E305 Money and Banking FINAL

According to PPP, the real exchange rate between two countries will always equal

1

If the interest rate on euro-denominated assets is 13 percent and it is 15 percent on peso-denominated assets, and if the euro is expected to appreciate at a 4 percent rate, for Manuel the Mexican the expected rate of return on euro-denominated assets is

17 PERCENT

The quantity theory of inflation indicates that if the aggregate output is growing at 3% per year, velocity is constantand the growth rate of money is 5%, then inflation is

2% 5-3=2%

Liquidity Risk

A bank may not able to meet with its payment obligations when many depositors attemptto withdraw their deposits during a short period. This can happen while the bank issolventwith enough assets to cover its liabilities,if most of such assets are illiquid. The banksmay have to execute 'fire sales'to pay its customers back leading to capital loss and a reduction in net worthandpotentially face the risk of being insolvent.

Savings Investment Gap and Trade Deficit

A country's trade balance (current account balance) is the difference between the value of exports of goods and services and the value of imports of goods and services. Through national accounting identities, the trade balance can also be expressed as the difference between national (both public and private) savings and investment.This value is also equal to the net capital inflows to the country, i.e, capital and financialaccount balance.We can express these identities as, NX = EX -IM = CI -CO = NCI = S -I.

Spot exchange rate and forward exchange rate

A spot rate is a contracted ratefor a foreign exchange transaction that is taking place immediatelyand settled at the earliest possible date. A forward rate, on the other hand, isthe rateof a foreign exchange transactionagreed by two parties today but to be settled on a future date, agreed by two parties.

f the U.S. dollar appreciates from 1.25 Swiss franc per U.S. dollar to 1.5 francs per dollar, then the franc depreciates from ________ U.S. dollars per franc to ________ U.S. dollars per franc.

A) 0.80; 0.67

The speculative motive for holding money is closely tied to what function of money?

A) Store of wealth

NEGATIVE INTEREST RATES

An unconventional monetary policy tool experimented during the recent years by some central banks. Under negative interest rates, savers have to pay an interest for their savings while a borrower earns an interest for borrowing money.

Everything else held constant, when a country's currency appreciates, the country's goods abroad become ________ expensive and foreign goods in that country become ________ expensive.

B) more; less

According to the law of one price, if the price of Colombian coffee is 100 Colombian pesos per pound and the price of Brazilian coffee is 4 Brazilian reals per pound, then the exchange rate between the Colombian peso and the Brazilian real is:

C) 25 pesos per real.

If the money supply is $500 and nominal income is $3,000, the velocity of money is?

C) 6. 3,000/500

The theory of purchasing power parity cannot fully explain exchange rate movements because

C) some goods are not traded between countries.

The quantity theory of money is a theory of how

C) thenominal value of aggregate income is determined.

If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the Canadian dollar in terms of Mexican pesos will

D) fall by 2 percent.

The theory of PPP suggests that if one country's price level rises relative to another's, its currency should

DEPRECIATE

Federal Reserve System

Federal Reserve Systemincludes the FederalReserveBoardof Governors in Washingto DC and the 12 regional Federal Reserve Banks. The Federal Open Market Committeealso is a part of that system.

money velocity

How many times a dollar changes hands or used for transactions during a given period.

n increase in the domestic interest rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant.

INCREASE; APPRECIATE

money printing

Monetizing of the government's budgetdeficit by selling governmentbonds to the central bank, which increases assets (and liabilities)of the central bank and thereby the money supply.

In a liquidity trap, monetary policy has ________ effect on aggregate spending because a change in the money supply has ________ effect on interest rates

NO; NO

If the government finances its spending by issuing debt to the public, the monetary base will ________ and the money supply will ________.

NOT CHANGE; NOT CHANGE

Open Market Operations (OMO)

Open market operations (OMOs), the purchase and sale of securities in the open market by a central bank, are a key tool used by the Federal Reserve in the implementation of monetary policy.

Purchasing power parity

Purchasing power parity (PPP) is a theory which states that the exchange rates between two currencies isin equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services.

Credit Risk

Some of the borrowers of a bank may not pay back a loan or a part of a loan and the agreed interest, requiring the bank to write of that loan from the balance sheet. This reduces the net-worth of the bank and many such simultaneous write-offsduringa shortperiod may cause a bank to be insolvent.

Federal Open Market Committee (FOMC)

The Federal OpenMarket Committee (FOMC)is responsible for monetary policy decision in the US. The FOMC consistsof seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks.Chairman of the Board of Governors is also the chair of FOMC.FOMCmeets eight times a year and issues directives to the trading desk at the Federal Reserve Bank of New York

Fed's Monetary Policy Tools

The Federal Reserve controls the fourtools of monetary policy--open market operations,the discount rate, reserve requirementsand the interest rate paid on reserves. The Board of Governors of the Federal Reserve System is responsible for the discount rate,reserve requirements and the interest rate paid on reserves,and the Federal Open Market Committee is responsible for open market operations.

Interest Rate Risk

The assets in a bank'sbalance sheet are mostly long-term loans which are less sensitive to fluctuations in short-term interest rates. The liabilities, checking and saving deposit, however are very sensitive to short-term interest rates. Therefore, an increase in interest rates affect the profitability of a bank adversely and a decrease in interest rates have a favorable effect.Interest rate risk is the risk faced by a bank when the rates drop, as a result of having more rate-sensitive liabilities than rate-sensitive assets.

Velocity

The average number of times that a dollar is spent in buying the total amount of final goods and services produced during a given time period

Federal Funds Rate

The federal funds rate is the interest rate banks charge each other for overnight loans to meet reserve requirements.

Seigniorage Revenue

The profit earned by the central bank by printing money. The difference between the face value of a currency note and its printing cost adds to the profit of a central bank which usually is transferredto the governmenttreasury ultimately.

Real exchange rate

Thereal exchange rate is defined as the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate.This rate is equal to 1 when PPP between the two countries is maintained. When the real exchange rate is greater than 1, the currency of a country is considered overvalued.

Theory of unbiased forward rates

This theorystates that the forward exchange rate for a transaction to be settled on a specific future date is an unbiased predicted of the spot rate to be expected on that date.

The classical economists' conclusion that nominal income is determined by movements in the money supply rested on their belief that ________ could be treated as ________ in the short run

VELOCITY; CONSTANT

Bank Runs and Bank Panics

When many of a Bank's customers attemptto withdraw their deposits during a short period, a bank may exhaust all its liquid resourcesand run out of money even if it enoughassetsin illiquid or less liquidforms. This can happen when a news spreads that a bank is at the verge of bankruptcy, with or without facts.If one bank fails as a consequence, people may lose confidence on the entire bankingsystem and attemptto withdrawtheir deposits at other banks too, leading to bank panic.

liquidity trap

When the economy is at a recession with a negative output gap while the nominal interest rates are at or near zero and the inflation is very low or negative.Since the central bank is consideredrun out of policy tools to boost the economy, it is very hard to come out of therecession.

International Fisher Effect

When there's a difference between the nominal interest rates in two countries, the exchange rate should adjust.In an equation form, iF-iD = (et+1t+1-ett)/ett

the interest parity condition.

condition that states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency

Financing government spending with taxes

has no net effect on the monetary base

Costsof Inflation

includes menu costs, shoe leather costs, distracted firms, relative price variability, income inequality, distortion of the tax system and increased uncertainty.

If initially the money supply is $1 trillion, velocity is 5, the price level is 1, and real GDP is $5 trillion, an increase in the money supply to $2 trillion

increases the price level to 2.