates were more responsible for the housing bubble than low short-term interest rates?
To lessen the Federal Reserve's responsibility under Greenspan's watch as Chairman for causing, at least partially, the housing bubble with low interest rates.
Which of the following is the most highly liquid asset found on a bank's balance sheet?
U.S. Treasury securities
Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City, remarked about the Federal Reserve System that: "[I]t was designed as a public-private partnership, accountable to, and yet independent of, the government." Source: Thomas M. Hoenig, "Twelve Banks: The Strength of the Federal Reserve System," speech delivered at Copper Mountain, Colorado, September 15, 2006. Part 2 In what sense is the Federal Reserve System a "public-private partnership"?
While authorized by the government, it is owned by private banks.
Loan sales is
a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.
Standby letters of credit are
a promise by a bank to lend funds, if necessary, to the seller of commercial paper at the time that the commercial paper matures.
Off-balance-sheet activities are
activities that do not affect a bank's balance sheet because they do not change either the bank's assets or its liabilities.
Trading activities are
activities that include trading in the futures, options, or swaps market.
In his history of the Federal Reserve, Allan Meltzer of Carnegie Mellon University describes the views of Federal Reserve officials in the fall of 1930: Most of the policymakers regarded the substantial decline in short-term market interest rates ... as the main ... indicators of the current position of the monetary system.... [Policy] was "easy" and had never been easier in the experience of the policymakers of the Federal Reserve System. Source: Alan H. Meltzer, A History of the Federal Reserve: Volume 1: 1913-1951, Chicago: University of Chicago Press, 2003, p. 315. What does it mean to say that Fed policy is "easy"? An "easy" Fed policy suggests
an increasing money supply and falling interest rates.
Loan commitment is
a bank's consent to provide a borrower with a stated amount of funds during some specified time.
What is meant by the "fragility" of commercial banking? The "fragility" of commercial banking means that ________.
banks borrow short to lend long and are relatively illiquid on any given day
All of the following are reasons why the Dodd-Frank Act required SIFIs to hold more capital, except:
because the FDIC was prohibited from intervening when SIFIs experienced economic distress.
In a paper written in April 2010, looking back at the financial crisis, former Fed Chairman Alan Greenspan wrote: Some bubbles burst without severe economic consequences, the dotcom boom and the rapid run-up of stock prices in the spring of 1987, for example. Others burst with severe deflationary consequences. That class of bubbles ... appears to be a function of the degree of debt leverage in the financial sector, particularly when the maturity of debt is less than the maturity of the assets it funds. Source: Alan Greenspan, "The Crisis," April 15, 2010, p. 10. What does Greenspan mean by "debt leverage"?
borrowing and purchasing assets with borrowed funds
The debt-deflation process is the process of _____________that can increase the severity of an economic downturn. The debt-deflation process contributed to the severity of the Great Depression by __________the real interest rate and the real value of debts, which _____________the burden on borrowers and led to ___________loan defaults.
falling prices of goods and services increasing; increased, more
An article in the New York Times quoted former Fed Chairman Alan Greenspan as arguing in 2010: "The global house price bubble was a consequence of lower interest rates, but it was long-term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seemingly conventional wisdom." Source: Sewell Chan, "Greenspan Concedes That the Fed Failed to Gauge the Bubble," New York Times, March 18, 2010. A house price bubble
occurs when house prices move beyond their fundamental values.
The positions of the Reserve Bank presidents during this episode are better explained by the ____________view of Fed motivation than by the __________view as the presidents were _____________.
principal-agent; public interest; acting in the best interests of their member banks
Financial journalist James Stewart notes that in contrast to its actions with respect to Lehman Brothers, "the Fed did lend into continuing runs at both Bear Stearns and A.I.G., although officials argued then that those companies had adequate collateral to guarantee repayment." Source: James Stewart, "Pointing a Finger at the Fed in the Lehman Disaster," New York Times, July 21, 2016. Part 2 In "lending into continuing runs" the Fed ____________additional __________ banks in order to avoid ___________longer-term assets at a __________, further ___________investor confidence.
provided; capital from; selling; loss; undermining
The FDIC stands for
the Federal Deposit Insurance Corporation.
All of the following might be reasons why the Fed did not lend to Lehman Brothers in the days before its bankruptcy, except:
the failure of Lehman Brothers would have little impact on the economy.
What is "contagion"? What role does it play in bank panics? Contagion is when ________.
the failure of one bank causes runs on other banks. If multiple banks experience bank runs, the result is a bank panic.
Evaluate the economist's statement. The economist is thinking that ________.
the president may want the Fed to lower interest rates during elections, but the Fed will focus on the long-term health of the economy.
Did the federal government lose money from TARP? Briefly explain.
No, TARP funds were invested heavily into bank stocks to increase bank capital. These holdings eventually made the government a profit.
In July 2010, Congress was considering having the federal government set up a "lending fund" for small banks. The U.S. Treasury would lend the funds to banks. The more of the funds the banks loaned to small businesses, the lower the interest rate the Treasury would charge the banks on the loans. Congressman Walt Minnick of Idaho was asked to comment on whether the bill would be helpful to small businesses. Here is part of his response: "The bank that's struggling to write down their commercial real estate assets is having to take a hit to capital, and this provides replacement capital on very, very favorable terms. So it deals with the left side of the balance sheet..." Source: Robb Mandelbaum, "Can Government Help Small Businesses?" New York Times, July 29, 2010. Part 2 a. Would a loan from the Treasury be counted as part of a bank's capital? b. Does a bank's capital appear on the left side of the bank's balance sheet?
No, a loan from the treasury would not be counted as bank capital. Bank capital appears on the right side of the balance sheet, because it is the difference between assets and liabilities.
Does a bank have to be insolvent to experience a run?
No, bank runs are caused by bank panics, which can occur whether a bank is insolvent or not.
A columnist writing in the Wall Street Journal observed: "Franklin D. Roosevelt's March 1933 inaugural line 'that the only thing we have to fear is fear itself' was inspiring, but wrong. There was plenty to fear, not least the deflation that then gripped the nation." Prices fall when a country experiences deflation, so isn't deflation good for consumers?
No, borrowers would be hurt by the higher real interest rates and higher real value of debts that deflation causes.
The most important bank liabilities are
Small-denomination time deposits and Checkable deposits.
An opinion column on barrons.com, discussing the conflict between President Trump and Fed Chair Jerome Powell, observed: "Leave aside the arguments over policy for a moment. Consider instead the Constitutional question of an unelected agency of government officials working to thwart the policies of elected officials." Is it correct to describe the Fed as "an unelected agency of government officials"?
Yes, it is true that Fed officials are not elected, so in some sense the quote is correct.
Can these views help to explain the actions by the Fed during the early years of the Great Depression?
Yes, to an extent, because the Federal Reserve was acting on the predominant economic model of the time, which said that the economy will self-adjust and any attempt to intervene will either do nothing or create negative consequences.
