Econ 411 Chapter 13, 15, 16, & 18

Requiring "Skin in the Game"

- "Skin in the Game" would require financial institutions to hold some the risky securities they create, creating a disincentive to crate risky securities- Buyers of subprime MBS were unaware of the riskiness of these securities

Policy Rule

- A ______ ____ such as a law requiring the Fed to produce π(ideal) eliminates the time-consistency problem, and people expect π(ideal) - A policy rule forces central bankers to behave conservatively, even if they are not conservative

Lender of the Last Resort

- A central bank can serve as this, making emergency loans to institutions to avoid fire sales of illiquid assets - The Fed was created in 1913 primarily to serve as this, but it did not lend enough to stop the panics of the 1930s; it has learned from this mistake, acting quickly during recent crises -Deposit insurance helps prevent bank runs, but these are still needed - Money center banks raise funds primarily by borrowing that disappears quickly if lenders lose confidence - The Fed lends to banks through discount loans if the bank is solvent and can post sufficient collateral - Fed loans are available to banks; institutions that accept deposits and make loans - At times the Fed has stretched its role: 1. After 9/11, the Fed lent to banks that in turn lent to securities firms facing liquidity crises 2. The Fed lent directly to securities firms during the 2007-2009 crisis

Changing Regulatory Structure

- A combination of federal and state agencies regulate commercial banks - The federal agencies are the OCC, the FDIC and the Fed- The SEC regulates investment banks, but is interested in preventing illegal activities in securities markets, not preventing insolvency - The Dodd-Frank Act creates the Financial Services Oversight Committee (FSOC) to monitor the entire financial system for threats to stability - The Fed regulates financial holding companies, but has largely reviewed mergers and acquisitions, as other agencies regulate the components of FHC - In the future the Fed may monitor risky activities of all parts of FHC

Evidence on Independence and Inflation

- Academic researchers constructed indexes of central bank independence and found that the countries with the most independent central banks had the lowest average inflation rates :- But correlation is not causation; there may be a third factor- Germans hate inflation and this may be the reason their central bank kept inflation low, and the government supported this policy by making the central bank independent - Most governments have become convinced that independence does reduce inflation, which is a reason for the trend toward independence since 1989

The Fed's History of Secrecy

- Before 1994 the FOMC did not release any information, not even its interest-rate targets - A "Policy Record" of each meeting was released only following the subsequent meeting - The Fed at times had to make unpopular decisions, so a lack of transparency may have reduced political criticism

Independence Around the World

- Before the 1990s most central banks were less independent than the Fed, but Germany and Switzerland did have highly independent central banks - In 1989 New Zealand made its central bank one of the most independent, changing it from one of the least independent. Other countries followed, including the United Kingdom, Japan, and many Latin American countries - Today U.S. style independence is the norm- The European Central Bank (ECB) is highly independent as it does not depend on legislation from any one country - The Bank of China's major decisions must be approved by the State Council, a part of the government, so it is not independent

Independence and Time Consistency

- Conservatism helps escape the time-consistency problem since less-conservative politicians would adopt policies resulting in higher inflation without any gain in output - Policymakers have longer time horizons than politicians, giving them a better chance of overcoming the time-consistency problem - The Fed has acquired a reputation for keep inflation low for nearly three decades that is not tied to any one person

Opposition to Inflation Targeting

- Critics feel the Fed should stabilize both output and inflation and not focus primarily on inflation - Advocates of inflation targeting counter with two arguments: 1.Inflation targeting stabilizes output- From the Phillips curve, and change in inflation changes output, so targeting stabilizes both 2. Inflation targeting is flexible and allows temporary deviations to stabilize output -Critics still feel inflation targeting deemphasizes output stability - The recent crisis demonstrates the benefit of not targeting, as the Fed's inflation forecast didn't change and it may not have acted as aggressively if it had an explicit inflation target

Opposition to Independence

- Critics of independence argue that elected officials should control economic policy - Some critics believe the Fed's priorities are those of financial interests and not ordinary citizens; focusing too much on inflation and too little on maximum employment - Legislation has been proposed to reduce the Fed's independence, including adding the secretary of the treasury to the FOMC - Political criticism of the Fed increased due to the 2007-2009 financial crisis - As a result, the Government Accountability Office (GAO) will conduct a one-time audit of the Fed's lending during the crisis, although Congress proposed an annual audit that the Fed opposed - Anger with the Fed also led to 30 votes opposing Bernanke's reappointment as chair in 2009, the most opposing votes ever for a Fed chair. The battles over GAO oversight and Bernanke's reappointment may have weakened the Fed

Discouraging Excessive Risk Taking

- Excessive risk taking, the key cause of financial crises, may be limited by a variety of proposals: 1. Requiring "Skin in the Game" 2. Reforming Ratings Agencies 3. Reforming Executive Compensation

Responses to Financial Crises

- Financial crises, typically involving crashes in asset prices and failures of financial institutions, cause central bankers to lower rates by more than the Taylor rule prescribes - The Fed lowered the real federal funds rate below the Taylor rule-prescribed rate in response to the 1998 crisis that developed when Russia defaulted on its debt, leading to the near failure of the hedge fund Long Term Capital Management

Money Targets

- From the 1960s through the 1980s the leading proposal for a rule was Friedman's constant-rate-of-growth rule - Rather than targeting interest rates as is now practiced, monetarists proposed that central banks target the money supply and let markets determine the interest rate - A low rate of money growth would keep inflation low - The monetarist rule does not "lean against the wind". With unstable money demand, money targets destabilize output, so money targets have lost support, except for the ECB which still announces a target for money growth

Pro of Giveaways

- Giveaways attempt to prevent the problems of an insolvent institution from spreading, since defaults on debts create losses in other institutions

Cons of Giveaways

- Giveaways have two costs: the direct costs of payments and increased moral hazard 1. Taxpayers bear the direct costs of a give away 2. Frequent bailouts increase moral hazard and the losses fall largely on the taxpayers

Financial Rescues

- Governments and central banks use expansionary monetary and fiscal policies to try to break the vicious circle of falling aggregate expenditure and financial system problems - Policymakers use a range of other actions dealing with financial system problems - These policies involve using government or central bank funds to provide bailouts, ranging from giving away money to loans or asset purchases that can be costless or even profitable

Fed moving towards transparency

- In 1993 the Fed began releasing minutes 6 weeks after each meeting,and in 2004 reduced the delay to 3 weeks - The FOMC began announcing its interest rate targets in 1994, and later added statements about possible future decisions - Since 1979 the Fed has issued semiannual projections of future output, unemployment, and inflation, and began issuing quarterly projections in 2007 - Alan Greenspan never granted press interviews, but Bernanke has granted two televised interviews to help build political support for the Fed, as the financial crisis created considerable controversy about Fed actions and policies - Beginning in April 2011, Chairman Bernanke began holding press conferences following FOMC meetings - The Fed remains less transparent than many central banks

.Liquidity Crises

- In a bank run, solvent banks may lack enough liquid assets to meet depositors' demands, forcing sales of assets at fire-sale prices and resulting in losses that can cause insolvency - Hedge funds and investment banks that raise funds by borrowing experience liquidity crises when creditors lose confidence and stop lending, forcing a fire sale of assets, resulting in insolvency - Crises can spread to other financial institutions as depositors and creditors, seeing the failure of other institutions, lose confidence in the institution they deal with, spreading a crisis throughout the economy

Smaller Responses to Output Gaps

- Inflation is measured more accurately than potential output - Some economists feel a smaller response to output gaps would have avoided the mistake of the 1970s - Other economists feel that failure to respond to output gaps would allow recessions to linger - Most central banks have not deemphasized output gaps

Deviations from the Taylor Rule

- Interest rates may deviate from the Taylor rule prescription, for example, due to a zero lower bound - Central banks choose to deviate from the Taylor rule in response to asset price declines or financial institution failures by lowering rates - Some economists favor raising rates to stop asset price bubbles, but this idea is controversial

Addressing Too Big to Fail

- Large institutions are extensively interconnected and their failure could trigger other insolvencies, which is why they are rescued - Preventing institutions from becoming too large or interconnected can be addressed in different ways: 1. Restrictions on asset size 2. Restrictions on scope

Giveaways of Government Funds

- Lending to a solvent institution in a liquidity crisis prevents failure,and the loans are repaid with interest, so there is no cost to the central bank or the government (and taxpayers) - Insolvency may be the result of factors other than a liquidity crisis,normally resulting in failure - Governments or central banks give money away: - Policymakers may seek to restore solvency and keep the institution in business - They may allow failure and compensate others for losses due to the failure

Well-intentioned Mistakes

- Mistakes about the natural rate of unemployment or the effects of interest rates on spending could cause efforts to stabilize the economy to backfire and destabilize it - Apparent overreactions to movements in output and inflation in the 1970s appeared to destabilize the economy, building support for a monetary rule

Central Bank Independence

- Monetary policy is made, not by elected officials, but by central bankers who are appointed and not accountable to voters -Fiscal policy is made by Congress and the President, who voters can dismiss if they dislike the policies - The Federal Reserve is an independent central bank - The current consensus is that central banks should be independent

Adjusting Interest Rates

- Most central banks use interest rates as their policy instruments, so they are interest-rate targeters and inflation targeters - Because of time lags, inflation targeting requires forecasting inflation - Hypothetically, assume a supply shock increases inflation in Laurencia: If interest rates are held constant, inflation will stay above the target value - Adjusting interest rates will push inflation back toward the target; initially a rate increase is needed

Risky Rescues

- Policymakers face a difficult choice: - Financial institution failures can damage the financial system and the economy - Preventing failures can be costly to taxpayers and creates moral hazard

Reputation

- Policymakers' desire to maintain a reputation as a conservative also solves the time-consistency problem - A performance record of low inflation earns a reputation as a conservative and people expect low inflation - An inflation-surprise decision harms a central banker's conservative reputation, which deters an inflation-surprise decision, solving the time-consistency problem - A long term in office encourages central bankers to develop long time horizons, making them care more about their reputations

Making Interest-Rate Policy

- The FOMC meets every six weeks to set the target federal funds rate- Since GDP is measured with a long lag, Fed economists estimate current output - Estimates of GDP are provided before each meeting in the "Green Book" - The "Beige Book" provides reports on economic activity in each Federal Reserve district

Coping with uncertainty

- The Fed employs about 500 economists to study the economy - It has a complex statistical model (FRB/US model or Furbus) similar to the AE/PC model that it uses to understand economic behavior - Research reduces but does not eliminate uncertainty, so the Fed moves cautiously - Interest-rate smoothing is a central banks practice of moving interest rates through a series of small changes - The Fed typically adjusts its target rate by 1/4 percent, which slows the adjustment to equilibrium; but many economists feel this guards against over adjustment - During financial crises, interest rate changes can be much larger

The Case for Inflation Targeting

- The Federal Reserve has not adopted an explicit inflation target - Bernanke has advocated inflation targeting and he and Frederic Mishkin coined the phrase "constrained discretion" - The 2007-2009 financial crisis has diverted attention away from inflation targeting - The Fed appears to have an implicit inflation target of 1-2 percent with results similar to explicit inflation targeting countries - Some economists feel the lack of an explicit target hasn't affected the choice of interest rates, and the result has been low and stable inflation - Advocates of inflation targeting argue that the policy reduces the dangers of discretionary policy and anchors inflationary expectations

Forecasts and Policy Options

- The Green Book also contains forecasts for a number of macroeconomic measures based on the "judgment" of the economists responsible for each forecast - If movements in output and inflation can be forecast, interest rates can be adjusted in advance, reducing the problem of policy lags - The "Blue Book" reviews financial market events since the last meeting, discusses three possible policy options, and proposes language that will accompany the interest-rate announcement

The Independent Federal Reserve

- The U.S. constitution gives Congress the power to create money, a power it delegated when it established the Fed in 1914- The U.S. government has an informal tradition of treating the Fed as independent and nonpolitical - Traditionally Fed chairs serve for a long time even though Presidents can replace the chair every four years - The Fed is financially independent from Congress as it earns income from its asset holdings and returns the surplus to the Treasury - The Fed's annual earnings total billions of dollars, most of which is returned to the Treasury - The Fed chair testifies before Congressional committees twice a year, but under current law Congress cannot force the Fed to change policies

Lehman Brothers

- The bankruptcy of this investment bank on September 15, 2008 was the key blow to the financial system -This institution also suffered large losses on subprime MBS - The Fed tried to arrange a takeover by Barclay's but British regulators of the U.K. bank objected -Ben Bernanke and Treasury Secretary Paulson claimed that they did not have the legal authority to lend to this institution - Their critics claimed they underestimated the harm of this institution's failure and should have done something

Vicious Circle of Financial Crises

- The recession may further reduce asset prices due to lower profits and lower demand for houses - The recession can worsen problems of financial institutions - Both of these feedbacks can trigger a vicious cycle of falling output and worsening financial problems - A crisis may sustain itself for a long time

The Federal Open Market Committee (FOMC) Meeting

- The voting membership FOMC is comprised of the 7 Fed governors and 5 of the 12 Fed bank presidents, but the other 7 presidents attend the meetings and join the discussions - After the discussions the Chair proposes an interest rate target - A chair's proposal has never been defeated, and it is rare to have more than one or two dissenting votes - Following the interest-rate vote, the committee may discuss longer-term issues such as adopting an explicit inflation target or ways to increases spending in a liquidity trap

Inflation Targets

- Today many central bankers practice explicit inflation targeting - Explicit targets were introduced in New Zealand in 1989 and Canada in 1990 - Inflation targeting is a goal of monetary policy that may not be achieved perfectly; money and interest rate targets are policy instruments, which the central bank controls precisely - Inflation fluctuates around the target, so some countries have a target range - Inflation targeting is forward looking

Policy Mistakes

- Unlike the AE-PC model, the true behavior of the economy is not known precisely - Mis-estimates about the behavior of the economy lead to policy mistakes - Well-intentioned policies can backfire - One type of mistake to make involves the slopes of the AE and PC curves - When output changes it is difficult to determine how much is due to interest rates (moving along the curve) and how much is due to expenditure shocks (shifts of the AE curve) - The slope of AE curve may change over time

Monitoring the Policy

- When inflation targeting begins central banks publish more information about their policies - A typical practice is for the central bank to publish an inflation report every three months, including forecasts of inflation and the interest rates needed to attain the target - In some countries central banks provide formal explanations if inflation deviates significantly from the target

Regulating Nonbank Financial Institutions

- While banks are heavily regulated, investment banks, hedge funds and insurance companies are not and thus engage in riskier behavior - Banks are regulated because of deposit insurance the government must pay depositors if banks fail and regulation reduces risky behavior - Lenders have incentives to monitor nonbank institutions but the recent crisis showed that lenders had not effectively monitored the nonbank institutions, and the government rescued them even thought it had no obligation to do so - Nonbank financial institutions may face higher capital requirements, restrictions on assets and more supervision in the future in an attempt to avoid similar crises - Opponents of increased regulation argue that regulation inhibits financial innovation 1. Junk bonds and securitization of most assets are financial innovations that proved beneficial, while securitized subprime mortgages failed, so it is difficult to identify successful from potentially harmful innovation 2. Regulation should prohibit excessive risks while allowing innovation, a very difficult task - If a regulatory agency had resolution authority to take over failing nonbank financial institutions, the process would be orderly and potentially avoid panic

Conservative Policymaker

- a central bank official who believes it is more important to keep inflation low than to stimulate output -They believe the costs of inflation outweigh the benefits of higher output, and thus don't raise inflation - They reduce the time-inconsistency problem because people believe that inflation will stay at π(ideal) and thus expect π(ideal)

Taylor Rule

- a formula for adjusting the interest rate to stabilize the economy -The equation captures the idea of leaning against the wind ***STUDY EQUATION AND FACTORS - The Fed deviated from the rule starting in the fall of 2007 in response to the financial crisis - The FOMC does not consciously follow the rule - The FOMC's decisions produce interest rates close to the rates implied by the rule - guides monetary policy to lean against the wind, stabilizing output and inflation - The choice of the response coefficients, a(y) and a(π), determines how strongly policy responds to shocks, and different coefficients have different short-run effects on the economy

Financial Crisis

- a major disruption of the financial system, typically involving crashes in asset prices and failures of financial institutions -the response of the central bank is the key to controlling these -Most of these involve asset-price crashes, failures of financial institutions, or both - Asset-price crashes are sudden large drops in asset prices, such as stock or real estate - Crashes may follow a bubble driven by self-fulfilling expectations, then sentiment shifts and prices fall, often causing a vicious cycle of selling and panic

Monetary Policy Rule

- a simple rule or formula that tells the central bank how to run policy. - Milton Friedman advocated that the money supply grow by a constant percentage rate each year - Another rule might dictate that money grow at a rate determined by some formula - A rule could specify the setting of an interest rate: A rule can be adopted by the central bank or imposed through legislation - Taylor's rule has blurred the distinction between rules and discretion,since this rule "explains" the Fed's discretionary policy - The Fed does not consciously follow the rule and deviates significantly from the Taylor rule interest rate at times

Dodd-Frank Act (The Wall Street Reform and Consumer Protection Act, 2010)

- enacts new regulations that contain some of the ideas below - Four categories for reform: 1. Increased regulation of nonbank institutions 2. Avoiding the too big to fail problem 3. Discourage excessive risk taking 4. New structures for regulatory agencies

Supporters of using policy to stop bubbles

- note that asset-price crashes can cause or contribute to a recession, so raising interest rates to stop a bubble may avoid a crash, and policy may be unable to stop a recession after a crash due to lags

Rational Expectations

- the best possible forecasts based on all information -Undermine the inflation problem of adaptive expectations, because disinflation is costless if people expect the central bank to reduce inflation -An announcement by policymakers that inflation will be reduced shifts the Phillips curve down with a zero output gap if inflationary expectations are rational

Transparency

- the provision to the public of clear and detailed information about policy making - In the past two decades central banks have become more transparent, accompanying movements toward independence and inflation targeting - Central banks issue publications that give the rationale for recent decisions and likely future policies - Some central banks publish economic forecasts - Some central banks publish minutes of meetings at which interest rates are set - Some central banks hold press conferences to explain their actions and answer questions

Primary Dealer Credit Facility (PDCF)

-Created by the Fed in March 2008, expanding its role of lender of last resort. This Facility offered loans to primary dealers of government securities -Primary dealers include investment banks and the largest commercial banks, so investment banks were now eligible for emergency Fed loans

Firm Financing

-Firms can finance investment with profits or by borrowing -Higher earnings reduce the cost of financing investment compared to borrowing since firms may have difficulty borrowing due to credit rationing or may pay higher interest rates due to default risk -Booms increase firms' profits and investments while recessions have the opposite effect, and the feedback magnifies both booms and recessions

Effects on Net Worth and Collateral

-Higher asset prices increase the values of collateral and net worth,reducing adverse selection and moral hazard, so banks are more willing to lend and credit rationing is reduced -Greater lending increases investment

Home Equity Loans

-Increased house prices increase ____ ______ _____ which increase consumption spending

An increase in the target federal funds rate affects the financial markets in several ways:

-Longer-term interest rates increase when the target rate increases or before if the increase is expected -Asset prices such as stock prices fall -Higher interest rates increase net capital inflows, appreciating the exchange rate

Flexible Targeting

-Means the central bank is concerned with output stability as well as inflation -Central banks practice this - Inflation targeting is not as rigid as a policy rule; it is "constrained discretion"

Economic Recovery and Reinvestment Ac

-Passed when President Obama took office in 2009, allocating 5% of GDP to tax cuts, infrastructure spending, and aid to state governments

Federal Funds Rate

-The Fed controls the _______ _____ ____, an interest rate for 1-day loans, while economic activity is affected by intermediate (e.g. 5-year car loans) and long-term (e.g. 10-year corporate bond) interest rates -Changes in this affect longer-term interest rates through the term structure of interest rates

Term Auction Facility (TAF)

-The Fed created this in December 2007, when banks were reluctant to borrow, fearing that borrowing would signal that they were in trouble. Here, the Fed initiated the lending, not the banks, and borrowing increased dramatically

Risky Loans

-The Fed makes these as lender of last resort -If a central bank makes these to prevent failures, repayment is not certain

Expenditure Shocks

-The Fed offsets ___________ ______ by changing real interest rates - These also shift the AE curve

Expectations Theory

-The ____________ ______ states that a long-term interest rate equals the average of current and expected one-period rates plus a term premium -If a period is 1 day, the 1-year rate is a 365 period rate equal to the average of expected federal funds rates over the next year plus the term premium

Investment Multiplier

-The effect of firms' earnings on investment, which magnifies fluctuations in aggregate expenditure.

Flight to Safety

-The succession of crises in 2007-2009 created fear of any risky asset, resulting in a flight to safety - Institutions bought only the safest asset, Treasury bills, raising their price and dropping yields to almost zero - In contrast, the prices of stocks and BAA bonds fell as did securitization

Insolvent

-When a financial institution's value of its assets is less than its liabilities, making net worth negative. Usually accompanies asset-price crashes in typical crises -Regulators force closures of banks that are this -This can spread between institutions because they are connected, for example banks have deposits in and loans to other banks

Stock Prices and Investment

-When stock prices increase, firms raise more money per share, so financing investment by selling stock becomes cheaper -Rising stock prices thus increase investment expenditure -Selling fewer shares results in less dilution of existing equity shares

Monetarists

-a school of economists who believe that monetary policy has strong effects on the economy and that policy should beset by a rule. - believe discretionary policies do more harm than good, so policy should be constrained by rules

Time-Consistency Problem

-a situation in which someone has incentives to make a promise but later renege on it; because of these incentives, others don't believe the promise -Finn Kydland and Edward Prescott showed how this leads central banks to produce high inflation and that solving this problem is the key to controlling inflation -Economic example: the government promises not to tax profits from firms' new factories, which the government can tax after the factories are built. But the firms know this and thus don't build.

Adaptive expectations

-backward-looking expectations, are based on past inflation -make disinflation costly in terms of lost output,so policymakers are unwilling to pay this price, keeping inflation high

Stabilization policy

-conducted by adjusting the short-term interest rates that central banks frequently use as their policy instruments -In the 1950s Federal Reserve Chair William McChesney Martin described the Fed's job as "leaning against the wind," where the"wind" means movements in output and inflation

Troubled Asset Relief Program

-created on October 3,2008 to buy "troubled assets" from financial institutions - Instead the Treasury used the funds for equity injections, becoming a shareholder in most of the largest financial institutions

Money Market Investor Funding Facility (MMIFF)

-lent money to banks to buy commercial paper from money funds, providing the funds with liquidity and making them willing to buy more commercial paper

Term Asset-Backed Loan Facility (TALF)

-lent money to institutions to buy securitized bank loans, encouraging securitization

Equity Injections

-stock purchases by the government, are made to provide capital when markets won't, restoring solvency - By purchasing stock of a financial institution, the government becomes an owner, and can lose money should the institution, or profit if the institution recovers -These are controversial because of uncertainty regarding potential gains and losses, they deviate from free markets, and they interfere with market forces

Inflation-Surprise Decision

-the central bank's choice of outcome B (in slide figure), which produces higher real incomes and lower unemployment in the short run -The public understands the incentive not to keep inflation at ideal and thus expects high inflation -High expected inflation shifts the Phillips curve up, resulting in high actual inflation, an outcome called the high inflation trap - Policymakers don't increase output in the high-inflation trap because inflation is already a serious problem

Too Big to Fail (TBTF)

-the doctrine that large banks facing insolvency must be bailed out to protect the financial system -Large banks have many links to other institutions and failure of a large bank more likely causes a crisis

Monetary Transmission Mechanism

-the process through which monetary policy affects output -An increase in the target federal funds rate reduces output, and a decrease in the target rate increases output -The Fed's policy change affects the economy through a number of channels

Financial Markets and the banking system influence aggregate expenditure:

1) Events in the financial system are one of the initial causes of output fluctuations; asset-price crashes and banking crises have caused recessions (positive ex.increases in stock prices increase peoples' wealth which increases consumption expenditure) 2) The financial system is part of the monetary transmission mechanism and central bank actions affect asset prices and bank lending, which magnify the responses of output to policy actions

Direct Costs of a Financial Crisis

1. Asset holders suffer losses when asset prices fall 2. Owners of financial institutions lose their equity 3. Creditors of financial institutions lose the funds they have lent - When banks fail, uninsured depositors and the FDIC also incur losses

Opponents of trying to stop bubbles cite several reasons:

1. Bubbles are difficult to identify 2. The effects of increasing interest rates on a bubble are unpredictable;there may be no effect or possibly a crash 3. Raising interest rates reduces output and increases unemployment, so the costs may exceed the uncertain benefits

Indirect Costs of a Financial Crisis

1. Falling asset prices decrease aggregate expenditure 2. Failures of financial institutions cause a credit crunch 3. Lower lending reduces aggregate expenditure by firms and individuals who rely on bank loans for funds

An increase in the target federal funds rate has several effects on bank lending:

1. Higher interest rates increase adverse selection and moral hazard making a larger proportion of loan applicants risky, so banks reduce their lending 2. Higher interest rates reduce the value of collateral and net worth, also reducing lending

Higher interest rates reduce aggregate expenditure:

1. Spending for investment (including housing) and consumer durable goods falls 2. Lower asset prices reduce wealth and consumption 3. Lower asset prices reduce investment because issuing stock is more costly 4. Reduced bank lending reduces investment 5. An appreciated exchange rate reduces net exports

There are two reasons why a central bank responds to a financial crisis:

1. The crisis will reduce output due to reduced consumer confidence,falling asset prices, and reduced bank lending, so a central bank acts preemptively due to policy lags 2. A crisis may worsen by spreading to other institutions, so the central banks response may appear to be stronger than necessary

The 2007-2009 financial crisis was the worst since the Great Depression, and the many problems contributed to a deep recession:

1.There were large declines in stock and house prices 2.Failure and near failure of major financial institutions -Losses on subprime mortgages and the breakdown of loan securitization caused a credit crunch.

Capital Crunch

A _______ ______ is a fall in capital that forces banks to reduce lending

Credit Crunch

Bank lending policies change for reasons in addition to asset prices changes, and changes in the willingness to lend affect aggregate expenditure; a sharp fall in lending is a ______ ______

Monetrary Transmission Procress

Process through which monetary policy affects output

Time Lags

The ____ ____ between central bank actions and the results of policies make stabilizing the economy difficult

Rule Tradeoffs

The more aggressive rule, TR-I, does a better job stabilizing inflation, while TR-II does a better job stabilizing output; so central banks face a trade-off between output stability and inflation stability

Risk Perceptions, Regulation, Capital Requirement

The three main reasons why banks change lending policies

Risk Perceptions

____ ___________ change as events change assessments of default risk

Capital Requirements

_______ ____________ may force banks to reduce their assets (loans) if losses reduce capital

Regulation

__________ changes over time, becoming more or less stringent

Expected

__________ rate changes are already reflected in expected future interest rates and thus don't change rates. Fed officials may signal rate changes in speeches before the rate is changed. Bond traders may infer changes based on a likely recession or increased inflation. - If a rate change is ________, interest rates change before the policy action

Expenditure Shocks

___________ ______ from the financial system have contributed to the last three U.S. recessions

Discretionary policy

a monetary policy that is adjusted at each point in time based on the judgment of the central bank. The Fed operates using discretion

Strict Targeting

when the inflation target is the central bank's only goal