Money and Banking Chapter 10, 17, 18, 19, and 20
Currency Risk
Banks face currency risk if the
ECB Deposite rate facility
Banks with excess reserves at the end of the day can deposit them overnight in the at a interest rate substantially below the target-refinancing rate. Rate is set by the ECB Governing council deposit facility places a floor under the market interest rate charged on loans made by the banks
Law of One Price
Based on the concept of Arbitrage, the identical products should sell for the same price.
In 2002, the Federal Reserve changed its discount lending procedures. Which of the following statements is correct?
Before 2002 the Fed discouraged banks from borrowing and actually created volatility in the market for reserves.
Which of the following factors would increase the portfolio demand for money? Option i: A financial crisis is looming Option ii: You expect future interest rates to rise Option iii: A new website allows you to liquidate your stock holdings quickly and cheaply
Both options i and ii would increase the portfolio demand for money. If future interest rates are expected to rise, bond prices will fall, making money relatively more attractive. The prospect of a financial crisis will increase the relative riskiness of alternative assets, thus increasing the portfolio demand for money.
Refer to the diagram below and explain how the central bank could use its control over the quantity of money to target a particular level of interest rate in the face of changes in velocity. Suppose there is a fall in velocity and so the money XXXX curve shifts to the XXX. The central bank could XXXX the stock of money in the economy to shift the money XXXX curve to the XXXX and restore the target interest rate.
Demand Right Increase Supply Right
Suppose the interest rate on a one-year U.S. bond were 10 percent and the interest rate on an equivalent Canadian bond were 8 percent. If the interest-rate parity condition holds, is the U.S. dollar expected to appreciate or depreciate relative to the Canadian dollar over the next year? You would expect the U.S. dollar to XXXX Explain your choice. If the interest parity condition holds, the return on the two bonds should be XXXX. or this to happen, given the interest rates on the two bonds, the holder of the Canadian bond must XXX or this to happen, given the interest rates on the two bonds, the holder of the Canadian bond must
Depreciate Equal Gain
European System of Reserve requirements
Designed to give the ECB tight control over short term money. Typically works well
reserve currency.
Dollar an example of this Highly stable currency
The real Exchange rate
Dollar price of domestic goods / Dollar price of foreign goods Whenever the ratio in this equation is more than one, foreign products will seem cheap.
Assuming steady demand, and an increase in the money supply, what would that due to the price of money?
Drives the price of money down (Inflation)
Excess Reserve-to-deposit Ratio
ER/D Banks hold reserves as a proportion of their deposits
Costs of holding a larger balance sheet
Exposes the central bank to interest-rate and credit risk May displace private intermediaries and make the allocation of capital less efficient Threat to central bank independence
Explain how money growth reduces the purchasing power of money. By increasing the supply of money, holding demand for money constant, the value of each dollar relative to goods and services in the economy will XXXX. The price of money in terms of goods and services has XXXX
Fall Fallen
ECB's marginal lending facility equivalent to the FED
Fed's primary credit facility ECB offers loans that are way above the Target - Refinancing rate
Currency-to-deposit Ratio
C/D Is the fraction of deposits that people hold as currency
Government Officials
Can intervene in foreign FX markets in several ways
Monetary Base
Central Bank liabilities form the base on which the supplies of money are credit are built. The CB controls this. ONLY the fed can create/destroy the monetary base
Discount Loans
Commercial Banks ask for loans, and must provide collateral. (Mostly T-Bills) For the borrowing bank, it is a liability matched by an offsetting increase in the level of its reserve account. For the Fed, the loan is an asset that is created in exchange for a credit to the borrower's reserve account.
Reserves
Commercial bank accounts at the FED (Liability) Commercial bank reserves: deposits at central bank & the cash in the banks own vault (Vault Cash) Reserves are assets of the commercial bank, and liabilities of the central bank
Real Exchange Rate Facts
Competitiveness of US exports depends on the real FX rate Appreciation of the real FX rate makes US exports more expensive to foreigners, reducing their competitiveness. Depreciation of real FX rates makes US exports seem cheap to foreigners, improving their competitiveness.
What are the biases in the CPI?
Consumers' buying patterns change all the time. There is significant difficulty taking into account improvements in the quality of goods and services included in the CPI.
Countries A and B both have the same money growth rate and in both countries, real output is constant. In Country A velocity is constant while in Country B velocity has fallen. In which country will inflation be higher? Country A or Country B Explain why. The fall in velocity In Country B reflects XXXX in money demand. This XXX the inflationary pressures from the rise in the stock of money.
Country A Increase, Reduces
Government's Banks Liabilities
Currency Government's Account
Two Exchange rate regimes can be considered hard pegs
Currency boards Dollarization or euroization
Monetary Base
Currency in the hands of the public and in the banking system. Also called High-Powered Money The central bank can control the size of the monetary base.
Largest Central Bank Liability
(Currency) All central banks have a monopoly on the issuance of the currency used in transactions
Central Bank Liabilities
(Currency, Governments deposit account) Governments bank functions (Deposit accounts of commercial banks) Bankers bank
If interest rates increase
(ER/D) & (C/D) fall this increase the money multiplier and quantity of money
Largest Central Bank Assets
(Securities) are the primary asset of most central banks Traditionally, the fed exclusively hold T-Bills 2007-2009 crisis, the central banks chose to acquire a variety of risky assets
3 Assets of a Central Bank
(Securities, FX reserves) Needed to perform its role as the governments banks (Loans) Service to commercial banks
Discount Loans
(central bank asset) Discount loans are the loans the FED banks when commercial banks need ST cash. in 2008/2009 the FED made substantial loans to non-banks as well
Rise in the supply of Dollars
1. An increase in american's preference for foreign goods 2. an increase in the real interest rate on foreign bonds (relative to US bonds.) 3. An increase in american wealth 4. A decrease in the riskiness of foreign investments relative to US investments 5. An expected depreciation of the dollar
Shifts in the demand of dollars can be caused by:
1. Foreigners prefer more american made goods 2. The real yield on US bonds rise (relative to foreign bonds) 3. when foreigner wealth increases 4. When the riskiness of american investments falls 5. when the dollar is expected to appreciate
The quantity of money in the economy depends on:
1. The monetary base, which is controlled by the fed 2. the reserve requirement 3. the banks desire to hold excess reserves 4. nonbanks public's demand for currency
Why the Law of One price Fails
1. Transportation cost can be significant 2. Tariffs, the taxes countries charge at their borders, can be high. 3. Technical specification can differ. 4. Tastes differ across countries, leading to different pricing. 5. Some things simply cannot be traded.
Foreign Exchange Reserves
2nd largest asset Central bank/Government balances of foreign currency Held in the form of bonds issued by foreign governments. Changing market values of currencies = Foreign exchange interventions
If velocity were constant at 2 while M2 rose from $6 trillion to $9 trillion in a single year, what would happen to nominal GDP? Nominal GDP would rise by: XXXX If real GDP rose 2 percent, what would be the level of inflation? Inflation would equal: XXXX
50% 48%
Typical time frame to maintain an effective interest rate
6 - 8 weeks
Increase demand - shifts the demand curve to the right (Leads to a rise in the value of the dollar)
Increase in foreign preference for american goods Increase in real interest rate on US bonds Increase in foreign wealth Reduction in riskiness of US investments Expected future dollar appreciation
Increase supply shifts supply curve to the right (Leads to fall in the value of the dollar)
Increase of american preference in foreign goods Increase in real interest rate on foreign bonds increase in american wealth reduction of riskiness of foreign investment Expected depreciation of the dollar
Currency Appreciation
Increases the price foreigners pay for a country's exports and reduces the price residents of the country pay for imports This shift in foreign vs. domestic price hurts domestic businesses.
Explain why we observed a fall in the velocity of M2 during the financial crisis of 2007-2009. The XXXX in uncertainty during the financial crisis drove investors to hold a XXXX portion of their assets in the form of money. XXXX money holding relative to the level of economic activity means that each dollar has to be used XXXX times, XXXX velocity.
Increasing Larger Increased Fewer Lowering
sterilized foreign exchange interventions
A change in foreign exchange reserves alters the asset side of the central bank's balance sheet but the domestic monetary base remains unaffected
Depreciation
A decline in the value in one currency relative to another is called depreciation of the currency that is falling in value.
two criteria for the use of money growth as a direct monetary policy target
A stable link between the monetary base and the quantity of money A predictable relationship between the quantity of money and inflation.
Banker's Bank Liabilities
Accounts of the commercial banks (Reserves)
Effect of an Increase in the demand for dollars in the Dollar-Euro Market
An increase in demand leads to an appreciation of the dollar The number of euros per dollar falls Demand curve (Downward sloping) shifts right and Up! Y axis - Number of Euros per dollar X axis - quantity of dollars traded
European Central bank "tool kit"
An overnight interbank rate (equivalent to the federal funds rate) A rate at which the central banks lends to commercial banks (equivalent to the discount rate) A reserve deposit rate (equivalent to the IOER) A reserve requirement
Suppose that, driven by waves of national pride, consumers across the world (including in the United States), decide to buy home-produced products where possible. Explain how the demand and supply curves for dollars be affected? A fall in foreign demand for U.S. goods would shift the XXX curve for dollars to the XXXX while the fall in U.S. demand for foreign goods would shift the XXXX curve for dollars to the XXXX What can you say about the impact on the equilibrium dollar exchange rate? As the economy of the world outside the U.S. is larger than the U.S. economy, you might expect the XXXX shift to dominate, leading to XXXX of the dolar
Demand Left Supply Left Demand A Depreciation
Benefits of a larger balance sheet.
Influences the prices of a variety of securities and it supplies a large volume of high-quality liquid assets
Monetary Policy Tool of Choice
Interest Rates
Carry Trade
Investors anticipate that a high-yielding currency will depreciate less that world be necessary to equalize investment returns across currencies (Risk)
Three good features of monetary policy
It is easily observable by everyone. It is controllable and quickly changed. It is tightly linked to the policymakers' objectives.
Bretton Woods system
It was a system of fixed exchange rates that offered more policy flexibility over the short term than had been possible under the gold standard.
A small Eastern European economy asks your opinion about whether it should pursue the path to joining the European Economic and Monetary Union (EMU) or simply "euroize" (i.e., dollarize by using the euro for all domestic transactions). What advice would you give?
The economy should join the EMU rather than "euroize." Membership in the EMU would give the economy a say in monetary policy decisions and a share in the seignorage revenue from the printing of the euro
sloping Upward (Supply of dollars)
The higher price a dollar commands in the market, the more dollars are supplied The more valuable the dollar, the cheaper are foreign-produced goods and foreign assets (relative to domestic ones in the US market.)
4 inputs to the Taylor Rule
The natural rate of interest A measure of inflation A measure of the inflation gap A measure of the output gap
Differences between the ECB's refinancing operations and the Fed's daily open market operations:
The operations are done at all the National Central Banks (NCBs) simultaneously. Hundreds of European banks participate in the ECB's weekly auctions. Because of the differences in financial structure in different countries, the collateral that is accepted in refinancing operations differs from country to country. (The ECB and the NCBs accept tens of thousands of different marketable assets as collateral, including not only government-issued bonds but also privately issued bonds and bank loans.)
How did the financial crisis of 2007-2009 affect the size and composition of the balance sheet of the Federal Reserve?
The Fed broadened the range of assets held to include riskier instruments. The assets on the Fed B/S increase by 2.5 times, from securities. The liability side of the B/S, commercial bank deposits rose dramatically.
Cash Withdrawal
The Fed can always shifts its holdings of various assets. (Currency exchange for reserves) But it cant shift its liabilities When you take cash from an ATM you are changing the FED's B/S. (involving 3 B/S's) Page 35
How might the Federal Reserve exit from the unconventional policies it employed during the financial crisis of 2007-2009 without causing inflationary problems?
The Fed could tighten monetary policy without selling assets by raising the deposit rate it pays on reserves. As the deposit rate sets a floor to the market funds rate, the fed funds rate would rise to this level even if reserve supply is unchanged.
You need to purchase Japanese yen and have called two brokers to get quotes. The first broker offered you a rate of 125 yen per dollar. The second broker, ignoring market convention, quoted a price of 0.0084 dollars per yen. To which broker should you give your business?
The First Broker
Nominal Exchange rate
The Rate at which one can exchange the currency of one country for the currency of another. The rate changes every day.
Spot Rate
The best predictor of tomorrow's exchange rate
Increase the size of the Balance sheet
The central bank can buy things and then create liabilities to pay for them.
What happens when QE and TAP have vastly expanded the amount of reserves and assets on the central bank's balance sheet?
The central bank may need to sell a large volume of assets to reduce reserve supply sufficiently to raise the policy rate target. QE and TAP are way more difficult to sell, historically
Slopes Downward (Demand curve for dollars)
The cheaper the dollar -- the lower the dollar-euro exchange rate -- the more attractive are US investments and the higher is the demand for dollars with which to buy them
Dollar-Euro Exchange rate
The price of one euro in dollars. Most European countries (Members of the European Monetary union) use the euro.
Lucas critique
The problem is that when policymakers change the way they make policy, everyone changes the way they act
Monetary Base increases
The quantity of money increases
Real Exchange Rate
The rate at which one can exchange the goods and services from one country for the goods and services from another country Its a cost of basket of goods relative to the cost of the same basket of goods in another country.
Equilibrium Exchange Rate
The rate that equates supply and demand for dollars
Consensus of monetary policy makers
The reserve requirement is not useful as an operational instrument Central bank lending is necessary to ensure financial stability Short-term interest rates are the conventional tool to use to stabilize short-term fluctuations in prices and output.
When you withdraw cash from your bank's ATM, what happens to the size of the Fed's balance sheet?
The reserves held by your bank at the Fed decline Correct , but there is a larger Correct volume of currency in the hands of the nonbank public. Your action has raised Correct the currency-to-deposit ratio and can lead to a change in the money supply. The Fed may choose to alter policy to offset the impact on the money supply.
Appreciation
The rise in value of one currency relative to another.
In which of the following cases will the size of the central bank's balance sheet change? Case A: The Federal Reserve conducts an open market purchase of $100 million U.S. Treasury securities. Case B: A commercial bank borrows $100 million from the Federal Reserve. Case C: The amount of cash in the vaults of commercial banks falls by $100 million due to withdrawals by the public.
The size of the central bank's balance sheet will increase by $100 million in Cases A & B, but not in Case C, where only a change in the composition of central bank liabilities will occur.
four leading conventional monetary policy tools
The target federal funds rate range The interest rate on excess reserves (IOER rate) The discount rate The reserve requirement
What are the three Conventional policy tools?
The target range for the federal funds rate The interest rate on excess reserves (IOER rate) The rate for discount window lending
seignorage
There is a loss of revenue that comes from issuing currency
Relationship between velocity of money and cost of holding money
There is a relationship. Using the relationship from the 1980s as a basis for policymaking in the 1990s and thereafter would not have produced the desired result.
sterilized intervention two transactions
There is the purchase or sale of foreign currency reserves, which changes the central bank's liabilities. Then an immediate open market operation, of exactly the same size, designed to offset the impact of the first transaction on the monetary base.
Forward guidance
This is when the central bank communicates intentions regarding the future path of monetary policy. This is the simplest of the 3 other unconventional rules for the Taylor Rule To stimulate economic activity, forward guidance aims at lowering the long-term interest rates that affect private spending.
General Situations of the Taylor Rule
When inflation rises above its target level. (The response is to raise interest rates.) When output falls below the target level. (The response is to lower interest rates.) If inflation is currently on target and there is no output gap, (The target federal funds rate should be set at the natural rate of interest plus target inflation.) A 1 percentage point increase in the inflation rate raises the target federal funds rate 1½ percentage points. for each percentage point output is above potential. (Interest rates will go up half a percentage point)
Targeted asset purchases (TAP)
When the central bank alters the mix of assets it holds on its balance sheet in order to change their relative prices in a way that stimulates economic activity. Sift the composition of the balance sheet toward selected assets in order to boost their relative price and stimulate economic activity. This can impact both the cost and availability of credit Most complicated to do out all 3 measures. The impact of TAP is likely to be greater in thin, illiquid markets. To be larger the bigger the difference between the yield on the asset that the central bank buys and the yield on the asset that the central bank sells.
Quantitative easing (QE)
When the central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually zero or lower). At a market federal funds rate equal to the interest on excess reserves, an addition to aggregate reserves no longer reduces the funds rate Very difficult to predict the results An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans. one of the problems with QE is that if there is uncertainly among the banks, there will now know how much to hold
Excess Reserve
Which the banks holds voluntarily, is the amount over the required reserve that the bank must hold.
The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it wasn't enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009, what might you advise this central bank to do?
You should advise the central bank to use unconventional monetary policy tools such as quantitative easing, where aggregate reserves are provided beyond the level needed to lower the policy rate to zero, or credit easing, a policy in which the central bank alters the composition of its balance sheet. The central bank could also inform markets of its commitment to keep interest rates low (forward guidance).
Secondary Credit
available to institutions that are not sufficiently sound to qualify for primary credit.
steady the financial system and the economy after the crisis, the Fed utilized its three of its XXX
conventional policy tools
Primary Credit
extended on a very short-term basis, usually overnight, to institutions that the Fed's bank supervisors deem to be sound.
concept of purchasing power parity (PPP)
extends the logic of the law of one price to a basket of goods and services
inflation Targeting
focuses on the objective of low and stable inflation Monetary Policy strategy that involves public announcement of a numerical inflation target and underscores the central bank's commitment to price stability.
Central banks that have a hierarchical mandate with inflation targeting basically are saying:
hitting the inflation target comes first, everything else comes second.
precautionary demand for money
holding money to insure ourselves against unexpected expenses. Rises with Risks
law of one price
identical goods should sell for the same price regardless of where they are sold.
Fisher's conclusion on the velocity of money
in the long run, the velocity of money is stable, so that controlling inflation means controlling the growth of the money aggregates.
Suppose that the Chinese central bank has been intervening in the foreign exchange market, buying U.S. dollars in an effort to keep its own currency, the yuan, weak. If China decided to allow the yuan to float freely, what would you expect to happen to each of the following? U.S. exports to China would XXXX b. U.S. imports from China would XXXX c. The U.S. trade deficit with China would XXXX
increase decrease narrow
when an individual withdraws cash
increase currency in public decreases reserves (money supply contracts)
M1 & M2
is the money we think of as available for transaction
OPEN MARKET OPERATIONS
is the purchase and sale of securities that the FED holds. Quantity is controlled and can move Yields.
discount lending
lending by the Federal Reserve Banks to commercial banks. Usually small lending not including financial recession
quantitative easing
making large-scale asset purchases to increase the supply of reserves far beyond the level needed to keep the federal funds rate near zero
two ways to see the connection between exchange rates and monetary policy
market for goods and purchasing power parity. Capital market arbitrage shows us how short-run movements in exchange rates are tied to the supply and demand in the currency markets.
When using US dollars as domestic currency
meaning the number of units of foreign currency that it takes to purchase one dollar.
gold standard
obligates the central bank to fix the price of gold
dollarization (euroization)
one country formally adopts the currency of another country for use in all its financial transactions.
What is the Federal funds rate?
overnight lending rate.
Outflow controls
place obstacles in the way of selling investments and taking funds out
Hierarchical mandate
price stability comes first and everything else comes second
Inflow controls
restrict the ability of foreigners to invest in a country.
If the market federal funds rate were below the target rate, the response from the Fed would likely be to:
sell U.S. Treasury securities.
How is the secondary discount rate set?
set above the primary discount rate due to the riskiness of the loan
minimum bid rate by the ECB
set by the Governing Council as the minimum interest rate accepted at these refinancing auctions
Effects of an increase in the supply of dollars in the dollar-euro market
slide 35 Picture An increase in supply leads to a depreciation of the dollar. The number of euros per dollar fall Dollar supply curve (Upward sloping) shifts right & down
What is the interest rate set on Primary Credit
spread above the IOER rate called the primary discount rate.
Velocity Stability
table in the long-run but not in the short-run.
What does the equation of exchange tell us?
that the quantity of money multiplied by its velocity equals the level of nominal GDP.
overnight cash rate
the European analog to the market federal funds rate
FED liquid security Holdings
the FED controls the federal funds rate and the availability of money and credit.
currency board
the central bank commits to holding enough foreign currency assets to back domestic currency liabilities at a fixed rate.
hard-peg system
the central bank guarantees convertibility of domestic currency into the foreign currency to which it is pegged
Zero lower bound
the idea that a nominal interest rate cannot fall below zero
Effective lower bound
the nominal interest rate level below which intermediaries and their customers will switch from bank deposits to holding cash.
velocity of money
the number of times each dollar is used. More frequently each dollar is used, the higher the velocity of money.
natural rate of interest
the real short-term interest rate that prevails when the economy is using resources normally. - Taylor rule originally used to be 2%
what is the opportunity cost for M2?
the yield on three-month U.S. Treasury bill minus the return on holding M2.
Taylor Rule
tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output. Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap)
Federal funds loans are:
unsecured loans.
Seasonal Credit
used primarily by small agricultural banks in the Midwest to help in managing the cyclical nature of farmers' loans and deposits. In recent years, there has been a push to remove this credit as it is easier to access money from larger commercial banks
Float Freely
values of all the major currencies float freely, they are determined by market forces. Fluctuations in their value are the consequences of shifts in supply or demand
Repurchase of agreements (repo)
which ECB, through the National Central Banks, provided reserves to banks in exchange for securities, and then reversed the transaction up to three weeks later.
Dual mandate
which the goal of price stability and maximum employment are equal. This is the current strategy that the FED Employes
Short run movements in exchange Rates
In SR, prices don't move much, these nominal exchange rates represent changes in real exchange rates
Quantity of money & Credit
In the Economy, bank reserves are the most important factor. Monetary policy Operations through changes in reserves.
Central Bank Balance sheet
Includes a Government's Bank and a bankers bank (Slide 7)
Why would a bank seek secondary Credit?
Temporary short fall of reserves They cannot find any lending from anyone else
Government Account (Liability)
Mostly tax revenue the government uses to make payments. The treasury normally keeps its account balances at the fed fairly constant.
Check my work Check My Work button is now disabled1Item 6 Item 6 10 points Which of the following factors would increase the transactions demand for money? Option i: Lower nominal interest rates Option ii: A fall in nominal income Option iii: Rumors that a computer virus had invaded the ATM network
Both options i and iii would increase the transactions demand for money. Lower nominal interest rates would reduce the opportunity cost of holding money, while a computer virus in the ATM network would lead to worries about the system closing down. Both of these factors will increase the transactions demand for money.
Open Market Operations
Buying/selling a security initiated by the central bank (Page 26 for chart)
Causes of a Speculative attack
Fiscal policy: If investors begin to think that at current levels, government spending must ultimately increase inflation, they will stop believing that officials can maintain the exchange rate at its fixed level. Financial instability: If a country's banking system is insufficiently capitalized or otherwise unsound, a central bank may face pressure to relax monetary policy to avoid or contain a financial crisis. If investors doubt that the central bank will keep interest rates high enough for a sufficient time to defend the currency peg, an attack may follow. Spontaneously:If enough currency speculators simply decide that a central bank cannot maintain its exchange rate, they will attack. (Spontaneous speculative attacks are like bank runs; they can be contagious.)
capital controls
Fix a company exchange rate Still use monetary policy to pursue its domestic objectives This is only expressed when a country does not participate in the international markets
speculative attack
Fixed exchange rates have benefits, but they are fragile and prone to a type of crisis
Foreign Exchange Intervention
Gov will buy/sell currency in an attempt to affect demand or supply. The US has only done it 2 times in the past ~10 years. (1997-2016) Japan do it all the time
PPP - Inflation
If inflation occurs in one country but not in another, the change in price creates an international inflation differential. The currency of a country with high inflation will depreciate.
In the first half of 1997, the Bank of Thailand maintained a fixed exchange rate of 26 Thai baht to the U.S. dollar, but Thai interest rates were substantially higher than those in the United States and Japan. Thai bankers were borrowing money in Japan and lending it in Thailand. a. Why was this transaction profitable? Bankers could borrow money in XXXX at a low rate, and lend in XXXX b. What risks were associated with this method of financing? There was the risk that the baht could XXXX ,making it more costly to repay the money borrowed in Japan. c. Describe the impact of a depreciation of the baht on the balance sheets of Thai banks involved in these transactions When the baht XXXX the costs to the Thai banks of repaying their loans which caused their reserves to
Japan Thailand Depreciate Depreciated Rose Shirink
Central Bank role in the lending process
Lender of the last resort.. Making loans when on one else can. Will also be the most expensive
Banker's Bank Assets
Loans
Goals of Monetary policy makers
Low and stable inflation High and stable growth A stable financial system Stable interest and exchange rates
Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase. Explain how the Fed's actions are intended to work. by purchasing mortgage-backed securities (MBS), the Fed sought to XXXX mortgage rates in order to XXXX home sales, XXXX house prices, and XXXX housing construction.
Lower Increase Raise Promote
M = C + D
M = Quantity of money C = Currency D = Deposits
M = m X MB
M=quantity of money m= money multiplier MB = Monetary Base
MB = C + R
MB = Monetary base C = Currency R = Reserves in banking system
what is the equation of exchange?
MV = PV Money Growth + Velocity of Money = Inflation + Real Growth
change in the composition of a central banks balance sheet after sterilized interventions
Markets are thin or functioning poorly The policy shift is large compared to the level of market transactions
Quantitative Easing
Massive expansion of reserves Without aggressive action by the fed, a financial crisis leads to deflation and depression
unconventional policy tools
Massive purchases of risky assets in fragile markets Communicating its intent to keep interest rates low over an extended period
Consider a country where the level of excess reserves fluctuates widely and unpredictably. Would such a country be a good candidate for a money growth rule to guide monetary policy? Yes. No. Explain your answer.
No To be effective at controlling inflation, a money growth rule requires a stable link between the monetary base and monetary aggregates, such as M1 and M2. This would not be the case here, since the volatile reserve-deposit ratio would cause fluctuations in the money multiplier.
Real Vs. Nominal Exchange Rates
Nominal = the rate at which currency can be exchanged Real = how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country.
Normal income proportion to money demand
Nominal income is roughly proportional to money demand
PPP - Currency being Under/over valued
One dollar purchases only 0.9 euro, it is undervalued relative to the euro.
What caused the instability of money demand over these three decades?
One reason has to do with the introduction of financial instruments that paid higher returns than money, but could still be used as a means of payment. A second explanation has to do with changes in mortgage refinancing rates.
unsterilized foreign exchange intervention
One that changes central bank liabilities
Purchasing Power Parity
One unit of US domestic currency will by the same basket of goods and services anywhere in the world. PPP implies that the real exchange rate is always equal to ONE PPP implies that when prices change in one country but not in another, the FX rate should change as well
Assuming the country is open to international capital flows, which of the following combinations of monetary and exchange-rate policies are viable? Option a:. A domestic interest rate as a policy instrument and a floating exchange rate. Option b: A domestic interest rate as a policy instrument and a fixed exchange rate. Option c: The monetary base as a policy instrument and a floating exchange rate.
Options a and c are both viable. They combine independent domestic monetary policy with a floating exchange rate and so are feasible options with international capital mobility.
An important supplementary tool for monetary policy used by the Fed XXX
Overnight reverse repo (ON RRP) rate. Serves to keep the market federal funds rate close to the IOER rate. Can be used to set a floor under the market federal funds rate
Paying interest on reserves allows a central bank to control what?
Price and Quantity of money Price: It can adjust the target range for the federal funds rate and IOER rate without changing the size or composition of its balance sheet Quantity: It can adjust the size and composition of its balance sheet without changing the target range for the federal funds rate or IOER rate
Effect on bonds if an investor sells
Prices down Interest Rates up Value of domestic currency is up
What are the 3 types of of loans that the Fed makes?
Primary Credit Secondary Credit Seasonal Credit
Central Bank's Balance Sheet
Publish their B/S regularly Publication is critical part of the transparency that makes monetary policy effective.
Foreign Exchange Intervention
Purchase of FX reserves (German Bonds) will increase both assets & liabilities on the FED B/S
R = RR + ER
R= Reserves in banking system RR = Required Reserves ER = Excess Reserves
Suppose you see the following newspaper headline: "Japan's Finance Ministry Sells Yen for U.S. Dollars." What is the objective of this policy? If the policy goal is achieved, what will happen to the prices of Japanese imports to the United States? What will happen to the prices of U.S. goods purchased by residents of Japan? The policy intervention by Japanese authorities XXXX the quantity of yen relative to dollars in the foreign exchange market. This XXXX the price of the yen, which is the same thing as of the dollar, which will make Japanese goods XXXX in the U.S. and will make U.S. goods XXXX for Japanese citizens.
Raises Lowers An appreciation Cheaper More Expensive
Real exchange Rate Equation
Real exchange Rate = (Nominal exchange rate X domestic price) / (Foreign Price)
Describe the impact of financial innovations on the demand for money and velocity. Financial innovations XXXX the demand for money and XXXX velocity
Reduce Increase
3 Uses of a Monetary Base
Required Reserve Excess Reserve Cash in hands of the nonbank public
Required Reserve Ratio
Required Reserve = required reserve ratio X deposits
Why is inflation higher than money growth in high‑inflation countries and lower than money growth in low‑inflation countries? At very high levels of inflation, the velocity of money XXXXX dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is XXXX by economic growth.
Rises Offset
Government's Bank Assets
Securities Foreign Exchange Reserves
Reserve Requirements
Set in 1935 minimum level of reserves banks must hold either as vault cash or on deposit at the Fed.
Money Multiplier
Shows how the quantity of money is related to the monetary base.
Fixed Exchange Rate
Some countries adopted fixing FX and maintain at a level of their choosing
Public Disclosure
Statement of the central banks own financial health. this helps us tell if policymakers are doing their job properly (Bank transparency)
How is the price of Money determined?
Supply and Demand
How are the short run exchange rates determined?
Supply and Demand Investors play a crucial role, because they are the ones who can move large quantities of currency across international borders.
Reserve demand becomes horizontal at the IOER rate because:
banks will not make loans at less than the IOER rate.
How are target rates set?
by the FOMC and the market federal funds rate, at which transactions between banks take place.
The reserve requirement does not meet all of the criteria of a good monetary policy tool, because it:
cannot be quickly changed.
The Fed can _____ in the economy.
change both interest rates and the supply of money
What is the quantity theory of money and what does it tell us?
money growth translates directly into inflation It tells us why high inflation and high money growth go together It explains the tendency for moderate- and low-inflation countries to fall below the 45-degree line
