Financial Institutions and Markets Test 1

Fisher Equation

1+r = (1+i)/(1+/\P) r is the real interest rate i is the nominal rate of interest /\P is the expected rate of inflation

Troubled Asset Relief Program

1. $700 billion 2. Preferred Shares 3. Restrictions

Main Organizational Elements of Fed

1. 12 Federal Reserve Banks 2. Several thousand member commercial banks 3. Board of Governors 4. Federal Open Market Committee

Merrill Lynch

1. 3rd largest investment bank 2. Sold to BOA for 60% of its value one year prior

Chairman of the Board

1. 4 year term, may be reappointed 2. When new Chairman is named, old one traditionally leaves regardless of time left in underlying appoint as Governor 3. Current Chairman: Janet Yellen

Lehman Brothers Failure

1. 4th largest investment bank declared bankruptcy

Board of Governors

1. 7 Governors appointed by the President, confirmed by the Senate 2. No 2 Governors from same Federal Reserve District 3. Governors have 14 year terms, expiring every 2 years 4. Nonrenewable terms

Why do we have Financial Markets?

1. Ability to resell financial claims makes SSUs more willing to provide them in first place

Loanable Funds 4

1. Abstract model of determination of nominal interest rates 2. Supply of LF: all sources of funds available to invest in financial claims 3. Demand of LF: All uses of funds raised from issuing financial claims 4. S and D determine equilibrium interest rate

Central Bank 4

1. Acts as national gov't fiscal agent, ex: depository bank 2. Regulates other financial institutions, especially depository institutions, don't allow them to take too many risks 3. Supervises nation's money supply and payments system 4. Acts as "lender of last resort" when financial system has liquidity problems

Open Market Operations 3

1. Affect the level of member bank reserves and monetary base 2. Buying Gov't Securities 3. Selling Gov't Securities

Real Return on Investment 2

1. Affected by technological changes and innovation 2. Varies with expected future conditions in product markets

Operation Twist

1. After two rounds of QE, in 2011, the Fed said it was going to buy $400B of bonds with long maturities 2. Will also sell $400B of bonds with short maturities 3. This is a shift in the maturity of the assets held by the Fed (toward longer maturity)

Consumers' Impatience/Time Preferences 2

1. All other things equal, consumers prefer to consume now rather than later 2. Consumers prefer a smooth consumption profile (over time) to one feast or famine

Main Roles 3

1. Allocation of Scarce Resources 2. Facilitates Risk Sharing 3. Other Important Functions

Due Diligence/Evaluation Costs

1. Asymmetric Info 2. Moral Hazard 3. Mitigating problems related to asymmetric info can be costly

Target Employment Rate 4

1. At FOMC meeting in Dec 2012, Fed said FFR would remain that way until unemployment rate dropped below 6.5% 2. Inflation between one and two years ahead is projected to be no more than 1/2 % point above Committee's 2% longer run goal 3. Longer term inflation expectations continue to be well anchored 4. Fed raises FF target in 12/2015, 12/2016

Financial Crisis Stage 2 4

1. Bank Panic, due to deteriorating BS, banks become insolvent 2. If every severe, leads to wave of bank failures, aka bank run or panic 3. Banks sell assets and stop giving loans to increase reserves 4. Asset prices decline hurting banks

Insolvent 2

1. Bank has a negative net worth 2. Banks are unable to pay off depositors and creditors, leads to failure

Simple Model of Fed Funds Rate 4

1. Bank reserves trade in a competitive market 2. Fed Funds Rate is simply the price in this market 3. Supply and demand determine price 4. Fed actions shift supply/demand curves in the market, affect prices (rate)

The Discount Rate 5

1. Banks may borrow from their district's Federal Reserve Bank (discount window) 2. Can get adjustment credit, helps cover short-term liquidity shortages 3. Can get seasonal credit, help through seasonal fluctuations 4. Can get extended credit, support in exceptional circumstances 5. Discount rate is rate which Fed charges on these loans

No Central Banking System 1832-1914 3

1. Banks were state-chartered and unregulated 2. No deposit insurance or minimum capital requirements, no guarantee for your money 3. Little supervision of lending or accounting practices

Members Banks

1. Buy stock in the FRB for their district 2. Collect dividends but do not share profits 3. Elect 6 of 9 FRB directors but have no other vote or say 4. As of 1980, Fed services are available to any depository institution for a fee (not just members) 5. Reserve requirements apply to all US depository institutions

Asymmetric Info

1. Buyers and sellers do not possess same info 2. Issuers more knowledgeable than SSUs

Buying Gov't Securities 3

1. Buying gov't securities from private sector 2. Increases level of bank reserves 3. Banks have more money to make loans and expand MS

Monetary Policy

1. By influencing money supply, a central bank can affect interest rates, unemployment, inflation, economic growth (change in GDP)

Real Interest Rate

1. Captures the price, in units of purchasing borrow, of borrowing purchasing power now 2. Real = nominal if purchasing power is constant, if inflation is 0

Bank Reserves

1. Cash or deposits held at other banks that may be used to satisfy depositor demands

Federal Reserve System 2

1. Catalyst: Banking Panic of 1907 2. Federal Reserve Act of 1913 established the Federal Reserve System Objectives

Quantitative Easing 2

1. Central bank (FED or ECV) purchases longer duration financial assets to inject a certain quantity of money into the economy 2. Buy longer maturity assets with electronically created reserves -By pushing up price of these assets, yield (interest rate) decreases -This amounts to pushing down on long end of "yield curve"

Preferred Shares

1. Certain institutions issue US gov't preferred shares/warrants (option to buy shares at agreed price) 2. Allows taxpayers to recoup funds through increases in share prices of institutions

Commercial Banks 3

1. Checkable, savings deposits 2. Business, consumer loans + mortgages 3. Large: $7.8 trillion in assets in 2003

Thrift Institutions 2

1. Checking/savings deposits 2. Specialize in residential mortgage loans to consumers

Other Important Functions 3

1. Clear and settle payments 2. Aggregate funds 3. Generate and disseminate info

Governments

1. Collect taxes and provide "public goods" (education, defense)

Depository Banks 4

1. Commercial Banks 2. Thrift Institutions 3. Credit Unions 4. Generally insured by FDIC up to $250,000

Why are Open Market Operations Preferred? 4

1. Conducted nearly every weekday 2. MS changes very quickly 3. OPO are flexible and precise 4. Increasing RR is too drastic, Increasing DR is too unpredictable

Fed Public Side 4

1. Congress created it, can strip powers 2. President appoints, Senate confirms 7 members of Board of Governors 3. After expenses, Fed gives earnings to Treasury 4. Details of responsibilities subject to oversight, subject to US laws, some explicitly specify Fed Goals

Demand for Loanable Funds

1. Consumer credit purchases 2. Business investment 3. Gov't budget deficits

Supply of Loanable Funds

1. Consumer savings 2. Business savings 3. Gov't budget surpluses 4. Central Bank actions

Examples of Direct Financing

1. Corporate bond issuance 2. IPO 3. Private placement of corporate bonds/equity

Regulatory Reform Act of 2010

1. Creates Consumer Protection Agency 2. Creates Financial Stability Oversight Council 3. Lots of additional regulatory power for Fed

Price Stability and Rising Inflation

1. Creates uncertainty in economy 2. Causes potentially undesirable wealth transfers

Financial Crisis Stage 3

1. Debt Deflation, deflation is a drop in the overall price level 2. Hurts firms' net worth because of increased burden of indebtedness 3. Debt is the most sticky of prices, debt contracts come fixed in nominal terms for long periods of time

Potentially Undesirable Wealth Transfers

1. Defined benefits often in nominal terms 2. Debt: wealth transfer from lenders to borrowers 3. Rising inflation erodes value 4. Potential for social conflict

Businesses

1. Demand labor, supply products, and invest in productive assets

5 Basic Types of Services by FI 5

1. Denomination Divisibility 2. Currency Transformation 3. Maturity Flexibility 4. Credit Risk Diversification 5. Liquidity

Money Multiplier

1. Depends on the cr ratio and the rr ratio

Classification of FI's 4

1. Deposit-type or depository institutions 2. Contractual savings institutions 3. Investment Funds 4. Other institutions

Reserve Requirements 4

1. Depository institutions must reserve set % of certain types of deposits 2. Most reserves are held at FRB of that district 3. Reserves can also be held as vault cash 4. Monetary Control Act of 1980

Financial Crisis Stage 1 4

1. Deterioration of FIs' balance sheets and deleveraging 2. Due to mismanagement of financial liberalization/globalization 3. Asset price declines (bursting of bubble) 4. Sudden increase in interest rates, uncertainty

Imperfect Mechanism 4

1. Discount window is not relied on very much 2. There are a variety of alternatives 3. Wary of increased Fed "scrutiny" that accompanies borrowing at discount window 4. Discount rates serve more of a "signaling" role

Full Employment

1. Doesn't mean 0% unemployment 2. High unemployment causes economic slack, idle workers and resources, unrealized potential GDP

Lessons from Great Depression 5

1. Don't let money supply fall by 1/3, MS = cash + checking + savings 2. Don't let average prices and wages fall dramatically 3. It's too hard to repay old debts when you earn less and sell less 4. Workers resist wage cuts, prefer to get laid off instead 5. Loose money helps private sector heal itself, different from gov't spending approach = taking up slack

2 Eras of Central Banking 2

1. Early Era: 1791 - early 1830s -First National Bank of the US (1791-1811) -Second National Bank of the US (1816-1832) -Both ultimately failed to survive political winds of the time 2. Modern Era: 1913 - onward -Banking act of 1913 established the Federal Reserve System

Foreign Exchange Risk

1. Effect of exchange rate fluctuations on profit of financial institution

Intrinsic Value

1. Explicitly backed by some commodity with intrinsic value 2. Gold standard, unit of paper currency is backed by a specified amount of gold

Currency Transformation

1. FI's buy securities in one currency and sell in another

Maturity Flexibility

1. FI's create securities with a wide range of maturity lengths 2. Home loans with maturities of 15-30 years 3. Overnight loans to other banks/institutions

Denomination Divisibility 3

1. FI's produce a wide range of denominations in providing their services 2. Many households are able to fund only modest deposits 3. Consequently unable to transact in direct financial markets

Liquidity

1. FI's tend to produce securities that are highly liquid, makes SSUs more willing to provide funds 2. Money market funds allow households very liquid access to interest-bearing wealth

Credit Risk Diversification 3

1. FI's typically hold large portfolios of credit risk, benefit from diversification 2. Direct market claim holders (SSU) are often expose to large, idiosyncratic (individual way of thinking) credit risks 3. Boeing issues large bond through a private placement, holder of this bond is heavily exposed to credit risk related to Boeing

Execution of Open Market Operations 4

1. FOMC decides when to buy or sell 2. Securities involved are usually US Treasuries (can be other assets though) 3. FOMC meets 8 times a year 4. FOMC issues policy directives to Open Market Desk at FRB of NY

Financial Institutions (Intermediaries) 2

1. Facilitate flows of funds from savers to borrowers 2. Banks, mutual funds, pension funds, insurers

Government

1. Fannie Mae and Freddie Mac: provided gov't guarantees on qualifying home mortgage loans

Long Run Fed Funds Rate 3

1. Fed can control Fed Funds Rate in the SHORT RUN 2. Market forces determine rate in LONG RUN 3. Traditional Fed monetary policy controls the "front end: of the yield curve

Monetary Base vs. Monetary Supply

1. Fed directly controls MB 2. Changes in MS are in response to MB meaning Fed has lots of influence over MS 3. Other influences are bank behavior (rr factor in money multiplier) 4. Consumer behavior (cr) in money multiplier

Fed Policy Rules and Forward Guidance 3

1. Fed's target for Fed Funds Rate has been 0 to .25 % since Dec 2008 2. FFR is at a zero boundary 3. Forward guidance to determine how long it anticipates maintaining its FF target, kept pushing back until mid 2015

Fed's Main Operating Liabilities 4

1. Federal Reserve Notes in Circulation 2. Depository Institution Reserves 3. Treasury Deposits 4. DACI: Deferred Availability Cash Items

Indirect Financing 2

1. Financial Intermediary brings SSU/DSU together 2. Financial claim from DSU goes to FI first, FI issues separate financial claim to SSU

Financial Claims 3

1. Financial assets and liabilities, financial contracts 2. Examples: Shares of stock, bonds 3. Also known as financial instruments and or securities

Primary Markets 3

1. Financial claims are born 2. DSU receive funds, claims are first issued 3. US Treasury auction, Facebook stock IPO

Quantitative Easing following Crisis

1. Financial markets stabilized, high unemployment rates and little economic growth 2. Short term interest rates plunged, 4% to .15%, near zero bound 3. The Fed couldn't rely on conventional monetary policy bc

QE Solutions to Crisis

1. Fiscal Policy: politically infeasible at the time 2. Unconventional monetary policy, aka quantitative easing

Great Depression vs. 2008 Recession

1. GD was much worse than Recession 2. Output, Employment, M2, prices all dropped over 25% 3. Stock collapse, bank collapse, bailouts for GD 4. Look at the Financial Crisis, Slide 11

Fed can pay interest on reserves

1. Gives Fed another way to influence bank behavior 2. Ex: Fed wants banks to hold more RR, increase interest rate paid on RR

Goal of Operation Twist

1. Goal is to flatten yield curve and reduce long term interest rates 2. Belief was that there were more closely related to investment and consumer purchases 3. Program extended in June 2012

Centralized Fed 5

1. Governors outnumber FRB presidents 7 to 5 on FOMC 2. Board sets reserve requirements 3. Board can review and disapprove of regional banks discount rates: effective control of discount rates 4. Board appoints top officers at regional banks 5. Board directs the Fed's economic research

Fiat Money

1. Has value based solely off of gov't decree 2. Coinage is legal tender that can be legally used to make payments and discharge debts 3. Financial system relies on credibility of money and gov't

Surplus Spending Units 3

1. Have income for the period that exceeds spending 2. Results in savings, saver, lender, or investor 3. Many SSUs are households

Deficit Spending Units 2

1. Have spending for the period that exceeds income 2. Borrower, usually businesses or governments

TARP Legacy 4

1. Helped stop run on shadow banking system 2. Hard to know what would have happened without TARP 3. Most major banks who received funds have paid them back 4. However, doesn't seem to have energized credit provision

Keynesian Theory

1. High gov't expenditures, low taxes, best way to achieve optimal economic performance 2. Unexpected increases in MS lower interest rates, creates higher aggregate demand, leads to greater output/employment

Federal Reserve Bank of New York 4

1. Holds day to day responsibility for implementing monetary policy for the Federal Reserve 2. Takes direction from FOMC, located on Wall Street 3. Vast holdings of gold bullion, 10% of world's official gold reserves, 5,000 metric tons of gold bullion, $270 billion as of 2010 4. Houses Foreign Exchange Desk, conducts foreign exchange interventions on behalf of Fed and Treasury

FOMC Activities

1. Holds eight meetings per year 2. Review economic/financial conditions 3. Determines the appropriate stance of monetary policy 4. Assesses the risk to its long run goals of price stability and sustainable economic growth

Major Players in the Economic System 4

1. Households 2. Businesses 3. Governments 4. Foreign Investors

Facebook IPO 3

1. IPO was May 18, 2012 2. Morgan Stanley was lead investment bank, $38 was ultimate underwritten value, after one week $41, in August, worth $20 3. People accused MS of setting IPO price too high

Tapering Program 2

1. In Dec 2013, tapering program reduces purchases by $10B/month 2. Q3 ended 10/2014

Quantitative Easing 3 4

1. In late 2012, Fed evolved from "Twist" 2. No longer purchasing maturity assets via sale of T-bills 3. Moving to "naked" purchases on long term assets, $40B/month MBS and $45B/month of Treasury bonds 4. No finish date in mind, going to continue until unemployment rate hit 6.5%

Moral Hazard

1. Incentive problems after transaction 2. Banks must monitor behavior of borrowers

Can Monetary Policy actually influence the inflation rate and unemployment rate?

1. Inflation rate: most economists believe so 2. Unemployment rate/GPD growth: more contentious

Risks of QE 2

1. Inflation: just as with conventional monetary expansion, repeated QE can lead to significant inflation 2. Ineffectiveness: Banks must ultimately lend out reserves in a way that spurs economy

Uncertainty in Economy 3

1. Info in prices difficult to interpret 2. Complicates decisions made by businesses, households, and gov't 3. Creates inefficiencies

Yield Curve 3

1. Interest rates as a function of maturity 2. Fed Funds rate is the rate on very short maturity interbank lending, front end of curve 3. This lending is critical for investment and growth, typically long-term

Glass-Stegall Act 4

1. Investment banking was separated from commercial banking 2. Starting in 1999, commercial banks could engage in investment banking 3. During financial crisis, remaining investment banks were forced to merge with large commercial banks 4. Merrill Lynch and Bank of America, Goldman and Morgan Stanley

Deleveraging

1. Involves a contraction in credit (fewer loans) as His reduce leverage 2. This follows asset price declines and loan underperformance 3. As credit provision weakens, economic activity wanes

Insurance Companies 2

1. Issue policies, collect premiums, invest in stocks and bonds 2. Policyholders are SSUs, businesses or governments are DSUs

Ben Bernanke

1. Japan had a lengthy period of zero lower bound during its lost decade 2. Studied how monetary policy could alter ZLB

Transaction Costs

1. Key principle deciding whether financing is direct or indirect is the size/significance of transaction costs 2. Refer to the economic costs of doing business 3. Low transaction costs, cut out middleman, use direct financing

Key Characteristics

1. Large, wholesale transactions 2. Minimum transaction size, $1 million 3. Sophisticated parties involved in transactions, commercial banks, governments, hedge funs

Excess Reserves 2

1. Lend out to earn interest 2. Hold for liquidity/safety or for Fed interest

Restrictions from TARP

1. Limits on executive compensation, bonuses, golden parachutes for participating institutions

Underwriting

1. Line up commitments to buy, often investment bank makes a "firm commitment", guarantees price

Fed's Main Operating Assets 4

1. Loans at Discount Window 2. Gold certificates 3. US Gov't Securities 4. CIPC: Cash Items in Process of Collection

Shadow Banking System 3

1. Long term positions financed via short term instruments, repos, commercial paper 2. Haircuts on repos rose rapidly, forced fire sales of assets 3. Fire sales further price decrease, causes haircuts, leads to more fire sales

Secondary Credit

1. Longer term loans for short term liquidity needs 2. Also to resolve severe financial difficulties 3. He said it's about 1.75%

Origins of 2007-2008 Crisis 5

1. Low interest rates in early 2000s filed a boom in housing market 2. Securitization led to credit boom in the mortgage market, lots of subprime mortgages 3. NINJA loans (No Income No Job (no) Assets) 4. High amounts of mortgage backed securities and collateralized debt obligations 5. Rating agencies gave these strong ratings

Total Reserves 2

1. Made up of Required Reserves and Excess Reserves 2. TR = RR + ER RR = k x DEP k = required reserve ratio DEP = total bank deposits

Fed's Balance Sheet 4

1. Main Operating Assets 2. Main Operating Liabilities 3. CIPC - DACI = "Float", net extension of credit related to payments 4. Cash Items in Procession of Collection - Deferred Availability Cash Items

Nominal Rates

1. Majority of rates encountered 2. Borrow $10,000 at rate of 10%, pay back $11,000 next year

Finance Companies

1. Make consumer/business loans 2. Main difference from depository institutions: don't take deposits 3. Raise cash by selling equity (stock), issuing short term debt called commercial paper

Credit Risk

1. Many FI's credit (default) risk: risk that a DSU may not pay as agreed 2. Manage through credit screening, diversification, monitoring

Distribution

1. Marketing and sales of securities to institutions and certain (wealthy) individuals

Financial System is Composed of 3

1. Markets for financial assets 2. Financial institutions and intermediaries 3. Regulatory bodies

Fed Balance Sheet Post Crisis

1. Massive expansion of mortgage backed securities post crisis 2. Massive expansion in depository institution reserves post crisis

A Primary Function of the Financial System

1. Match SSUs and DSUs

Functions of Money

1. Medium of Exchange, money is used to trade real assets 2. Store of Value, money serves as means of storing purchasing power, allows you to postpone consumption 3. Unit of Account, prices denominated in terms of monetary unit

National Banking Acts 3

1. Mid 1860s: series of banking acts designed to shore up money supply and permit US gov't to sell US gov't bonds 2. 10% tax on banknotes, got rid of banknotes practice 3. Banks could obtain charters as national banks and issue notes

Seasonal Credit

1. Midwestern bank with fluctuations around agricultural cycle

Structural Unemployment 3

1. Mistmatch between job requirements and worker skills 2. Undesirable but not something monetary policy can address 3. Hopefully temporary

Money Supply Model 4

1. Monetary Base = C + TR 2. Money Supply = C + DEP 3. M/MB = (C + DEP)/(C + TR) 4. Many formulas on slide 52

Money Supply 3

1. Monetary base is one definition 2. M1 = C + checking deposits 3. M2 = M1 + savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars

Taxonomy

1. Money comes from Greek "Moneta", temple of Goddess Juno where first coins were struck

Originate to Distribute 2

1. Mortgage brokers had little incentive to have home buyers' best interests at heart 2. Lax regulation of originators led to predatory lending

Transaction Costs and Choice of Financing Channel 3

1. Most transaction costs related to financing have a significant fixed component 2. Individual/small business financial needs are usually served by financial intermediaries 3. Large, established firms may find it more cost effective to transact in direct credit markets

Issues with Direct Financing 4

1. Must match in terms of amount (size of issue) 2. Maturity (5 year vs. 10 year bond) 3. Risk (high growth firms often require angel financing) 4. Liquidity (what if SSU needs cash earlier)

Foreign Investors

1. Non domestic households, businesses, governments

Credit Unions 2

1. Non-profit, cooperative, consumer organized, "common bond" 2. Primarily short-term installment consumer loans

Reserve Requirements 2

1. Not typically used, can have dramatic effects 2. Difficult to fine tune money supply

Contractual Savings Institutions 3

1. Obtain funds under long-term contractual arrangements, invest in capital markets (stock, bonds) 2. Life insurance companies, casualty insurance companies, private pension, state and local gov't pension funds 3. Life insurance issues policy (liability sold to public) and invests the $ in a portfolio of corporate bonds/stocks (assets)

Primary Credit

1. Overnight loans for essentially sound banks 2. He said it's around 1.25% right now

Federal Open Market Committee

1. Oversees the Fed monetary policy, takes action to influence money supply and interest rates 2. 12 members, 8 permanent, 4 rotating 3. President of FRB of New York has permanent seat, NY Fed operationally executes FOMC directives 4. Presidents of 4 other FRBs rotate through one year terms 5. Nonvoting Reserve Bank presidents attend the meetings of the Committee and participate in discussions

Fed Private Side 3

1. Owned by member banks 2. Operates as a profitable bank, doesn't rely on Congress for funds 3. Long (14 year) terms of Governors promotes independence

ECB's QE Program 4

1. Plans to buy over 1 trillion euros in public and private sector bonds 2. Purchasing pace of 60B euros/month, open ended objective to push inflation to 2% 3. Public debt maturities ranging from 2-30 years, include bonds with negative yields 4.Each central bank buys bonds issued by its own gov't

Investment Banking Services

1. Play key role in security issuance 2. Origination 3. Underwriting 4. Distribution

Origination

1. Prepare security for sale, determine amount to be raised

Humphrey-Hawkins Act: Goals of Fed's Monetary Policy 6

1. Price Stability 2. Full Employment 3. Economic Growth 4. Interest Rate Stability 5. Stable Financial System 6. Stable Foreign Exchange Markets

Current Discount Rates

1. Primary Credit 2. Secondary Credit 3. Seasonal Credit

Fed Regional Banks 6

1. Processing checks and electronic payments 2. Issuing Federal Reserve Notes, printed by Bureau of Engraving and Printing 3. Holding reserves of banks and other depository institutions 4. Monitoring regional economic conditions 5. Advising the Board of Governors 6. Helping make monetary policy

Case for FIs

1. Projects have higher NPVs 2. Subsequent investment in real assets increases economic growth

Objectives of Federal Reserve Act of 1913 6

1. Provide an elastic currency, Federal Reserve Notes, standardized currency 2. Ability to adjust money supply to changes in economy 3. 12 regionally autonomous Federal Reserve Banks 4. Serve as lender of last resort to keep banks liquid 5. Improve payments system (check clearing) 6. Supervise banks more vigorously

Restoring American Financial Stability Act 4

1. Provides Fed with authority to monitor and intervene in business affairs of large complex bank and nonbank holding companies posing risk to economy 2. Fed can preempt other primary regulators 3. Can even break up firms or require divestments of certain assets 4. Addresses "too big to fail" problem, preventive oversight of large banks so taxpayers don't have to bail them out

Financial System 4

1. Provides for efficient flow of funds from saving to investment 2. Brings savers and borrowers together via financial markets and institutions 3. Allows for financial contracting 4. Permits exchange of financial claims and assets

Twitter IPO 3

1. Public in November 2013, $26 2. Next day: $45, peaked at $50, closed at $44 3. Majority of IPOs increase in price on first day

Fed Funds Rate

1. Rate banks charge each other overnight for loans of reserves 2. This is a market rate related to supply and demand of reserves 3. Fed can influence but not directly control the Fed Funds Rate

Determinants of Real Interest Rate 3

1. Real return on investment 2. Consumers' impatience/time preferences 3. Gov't Policy

Realized Real Rates of Return

1. Reflect the impact of realized inflation on past investments Equation on Interest Rates, Slide 17

Opportunity Costs

1. Remember the value of time is a key component

Interest Rate

1. Rental price for purchasing power/money 2. Penalty to borrowers for consuming before earning 3. Reward to savers for postponing consumption 4. Expressed in terms of annual rates

Truth in Lending Act 1968

1. Requires lenders to provide borrowers with the APR when they apply for a loan

Fed's 3 Tools of Monetary Policy

1. Reserve Requirements 2. Discount Rate 3. Open Market Operations, in practice, this is the primary tool

Interest Rate Risk 2

1. Risk associated with fluctuations in the price of securities or investment income caused by fluctuations in market interest rates 2. Savings and Loan Crisis, interest rates very volatile, many S&L failed as short term market interest rates paid on deposits rose faster than long term interest rates earned on mortgage portfolios

Political Risk 2

1. Risk of gov't or regulatory action harmful to interests of financial institution 2. Significant political risk currently in Europe

Operational/Legal Risk

1. Risk of operational/oversight failure and legal consequences

ECB's QE Program Risk Sharing Details 3

1. Risk sharing for debt issued by European institutions 2. Limited ris/loss sharing for sovereign debt 3. Euro fell 1% against USD, eurozone bonds, US stocks up

Liquidity Risk

1. Risk that a financial institution may be unable to pay required cash outflows, even if profitable

Direct Financing 2

1. SSU and DSU directly interact 2. SSU transfers funds directly, DSU issues claims (stock, bonds) directly

Financial Claims with SSUs and DSUs 3

1. SSU provides cash that is spent by DSU now 2. DSU provides some form of IOU 3. IOU becomes SSUs financial claim

Sources of Transaction Costs

1. Search costs, getting in touch with SSU, time and hassle 2. Contract/legal costs 3. Due Diligence/Evaluation Costs

Regulatory Powers of the Fed

1. Securities Credit Regulation, establishes borrowing margin limits for buyers of securities on margin 2. Regulation of the Payment System 3. Truth in Lending Act: regulates disclosure of interest rates on consumer credit offered by banks, savings institutions 4. Control of International Banking Activities 5. Bank Regulation

Investment Funds 3

1. Sell "shares" to investors and use funds to purchase direct financial claims 2. Mutual Funds, Money Market Mutual Funds, Exchange Traded Funds

Selling Gov't Securities 2

1. Sell any asset to private security dealers or banks 2. Bank pays Fed which reduces levels of reserves, contract MS

Glass Steagall Act 1933

1. Separated investment banking from commercial banking, gradually weakened especially in the early 2000s

Fed Chairman 4

1. Sets agenda and chairs meeting of both Board of Governors and FOMC 2. Public face and voice of the Fed 3. Many FOMC votes are unanimous but sometimes members break with the chairman to disagree on policy 4. Split votes more common when chairman is expected to step down, posturing position as next chairman

Ownership of the Fed

1. Several thousand member commercial banks "own" the Federal Reserve Banks 2. Member banks represent "dual banking" 3. All National banks must be members of the Fed 4. About 17% of state banks choose to join 5. Some 36% of all US banks are in, representing about 76% of deposits

3 Aspect of Unconventional Policy 3

1. Short term rates should be cut aggressively when deflation or a severe downturn threatens 2. Short term rates should be kept lower for longer as economy recovers (Signaling channel) 3. Central bank large-scale asset purchases of longer term securities can complement conventional policy actions

Frictional Unemployment

1. Some acceptable unemployment related to appropriately matching works with firms

Allocation of Scarce Resources 2

1. Some economic units (households, firms) have excess financial resources 2. Other economic units wish to utilize these resources

Problems with National Banking Acts

1. State banks continued to operate because of demand deposits (checking accounts) 2. Demand deposit weren't insured, risk of failure if bank did not have adequate reserves 3. Pyramiding of reserves, banks could count deposits at other banks as reserves 4. Most banks loans "call loans", lots of bank panics ensued

Financial Markets 3

1. Stock Markets 2. Bond Markets 3. Foreign Exchange Markets

Monetary Control Act of 1980 2

1. Subjects all US depository institutions to uniform reserve requirements 2. Sets limits within which Fed is to specify required reserve ratio

Financial Crisis 5

1. Substantial disruption in the financial system and the functioning of financial intermediaries 2. Includes deterioration of banks' and other FIs' balance sheets 3. Significant asset prices declines (stock market, real estate) 4. Numerous bank failures and/or failures of other FI 5. Less provision of credit, economic recession, more uncertainty

AIG Bailout

1. Suffered liquidity crisis after credit downgrade 2. Accepted Fed loan to stay afloat

Monetary Base 2

1. Sum of Currency and Total Reserves in the banking system 2. MB = C + TR

Households

1. Supply labor, demand products, save for future

Effects of Debt

1. Surprise deflation increases firms' real liabilities, does not increase value of assets 2. Real net worth of firm falls 3. Firms are seen as greater credit risks 4. Drop in lending and economic activity

Commercial Banks 2

1. Take deposits and make loans 2. Depositors are SSUs, Borrowers are DSUs

Government Policy 2

1. Tax rates influence consumer wealth and willingness to lend 2. Fiscal policy (expansion creates demand for capital)

Financial Crisis Examples 5

1. The Great Depression 1929-late 1930s 2. The Great Recession 2008-? 3. Japan's lost decade beginning in early 1990s 4. Mexico and East Asia in the 1990s 5. Recent European debt crisis

Are implicit tradeoffs between the two primary goals of monetary policy?

1. The Phillips curve from macro suggest that there is a tradeoff

Phillips Curve

1. The lower the rate of inflation, the lower the levels of unemployment 2. There is a tradeoff between these two variables 3. Curve shifts when inflation is expected, or there are supply costs/shocks 4. Short run Phillips curve only valid if inflation stays constant

Natural Rate of Unemployment

1. Theoretical target for policy

Financial Claim 3

1. This is an asset to the SSU, liability to the DSU 2. What is payable by one is receivable by other 3. Known as financial assets, total financial assets = total liabilities

Mitigating Problems

1. To address adverse selection problems, commercial banks must rely on sophisticated mathematical models of credit risk

Financial Intermediaries 4

1. Transform claims by raising funds to issue claims to SSUs 2. Use funds to buy claims issued by DSUs 3. SSU has claim against FI, FI -> DSU 4. FIs exist because they reduce transaction cost, exploit economies of scale, invest in expertise

$700 billion

1. US Treasury to purchase or insure up to $700 billion of troubled assets 2. Meant for residential or commercial mortgages and any securities 3. Purchase of troubled assets to promote financial market stability

The Fisher Effect

1. Unanticipated inflation benefits borrowers at expense of lenders 2. Lenders charge added interest to offset anticipated decreases in purchasing power

Facilities Risk Sharing 3

1. Uncertainty is a fact of life for households and firms 2. "Risk Aversion" is the desire to share and/or trade risks 3. Example: insurance industry

Commercial/Investment Banks and Housing Market Risk 3

1. Underwrote MBOs, CDOs and had little interest in ensuring holders of these securities would be paid 2. Underwrote many credit default swaps, insurance contracts providing payoff to holder in event of default 3. Held chunks of these contracts on books, big exposure to housing sector

Life Without Central Bank 7

1. Unstable money supply 2. No standard currency, mostly private banknotes 3. Hard currency (gold/silver) hoarded, unevenly distributed 4. No coordinated payments system 5. Frequent bank failures 6. Disruptions of business credit from bank failures prolonged and intensified economic downturns 7. Exaggerated business cycle, boom and bust

TARP Evolution

1. Use remaining funds for Public Private Investment Program 2. Involves pooling public money with private money to fund purchases of mortgages and MBSs

Fed Funds Targeting

1. Used to focus directly on managing MS 2. Now, Fed targets interest rates, especially the "Fed Funds Rate"

Did QE work? 5

1. We don't know what the results would have been if we didn't do QE 2. Look at interest rate and asset price 3. Theory predicts QE pushes down long term yields 4. QE increases asset values of stock prices, real estate, and corporate bonds 5. QE predicts higher asset values to help spur consumer spending

Discount Rate and Monetary Supply 3

1. When Fed lends at discount window, MS increases 2. Bank borrows $5 mil, MS increases 3. Indirect channel: decreases in discount rates incentivize greater risk taking (lending) by banks "on the margin"

Secondary Markets 4

1. Where financial claims live 2. Financial claims are resold, prices adjust her time 3. Claims become more liquid since SSUs can set their own holding periods 4. SSUs more willing to accept financial claims in the first place

Bank Regulation of the Fed

1.Regulation of Bank Holding Companies 2. BHC is the dominant commercial bank organizational structure 3. Supervision and Examination of State Member Banks

Fed's QE Timeline

Quantitative Easing, Slide 8