Econ 3371 Exam 2 (Ch 6, 14)

According to the expectations theory of the term structure

interest rates on bonds of different maturities move together over time.

When banks borrow money from the Federal Reserve, these funds are called

discount loans.

According to the segmented markets theory of the term structure

interest rates on bonds of different maturities do not move together over time.

Three players in the money supply process

1. Central Bank 2. Banks 3. Depositors

default risk

the likelihood the issuer of a bond will be unable to pay interest or principle on the bond.

If a bank has excess reserves of $10,000 and demand deposit liabilities of $80,000, and if the reserve requirement is 20 percent, then the bank has total reserves of

$26,000.

Describe how each of the following can affect the money supply: (a) the central bank; (b) banks; and (c) depositors.

(a) The central bank can affect the money supply through open market operations, which changes the nonborrowed monetary base. It can also affect the monetary base, and hence money supply by issuing loans to financial institutions, which increases borrowed reserves. Finally, the central bank can change reserve requirements, which affects the money multiplier, and hence the money supply for a given monetary base. (b) Banks can affect the money supply through their holdings of excess reserves; less excess reserves means more loans, and hence a greater money supply. (c) Depositors can influence the money supply through their holdings of currency versus deposits. A higher currency-deposit ratio leads to a lower money multiplier, and hence a lower money supply for a given monetary base.

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the plot the resulting yield curves for the following paths of one-year interest rates over the next five years: a) 5%, 6%, 7%, 6%, 5%; b) 5%, 4%, 3%, 4%, 5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

(a) The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for a three-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond. (b) The yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond. 4.33% for a three-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond. The upward sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds, because long-term bonds would then have a positive liquidity premium. The downward-sloping yield curve in (b) would be less steep and might have a slight positive upward slope if the long-term bonds have a positive liquidity premium.

If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds; and (b) the segmented markets theory of the term structure holds.

(a) Under the expectations theory of the term structure, if 30-year bonds become less desirable, this will increase the demand for bonds of other maturities, since they are viewed as perfect substitutes. The result is a higher price and a lower yield at all other maturities, and an increase in yield at the end of the yield curve. In other words, the yield curve would steepen at the end, and flatten somewhat along the rest of the curve. (b) Under the segmented markets theory, the assumption is that each type of bond maturity is an independent market, and therefore not linked in any particular way. Thus changes in long rates won't affect shorter- and medium-term bond yields. Thus, the yield curve under the segmented markets theory will result in a jump in the 30-year rate, with the remainder of the yield curve unchanged.

Factors that Determine the Money Supply

-Changes in the Nonborrowed Monetary Base, MBn . The Nonborrowed Monetary Base arises totally from the Fed's control and is primarily due to Open Market Operations. -Changes in Borrowed Reserves, BR, from the Fed -Changes in the Required Reserve Ratio, rr -Changes in Excess Reserves Changes in Currency Holdings

If reserves in the banking system increase by $100, then checkable deposits will increase by $500 in the simple model of deposit creation when the required reserve ratio is

.20

A simple deposit multiplier equal to two implies a required reserve ratio equal to

50 percent. (1/.5=2)

What effect might a financial panic have on the money multiplier and the money supply? Why?

A financial panic would probably decrease the money multiplier and the money supply, for a given monetary base. In a financial panic, you would expect banks to want to make less risky loans, and have more liquidity on hand, which would increase the excess reserve ratio and decrease the money multiplier. In addition, depositors may get worried about the health of banks, and increase their holdings of currency, which also would decrease the money multiplier.

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek debt.

As the risk of default by the Greek government increased, this reduced the demand for Greek bonds relative to U.S. treasuries. The result was lower prices and higher yields of Greek debt relative to U.S. debt, similar to the graphs in Figure 2 shown in the text.

________ create money and make loans only from excess reserves in a fractional reserve banking system.

Banks

During the Great Depression years from 1930-1933, both the currency ratio c and the excess reserves ratio e rose dramatically. What effect did these factors have on the money multiplier?

Both of these factors worked to reduce the money multiplier. This can be seen in Figure 3 in the chapter, which indicates a dramatically declining money supply, while the monetary base grew modestly, if at all.

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

C rating because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond.

Prior to 2008, mortgage lenders required a house inspection to assess a home's value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre-2008 scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

Credit rating agencies had a conflict of interest that was said to contribute to the crisis in that the rating agencies had an incentive to provide overly optimistic ratings to clients whom they also advised. Similarly, the way in which lenders and the house inspection process occurred provided incentives for the house inspectors to provide overly optimistic assessments of the value of housing to ensure continued work in the future, and at the same time mortgage lenders benefitted because it continued the cycle of creating and selling mortgages as long as housing value was maintained.

Monetary base= ____________ + ___________

Currency in circulation + bank reserves

Liabilities

especially monetary liabilities

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Conversely, during recessions default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

"The Fed can perfectly control the amount of reserves in the system." Is this statement true, false, or uncertain? Explain.

False. Even though it can control the monetary base fairly precisely through open market operations, it has much less control over the amount of bank reserves in the system because banks decide how much to borrow from the fed, while the public decides how much currency it wants to hold relative to deposits, both of which affect the amount of bank reserves. In addition, float and Treasury deposits can unexpectedly change the amount of reserves in the banking system, which is essentially out of the control of the Fed.

"The Fed can perfectly control the amount of the monetary base, but has less control over the composition of the monetary base." Is this statement true, false, or uncertain? Explain.

False. Since the Fed cannot control the amount of discount lending to financial institutions, it does not have perfect control over the amount of reserves, and hence does not have perfect control over the monetary base.

assets

especially securities and loans to financial institutions

"According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?

False. The expectations theory of the term structure implies that, with a $1 investment in one-period bonds over two years, the expected return is given as which equals 2it assuming that one-period bond rates are expected to be the same across both periods. With a $1 investment in a two-period bond, the expected return is Thus, only if the (expected) one-period bond rate for both periods is greater than the expected two-period bond rate will one-period bonds be a better investment.

Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

If the Federal Reserve purchases a significant amount of longer-term treasury debt, this will reduce the effective supply of treasuries of those particular maturities, resulting in a higher price and lower yield. This should have the effect of lowering the "long end" of the curve, decreasing medium and longer-term yields. In other words, the yield curve will shift down, but mostly on medium and long-term maturities.

If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?

If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the expectations hypothesis.

Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%, 6%, and 6%, respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A and B?

Investor A, even though she receives a lower expected return, clearly prefers to hold short-term debt, perhaps because it is more liquid. Investor A's preferences are consistent with the segmented markets theory. Investor B is apparently maximizing expected return, but since he is indifferent between the five- and ten-year bonds, Investor B doesn't appear to favor any particular maturity, and so views the five- and ten-year bonds as essentially perfect substitutes, an assumption consistent with the expectations theory of the term structure.

Predict what will happen to the risk premiums on corporate bonds if brokerage commissions are lowered in the corporate bond market

Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium

In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held by banks. How, if at all, might this affect the multiplier process and the money supply?

Paying interest on reserves gives banks incentive to hold more reserves rather than lend them out, which should raise the excess reserve ratio, reduce the money multiplier, and reduce the money supply, holding the monetary base constant.

The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds?

Since TIPS bonds are traded much more lightly than their nominal counterparts, demand for these bonds is somewhat lower than comparable U.S. treasuries; hence the higher yield (controlling for the effects of inflation) represents a liquidity premium. Note that because this liquidity effect is relatively small, inflation compensation will generally be larger than the liquidity premium, implying that nominal bond yields overall will be higher than TIPS of comparable maturity.

The money multiplier declined significantly during the period 1930-1933 and also during the recent financial crisis of 2008-2010. Yet the M1 money supply decreased by 25% in the Depression period but increased by more than 20% during the recent financial crisis. What explains the difference in outcomes?

The difference is that the monetary base increased dramatically during the recent financial crisis, which was more than enough to offset the fall in the multiplier. During the Great Depression, the monetary base rose modestly, if at all.

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future?

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. What explains this sudden increase?

The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system, and doubt about the soundness of even the most healthy banks and financial companies. As a result, there was a sharp decrease in demand for financial commercial paper relative to the seemingly safer nonfinancial commercial paper. This resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investments

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?

The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher yield. After the announcement that the government would provide extraordinary assistance to support AIG and keep it from failing, demand for its corporate debt would rise, and its yields would fall.

If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected future short rates falls so that the long rate falls.

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future?

The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium or preferred habitat theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates are expected to fall far into the future. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: a) 5%, 6%, 7%, 6%, 5%; b) 5%, 4%, 3%, 4%, 5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

The yield to maturity would be 5% for a one-year bond, 5.5% for a two-year bond, 6% for a three-year bond, 6% for a four-year bond, and 5.8% for a five-year bond; (b) the yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4% for a three-year bond, 4% for a four-year bond, and 4.2% for a five-year bond. The upward- and then downward-sloping yield curve in (a) would tend to be even more upward sloping if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward- and then upward-sloping yield curve in (b) also would tend to be more upward sloping because of the positive risk premium for long-term bonds.

"If bonds of different maturities are close substitutes, their interest rates are more likely to move together." Is this statement true, false, or uncertain? Explain your answer

True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.

Why do U.S. Treasury Bills have lower interest rates than large-denomination negotiable bank CDs?

U.S. Treasury bills have a lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.

If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

You would raise your predictions of future interest rates, because the higher long-term rates imply that the average of the expected future short-term rates is higher.

A key assumption in the segmented markets theory is that bonds of different maturities

are not substitutes at all.

Bank Reserves=

deposits by banks at FED + Vault Cash

Shifts from Deposits into Currency affect...

bank reserves, not the monetary base

According to the liquidity premium theory, a yield curve that is flat means that

bond purchases expect interest rates to fall mildly in the future.

SIMPLE DEPOSIT EXPANSION MULTIPLIER FORMULA

change in Deposits = change in Reserves * 1/r

If the yield curve has a mild upward slope, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting

constant short-term interest rates in the near future and further out in the future.

Both ________ and ________ are monetary liabilities of the Fed.

currency in circulation; reserves

Everything else held constant, an increase in the excess reserves ratio causes the M1 money multiplier to ________ and the money supply to ___________.

decrease; decrease

Decisions by ________ about their holdings of currency and by ________ about their holdings of excess reserves affect the money supply.

depositors; banks

The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to

fall sharply in the near-term and rise later on.

A decrease in ________ leads to an equal ________ in the monetary base in the short run.

float; decrease

another word for the monetary base

high powered money

When the Fed buys $100 worth of bonds from a primary dealer, reserves in the banking system

increase by $100

Assuming initially that the required reserve ratio = 10%, the currency-deposit ratio = 40%, and the excess reserve ratio = 0, a decrease in the required reserve ratio to 5% causes the M1 money multiplier to __________, everything else held constant.

increase from 2.8 to 3.11 (1 + c)/ (r + c + e)

A(n) _________ in the riskiness of corporate bonds will _________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

increase; decrease; increase

If the Fed injects reserves into the banking system and they are held as excess reserves, then the monetary base ________ and the money supply ________.

increases; remains unchanged

Everything else held constant, an increase in marginal tax rates would likely have the effect of _______ the demand for municipal bonds, and _______ the demand for U.S. government bonds.

increasing; decreasing

depositors

individuals and institutions that hold deposits in banks also hedge funds

banks (all depository institutions)

large banks with primary dealers =bigger player than small banks

the Fed's balance sheet has

liabilities and assets

Purchases and sales of government securities by the Federal Reserve are called

open market operations.

A bond with default risk will always have a _________ risk premium and an increase in its default risk will ________ the risk premium.

positive; raise

Reserves are equal to the sum of

required reserves and excess reserves.

three tools of monetary policy

reserve requirement, discount rate, open market operations

High-powered money minus currency in circulation equals

reserves. (M1=CC+R)

An increase in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the ________.

right; left

Both ________ and ________ are Federal Reserve assets.

securities; loans to financial institutions

A ________ yield curve predicts a future increase in inflation.

steeply upward sloping

______ has better control over the monetary base than bank reserves

the Fed

Of the three players in the money supply process, most observers agree that the most important player is

the Federal Reserve System.

In the model of the money supply process, the bank's role in influencing the money supply process is represented by

the excess reserve.

When the default risk increases on a bond,

the expected return decreases, ceteris paribus.

reserve ratio

the fraction of deposits that banks hold as reserves

The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates

the liquidity premium (or preferred habitat) theory.

Everything else held constant, an increase in currency holdings will cause

the money supply to fall.

central bank

the most important player

During a "flight to quality"

the spread between Treasury bonds and Baa bonds increases.

Reserves are an asset for the bank because...

they are funds available to the bank

If junk bonds are "junk," then why do investors buy them?

they are very risky investments, but provide high yields to investors who buy them at very low prices and are therefore compensated with a high risk premium

Loans are an asset for the bank because...

they represent the banks' claims on its borrowers

Deposits are liabilities to the bank because...

they represent the depositors' claims on the bank

reserve ratio = total...

total reserves as a percentage of total deposits

Banks are not creating ______, but creating _______

wealth; debt