Money & Banking midterm

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

Describe how each of the following can affect the money supply: (i) the central bank; (ii) banks, and (iii) depositors.

(i) The central bank can affect the money supply through open market operations, which changes the non-borrowed 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. (ii) Banks can affect the money supply through their holdings of excess reserves; less excess reserves means more loans, and hence a greater money supply. (iii) 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

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?

-Initially default risk increases, yield increases, price of AIG decreases -After government intervention, default decreases, yield decreases, price of AIG increases

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rate on these bonds? What effect would it have on the rates of US treasury securities?

1. 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.

"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.

1. 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.

During the holiday season when the publics holdings of currency increases, what defensive open market operations typically occur?

A defensive open market purchase

If the manager of the open market desk hears that a snowstorm is about to strike NYC, making it difficult to. present checks for payment there and so raising the float, what defensive open market operations will the manager undertake?

A defensive open market sale

If the treasury has just paid a large bill to defense contractors and as a result its deposits with the Fed fall what defensive open market operations were the manager of the open market desk undertake?

A defensive open market sale

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a market bubble? Explain using the Gordon growth model.

A stock market bubble can occur if market participants either believe that dividends will have rapid growth or if they substantially lower the required return on their equity investments, thus lowering the denominator in the Gordon model and thereby causing stock prices to climb. By raising interest rates the central bank can cause the required rate of return on equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the expected growth rate of the economy and hence of dividends, thus also keeping stock prices from climbing.

"Whenever it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. Otherwise his expectations of the driving time are perfectly accurate. Considering that it snows only once every 10 years where Joe lives, Joe's expectations are almost always perfectly accurate." Are Joe's expectations optimal? Why or Why not?

Although Joe's expectations are typically quite accurate, they could still be improved by his taking account of a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations

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?

An increase in both the currency ratio and the excess reserves ratio resulted in a dramatic decrease of the money multiplier.

What are the main difficulties encountered by the newly established central banks in transition economies?

As the financial markets were suddenly liberalized in transition economies, the inflationary pressures from price liberalization caused payments deficits along with significant currency devaluations. However, one of the main obstacles faced by central banks in transition economies was the lack of independence to conduct monetary policy

If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high but is still less than what the market expected, what do you think would happen to long term bond prices?

Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and as we learned in Chapter 7, long-term interest rates would fall. The decline in long-term interest rates implies that long-term bond prices would rise.

Following the global financial crisis in 2008, assets on the Federal Reserve's balance sheet increased dramatically, from approximately $800 billion at the end of 2007 to $3 trillion by 2011. Many of the assets held are longer-term securities acquired through various loan programs instituted as a result of the crisis. In this situation, how could reverse repos (matched sale-purchase transactions) help the Fed reduce its assets held in an orderly fashion, while reducing potential inflationary problems in the future?

Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public. But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer maturity securities can be drawn off the balance sheet of the Fed.

Why was the Federal Reserve System set up with twelve regional Federal Reserve bank rather than one central bank, as in other countries?

Because of traditional American hostility to a central bank and centralized authority, the system of 12 regional banks was set up to diffuse power along regional lines.

Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?

Behavioral finance suggests that when stock prices rise, market participants are less likely to engage in short sales, which would otherwise capture unexploited profit opportunities and push misaligned stock prices back down to fundamental values. This is due to the notion that people are more averse to downside risk than upside risk, and since short sellers can incur nearly unlimited losses, very little short selling occurs in practice. In addition, short selling is sometimes seen as taboo, since it is viewed as profiting off the losses of others

The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio. What will happen to the money supply?

Both the Fed's purchase of $100 million of bonds (which raises the monetary base) and the lowering of the required reserve ratio (which increases the amount of multiple expansion and raises the money multiplier) lead to a rise in the money supply

Why is the composition of the Fed's balance sheet a potentially important aspect of monetary policy during an economic crisis?

By purchasing particular types of securities, the Fed can impact interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision

If float decreases below its normal double why might the manager of domestic operations consider it more desirable to use purchase agreements to affect the monetary base rather than out right purchase of bonds?

Changes in float tend to be temporary

Suppose the Fed buys $1 million of bonds from the First National Bank. If the First National Bank and all other banks use the resulting increase in reserves to purchase securities only and not to make loans, what will happen to checkable deposits?

Checkable deposits will remain the same.

Risk premiums on corporate bonds are usually anti-cyclical; that is they decrease during business cycle expansions and increase during recessions? Why?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, 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.

Why might eliminating the central bank's independence lead to a more pronounced political business cycle?

Eliminating the central bank's independence might make it more shortsighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the central bank might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

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

False. A shift from deposits to currency will affect the amount of reserves, and since other players are involved in this process, the Fed ultimately cannot control the level of reserves in the system.

"If most participants in the stock market do not follow what is happening to the monetary aggregates, prices of common stocks will not fully reflect information about them." Is this statement true, false or uncertain? Explain your answer.

False. All that is required for the market to be efficient so that prices reflect information on the monetary aggregates is that some market participants eliminate unexploited profit opportunities. Not everyone in a market has to be knowledgeable for the market to be efficient.

"Human fear is the source of stock market crashes, so these crashes indicate that expectations in the stock market cannot be optimal." Is this statement true, false or uncertain? Explain your answer.

False. Although human fear may be the source of stock market crashes, that does not imply that there are unexploited profit opportunities in the market. Nothing in rational expectations theory rules out large changes in stock prices as a result of fears on the part of the investing public.

"Forecasters' predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be optimal." Is this statement true, false or uncertain? Explain your answer

False. Expectations can be highly inaccurate and still be rational because optimal forecasts are not necessarily accurate. A forecast is optimal if it is the best possible even if the forecast errors are large.

"The theory of bureaucratic behavior indicates that the Fed never operates in the public interest." Is this statement true, false or uncertain? Explain your answer.

False. Maximizing one's welfare does not rule out altruism. Operating in the public interest is clearly one objective of the Fed. The theory of bureaucratic behavior only points out that other objectives, such as maximizing power, also influence Fed decision making.

"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 your answer.

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 in the banking system and hence the monetary base.

The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount rate." Is this statement true, false, or uncertain? Explain your answer.

False. The Fed also can affect the level of borrowed reserves by directly limiting the amount of loans to an individual bank or the broader financial system

"The independence of the Fed leaves it completely unaccountable for its actions." Is this statement true, false or uncertain? Explain your answer.

False. The Fed is still subject to political pressure because Congress can pass legislation limiting the Fed's power. If the Fed is performing badly, Congress can therefore make the Fed accountable by passing legislation that the Fed does not like.

"An efficient market is one in which no one every profits from having better information than the rest." Is this statement true, false or uncertain? Explain your answer.

False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information. Note, if the market is completely efficient then these profit opportunities would not exist.

"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. These investments are almost of the same profitability.

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

If yield curves on average were flat and the risk premium on long-term relative to short term bonds were positive then one would expect interest rates to fall more often than rise. Given that rates are as likely to rise as to fall this would force the risk premium to be zero. Thus we would be more willing to accept the pure expectations theory.

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

In a financial panic, you would expect the money multiplier to decrease and the money supply to decrease, which would cause the excess reserves ratio to increase. Thus depositors are likely to increase their holdings of currency.

Prior to​ 2008, mortgage lenders required a house inspection to assess its​ 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 was arranged through a third party. How does this illustrate a conflict of interest similar to the role that​ credit-rating agencies played in the global financial​ crisis?

Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

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.

"The money multiplier is necessarily greater than 1." Is this statement true, false, or uncertain? Explain.

It is uncertain. As the formula for the money multiplier indicates, if the R/Dratio is great than 1 (especially when banks are holding a lot of excess reserves), the money multiplier can be less than 1.

Why was the Term Auction Facility more widely used by financial institutions than the discount window during the global financial crisis?

It proved to be more widely used because the interest rate on these loans was set through a competitive process, and that interest rate was less (in some cases much less) than the discount rate. In addition, because of the structure of the Term Auction Facility there was some anonymity in the banks that were accessing these funds, which helped to avoid the stigma associated with discount window lending.

Open market operations are typically repurchase agreements. what does this tell you about the likely volume of defensive open market operations relative to the volume of dynamic open market operations?

It suggests that defensive open market operations are far more common than dynamic operations because repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the monetary base.

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

Junk bonds are referred to as "junk" in that 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

"The Federal Reserve System resembles the US Constitution in that it was designed with many checks and balances." Discuss.

Like the U.S. Constitution, the Federal Reserve System, originally established by the Federal Reserve Act, has many checks and balances and is a peculiarly American institution. The ability of the 12 regional banks to affect discount policy was viewed as a check on the centralized power of the Board of Governors, just as states' rights are a check on the centralized power of the federal government. The provision that there be three types of directors (A, B, and C) representing different groups (professional bankers, businesspeople, and the public) was again intended to prevent any group from dominating the Fed. The Fed's independence of the federal government and the setting up of the Federal Reserve banks as incorporated institutions were further intended to restrict government power over the banking industry.

Predict what would happen to the risk premiums on corporate bonds if brokerage commissions were lowered in the corporate bond market.

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

Explain why eleven states of the EU have opted no to adopt the euro as their domestic currency.

Monetary supplies as financial tools will be lost if a country uses Euro as its currency.

If a forecaster spends hours every day studying data to forecast interest rates, but his expectations are not as accurate as predicting that tomorrow's interest rates will be identical to today's interest rates, are his expectations optimal?

No, because he could improve the accuracy of his forecasts by predicting that tomorrow's interest rates will be identical to today's. His forecasts are therefore not optimal, and he does not have rational expectations.

Can we expect the value of the dollar to rise be 2% next week if our expectations are rational?

No, because this expected change in the value of the dollar would imply that there is a huge unexploited profit opportunity (over a 100% expected return at an annual rate). Since the rational expectations theory rules out unexploited profit opportunities, such a big expected change in the exchange rate could not exist.

If I read in the Wall Street Journal that the "smart money" on Wall Street expects stock prices to fall, should I follow that lead and sell all of my stocks?

No, because this is publicly available information and is already reflected in stock prices. The optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from selling your stocks.

Can a person with optimal expectations expect the price of Google to rise by 10% in the next month?

No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on IBM stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person's expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.

Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has had a sharp rise in the past week, you should go out and buy stocks? Why or why not?

No, you shouldn't buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices. Hence you cannot expect to earn more than the equilibrium return on stocks by acting on the money supply information.

The First National Bank receives an extra $100 of reserves but decides not to lend out any of these reserves. How much deposit creation takes place for the entire banking system?

None. Since there are no loans created from the new reserves, no additional deposit creation will occur.

"Considering that raising reserve requirements to 100% makes complete control of the money supply possible, Congress should authorize the Fed to raise reserve requirements to this level." Discuss.

One problem with this proposal is that it provides perfect control over the official measure of the money supply, but it may weaken control over the measure of the money supply that is economically relevant. An additional problem is that it will result in a costly restructuring of the financial system, as banks are forced to get out of the loan business

Compare the methods of controlling the money supply—open market operations, loans to financial institutions, and changes in reserve requirements—on the basis of the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Open market operations are more flexible, reversible, and faster to implement than the other two tools. Discount policy is more flexible, reversible, and faster to implement than changing reserve requirements, but it is less effective than either of the other two tools

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

If my broker has been right in her five previous buy and sell recommendations, should I continue listening to her advice?

Probably not. Although your broker has done well in the past, efficient markets theory suggests that she has probably been lucky. Unless you believe that your broker has better information than the rest of the market, efficient markets theory indicates that you cannot expect the broker to beat the market in the future.

What are the disadvantages of using loans to financial institutions to prevent bank panics?

Providing loans to financial institutions creates a moral hazard problem. If firms know that they will have access to Fed loans, they are more likely to take on risk, knowing that the Fed will bail them out if a panic should occur. As a result, banks that deserve to go out of business because of poor management may survive because of Fed liquidity provision to prevent panics. This might lead to an inefficient banking system with many poorly run banks

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?

Purchase of long term maturities make the price rise and the yield fall. The yield curve will become flatter or possibly inverted.

If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable deposits, and the monetary base?

Reserves will decrease by $1000, checkable deposits will decrease by $1000, but the monetary base will be unchanged, since reserves decrease by the same amount as currency increases.

The U.S. Treasure 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 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 yield overall will be higher than TIPS of comparable maturity.

What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the zero lower bound?

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion

Do you think that the 14-year non-renewable terms for governors effectively insulates the Board of Governors from political pressure?

The 14-year terms do not completely insulate the governors from political influence. The governors know that their bureaucratic power can be reined in by congressional legislation and so must still curry favor with both Congress and the President. Moreover, in order to gain additional power to regulate the financial system, the governors need the support of Congress and the President to pass favorable legislation.

Which entities in the Federal Reserve System controls the discount rate? Reserve Requirements? Open market operations?

The Board of Governors sets reserve requirements and the discount rate; the FOMC directs open market operations. In practice, however, the FOMC helps make decisions about reserve requirements and the discount rate.

The Fed is the most independent of all U.S. Government agencies. What is the main difference between it and other government agencies that explains the Fed's greater independence?

The Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget.

In what ways can the regional Federal Reserve banks influence the conduct of monetary policy?

The Federal Reserve Banks influence the conduct of monetary policy through their administration of the discount facilities at each bank and by having five of their presidents sit on the FOMC, the main policymaking arm of the Fed.

Compare the structure and independence of the Federal Reserve System and the European System of Central Banks.

The Federal Reserve and European System of Central Banks have a similar structure in that there is an equivalence between the Board of Governors (Fed) and the Executive Board (ECB) and then the FOMC (Fed) and the Governing Council (ECB). A key difference between the latter two bodies is that the FOMC has a majority of members as political appointments whereas the Governing Council has as a majority the heads of central banks. The ECB has a similar structure regarding independence. Both have instrument independence and have their high level goals set through legislation/treaty. The ECB might be considered to be more independent as all countries in the European community have to ratify changes to its charter whereas the Fed is subject to Congressional changes.

The Fed promotes secrecy by not releasing the minutes of the FOMC to Congress or the public immediately. Discuss the pros and cons of this policy.

The argument for not releasing the FOMC directives immediately is that it keeps Congress off the Fed's back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the directive immediately is that it would make the Fed more accountable.

During 2008, the difference in the yield between three-month AA-rated financial commercial paper and three-month AA-rated non-financial commercial per 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 the 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.

What is the main advantage and the main disadvantage of an unconditional policy commitment?

The main advantage to an unconditional policy commitment is that it provides a significant amount of transparency and certainty, which makes it easier for markets and households to make decisions about the future. The main disadvantage is that it represents a tacit commitment by the central bank; if conditions suddenly change where a change in the policy stance may be warranted, then holding to the commitment could be destabilizing. On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and the central bank could lose significant credibility.

What political realities might explain why the Federal Reserve Act of 1913 placed two Federal Reserve banks in Missouri?

The placement of two banks in the Midwest farm belt might have been engineered to placate farmers, an important voting block in the early twentieth century.

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 the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis predict will happen to the price of the stock when the $4 loss is announced?

The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.

In the 1960's and 1970's the Federal Reserve System lost member banks at a rapid rate. How can the theory of bureaucratic behavior explain the Fed's campaign for legislation to require all commercial banks to become members? Was the Fed successful in this campaign?

The theory of bureaucratic behavior indicates that the Fed will want to acquire as much power as possible by requiring all banks to become members. Although the Fed did not succeed in obtaining legislation requiring all banks to become members of the system, it was successful in getting Congress to legislate extension of many of the regulations that were previously imposed solely on member banks (for instance, reserve requirements) to all other depository institutions. Thus the Fed was successful in extending its power.

What is the primary tool that Congress uses to exercise some control over the Fed?

The threat that Congress will acquire greater control over the Fed's finances and budget or the threat that Congress will change its charter.

What are the two main sources of cash flows for a stockholder? How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. Which security would you predict to be more volatile?

There are two cash flows from stock: periodic dividends and a future sales price. Dividends are frequently changed when a firm's earnings either rise or fall, which can make them difficult to estimate. The future sales price is also difficult to estimate, because it depends on the dividends that will be paid at some date even further in the future. Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. These payments are established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy. Stock prices tend to be more volatile, because their cash flows are more subject to change.

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?

There was a significant increase in the monetary base during the recent financial crisis.

"Discount loans are no longer needed because the presence of the FDIC eliminates the possibility of bank panics." Is this statement true, false, or uncertain?

This statement is false. The FDIC alone would likely be ineffective in eliminating bank panics without the Fed's ability to provide discount loans to troubled banks to keep bank failures from spreading. In particular, the FDIC's insurance only covers about 1% of total bank deposits. Since the Fed has unlimited ability to provide loans to the banking system, it can be much more effective in stabilizing the banking system in a panic.

"Foreign exchange rates, like stock prices, should follow a random walk." Is this statement true, false or uncertain. Explain your answer.

True in principle. Foreign exchange rates are a random walk over a short interval such as a week because changes in the exchange rate are unpredictable. If a change were predictable, large unexploited profit opportunities would exist in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist, and so the foreign exchange rate will approximately follow a random walk.

"If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market." Is this statement true, false or uncertain? Explain your answer.

True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable, however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist.

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

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

"The independence of the Fed has meant that it takes the long view and not the short view." Is this statement true, false or uncertain? Explain your answer.

Uncertain. Although independence may help the Fed take the long view, because its personnel are not directly affected by the outcome of the next election, the Fed can still be influenced by political pressure. In addition, the lack of Fed accountability because of its independence may make the Fed more irresponsible. Thus it is not absolutely clear that the Fed is more far sighted as a result of its independence.

"The federal funds rate can never be above the discount rate." Is this statement true, false, or uncertain? Explain your answer

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the discount rate, it would never surpass the discount rate since banks would then borrow directly from the Fed, and not in the fed funds market, which would prevent the fed funds rate from ever rising above the discount rate. However, in practice, the fed funds rate can (and has) been above the discount rate. This may occur due to the stigma associated with banks borrowing directly from the Fed; i.e., banks may prefer to pay a higher market rate than to borrow directly from the Fed and incur the perceived stigma. In addition, nonbank financial institutions, which do not have access to the discount window, can and do participate in the federal funds market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is above the discount rate may not be arbitraged away

"The federal funds rate can never be below the interest rate paid on reserves." Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate on reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower rate; this should prevent the fed funds rate from ever falling below the interest rate paid on reserves. However, in practice, the fed funds rate can (and has) been below the interest rate paid on reserves. This is because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds market and provide a significant amount of funding to the market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest rate on reserves may not be arbitraged away

What are the reasons that compel some developing nations to adopt currency unions?

Very poor and small developing countries adopt the currency of larger "anchor" countries because they do not possess a domesTc currency. ±he naTonal central bank cannot carry out monetary policy due to large decline in the value of domesTc currency. For example, Ecuador discarded its naTonal currency and adopted the US dollar in 2000.

If monetary policy becomes more transparent about the future course of interest rates, how will stock prices be affected, if at all?

With more certainty over the course future interest rates will follow, uncertainty and risk would likely be reduced, which will lower the required return on investment ke and lead to a higher stock price. In addition, with a reduction in the uncertainty of future short-term interest rates, this would likely lower longer-term interest rates, increasing capital investment. This would likely raise long-run economic growth and dividend growth, also pushing stock prices higher

Classify each of these transactions as an asset, a liability, or neither for each of the "players" in the money supply process—the federal reserve, banks, and depositors.

a) You get a $10,000 loan from the bank to buy an automobile. Public: Assets rise by $10,000 due to automobile purchase, liabilities rise by $10,000 due to loan. Banks: Your bank assets unaffected: rise by $10,000 due to loan; this is offset by a decrease in their reserves assets of $10,000. But the $10,000 is deposited in another bank increasing reserves. So for banks as a whole asset loans and deposit liabilities increase by $10,000 and reserves don't change. Fed: unaffected. b) You deposit $400 into your checking account at the local bank. Public: Assets are unaffected ($400 increase in checking deposits is offset by a $400 decrease in currency holdings). Banks: Assets increase by $400 from reserves; liabilities increase by $400 due to checking account balance. Fed: Liabilities are unaffected (reserves increase by $400, currency decreases by $400). c)The Fed provides an emergency loan to a bank for $1,000,000. Banks: Assets increase by $1,000,000 in reserves; liabilities increase by the same amount due to borrowing from the Fed. Fed: Assets increase by the $1,000,000 from the loan; liabilities increase by $1,000,000 due to the increase in reserves. d)A bank borrows $500,000 in overnight loans from another bank. Assets and liabilities of the banking system as a whole are unaffected; however, individual banks' balance sheets will change due to the loan

If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes, what is the effect on the level of checkable deposits?

checkable deposits do not change

If you decide to hold $100 less cash than usual and therefore deposit $100 more cash in the bank, what effect will this have on checkable deposits in the banking system if the rest of the public keeps its holding of currency constant?

checkable deposits increase by $1,000

Why is paying interest on reserves an important tool for the Federal Reserve to manage crises?

it allows the Fed to increase its lending as much as it wants without reducing the federal funds rate

What basic principle of finance can be applied to the valuation of any investment asset?

present value

Why are repurchase agreements used to conduct most short term monetary policy operations, rather than simply buying and selling securities outright?

repurchase agreements allow the Fed to easily adjust open market operations in response to daily conditions and are temporary open market purchases that can be reversed

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?

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

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

you would raise your predictions