Chapter 5 Study Notes

Question 1

The business cycle

Answer 1

The business cycle represents a repetitive succession of changes in economic activity. The business cycle has four phases—expansion (recovery), peak, contraction (decline), and trough.

Question 2

Deflation

Answer 2

is the persistent and appreciable fall in the general level of prices. The cycle then enters the trough.

Question 3

Monetary Policy

Monetary economic theory

Answer 3

Monetary economic theory focuses on the money supply. A monetarist believes that the expansion and contraction of the money supply is the most important factor in controlling the demand for goods and services in the economy.

Question 4

Monetary Policy

Answer 4

Monetary policy attempts to control the supply of money and credit in the economy. This will affect interest rates, causing an increase or decrease in economic activity. The primary focus of monetary policy is the actions of the Federal Reserve Board as it attempts to control inflation.

Question 5

The Federal Reserve Board

Answer 5

The Federal Reserve Board (also referred to as the Fed or the FRB) attempts to control the money supply and credit to maintain a stable, growing economy while controlling inflation.

Question 6

The Federal Reserve Act

Guidelines

Answer 6

The Federal Reserve Act clearly states that the Fed must pursue maximum employment, stable prices, and moderate long-term interest rates. Although controlling inflation is a driving factor in the Fed’s monetary policy, it’s not specifically mandated in the Federal Reserve Act.

Question 7

Stable Prices

Answer 7

Supply and demand is the ultimate determinant of the average level of prices in the economy, but the level of demand for goods and services is affected by Fed policy. Moderating demand and therefore moderating prices is the Fed’s overriding long-term goal.

Question 8

Maximum Employment

Answer 8

The Fed strives to maintain the unemployment rate at a level that’s as low as possible without pushing it below the full employment level. If unemployment falls too low then the expectation is that there will be inflationary pressure on worker compensation (wage inflation).

Question 9

Wage Inflation

Answer 9

Wage inflation will cause businesses to raise prices to keep operating profits as stable as possible, which will hinder the achievement of one of the major objectives—stable prices. Therefore, the goal of maximum employment is to reduce the unemployment level until prices are stable and growth is moderate. Price stability means that the Fed should strive to keep inflation on a downward trend (disinflation) without creating wage inflation.

Question 10

Money Supply Measurements

Answer 10

The Federal Reserve Board attempts to control the money supply and credit to maintain a stable, growing economy with the aim of combating inflation.
There are several standard measures of the money supply that are used by the Federal Reserve Board, including the monetary base, M1, and M2.

Question 11

Definitions of the Money Supply

M1

Answer 11

Currency in circulation held by the public
+ demand deposits at commercial banks
+ other checkable deposits

Question 12

Definitions of the Money Supply

M2

Answer 12

+ money market deposit accounts (MMDAs)
+ savings and relatively small time deposits (less than $100,000)
+ balances at retail money market mutual funds

Question 13

Major Tools of the Federal Reserve Board (FRB)

Answer 13

The FRB has various tools at its disposal through which it may implement its monetary policy. These tools are:

• Setting reserve requirements
• Setting the discount rate
• Implementing open market operations
• Setting margin requirements
• Utilizing moral suasion

Question 14

Reserve Requirements

Answer 14

Member banks are required to keep a portion of their deposits on reserve with the FRB. By adjusting the amount that banks must keep on reserve at the FRB, the Fed can tighten or ease the money supply. If reserve requirements are lowered, the banks are able to extend more credit and therefore increase the money supply increases. The opposite effect occurs with an increase in reserve requirements.

Question 15

excess reserves.

Answer 15

After meeting its reserve requirement, a bank will strive to lend the remaining funds to borrowers. The amount of funds that a bank has above the reserve requirement is referred to as its excess reserves

Question 16

multiplier effect

Answer 16

The money that’s spent by the borrowers will eventually be deposited in another bank. This continues as money is deposited from bank to bank, creating a multiplier effect on deposits. In other words, the multiplier effect is the rate at which banks can create new money by relending deposits and, in turn, creating new deposits. Changing the reserve requirements will have an impact on the multiplier effect within the banking system.

Question 17

velocity of money

Answer 17

velocity of money measures the number of times a dollar is spent over a given period.

Question 18

Discount Window

Answer 18

The FRB was originally established to aid the banking system in emergency situations by acting as a banker’s bank. The FRB always stands ready to lend money to its members and fulfills that function through its discount window. The rate that’s charged for loans provided by the FRB is referred to as the discount rate.

Question 19

Borrowing from the discount window

Answer 19

When members of the Fed borrow using the discount window, new money is injected into the system (which is then expanded by the multiplier effect). The FRB can encourage or discourage use of discount window borrowing by changing the rate of interest that it charges for those loans.
By decreasing the discount rate, the FRB encourages borrowing, which expands the money supply. Conversely, the money supply will contract due to an increase in the discount rate.

Question 20

federal funds.

Answer 20

If a bank has excess reserves, it may lend additional funds to borrowers (e.g., commercial banks) that are in a deficit reserve position. These short-term loans of excess reserves that banks lend each other are referred to as federal funds. The rate of interest that’s charged on these loans is the federal funds rate.

Question 21

Fed Fund Rate

Answer 21

The federal funds rate is determined by supply and demand. Since federal funds are for short-term (overnight) purposes, they are considered money-market instruments and the rate is highly volatile.
The effective federal funds rate is published daily and shows the average rate that was charged the previous night for federal funds.
Although the FRB doesn’t directly set the fed funds rate, it does set a target. The FRB’s Open Market Operations are designed to maintain the fed funds rate within this prescribed target range.

Question 22

The Federal Open Market Committee (FOMC)

Answer 22

THey oversee the FRB’s buying and selling of U.S. government securities in the secondary markets. Open market operations are the most effective and frequently used tool of monetary control that’s employed by the FRB. The FOMC’s operations are also the most flexible tool and the easiest to reverse.

Question 23

Open Market securities

Answer 23

Open market operations typically involve the purchase and sale of U.S. government securities—primarily Treasury bills. However, the FRB also trades government notes and bonds. These trades are executed through primary government dealers, which include the nation’s largest banks and brokerage firms that have been appointed by the FRB.

Question 24

Open Market

Buying Securities

Answer 24

If the Fed buys securities, it pays for these securities with funds that are ultimately deposited in commercial banks. This causes deposits at banks to increase and therefore adds to the funds that are available for loans. The result of this activity is an increase in bank reserves. Money becomes more available and interest rates tend to move downward. This is referred to as an easy money policy.

Question 25

Open Market

Selling Securities

Answer 25

f the Fed intends to tighten (reduce) the money supply, it will sell securities to banks and securities dealers. The banks and dealers will pay for these securities by withdrawing the money from their demand (checking) accounts and, therefore, their bank reserves will decrease. The withdrawal of money from the banks will decrease the amount of money available for loans. Ultimately, this will have a tightening effect on the money supply, causing interest rates to rise.
Repurchase

Question 26

Open Market

Repurchase Agreements - Repo

Answer 26

repurchase agreement (also referred to as a repo) is a contract that’s entered into by the Federal Reserve to purchase U.S. government securities from dealers at a fixed price, with provisions for their resale back to the dealer at the same price plus a negotiated rate of interest. When the Fed effects a repo, it’s lending money and, therefore, increasing bank reserves (an easy money policy).

Question 27

Open Market

Repurchase Agreements - Reverse Repo

Answer 27

A reverse repo (also referred to as a matched sale) occurs when the FRB sells securities to dealers with the intention of buying the securities back at a future date. This has the short-term effect of absorbing funds from the money supply (a tight money policy).

Question 28

Monetary Policy

Using Margin Requirements

Answer 28

By increasing margin requirements, the FRB reduces the amount brokers and banks may lend, which causes the money supply to tighten. Changing the margin requirement is the least effective method that the FRB uses to control credit because it only affects securities market transactions.

Question 29

Moral Suasion

Answer 29

There are times when the Fed tries to influence bank lending policies through moral suasion (also referred to as jawboning). The Fed exerts its influence through the public media or through the examiners that are sent to member banks. Its efforts to control the money supply by these means are limited by the extent to which they can elicit cooperation from these institutions.

Question 30

How Money is Created

Answer 30

As measured by M1, money consists of currency plus checking account balances. While the FRB prints currency, the commercial banking system creates checking accounts. Banks make a profit if they can attract deposits and lend those funds at a higher rate of interest

Question 31

Intermediation

Answer 31

Intermediation is a term that refers to the ability of financial intermediaries (such as banks) to attract deposits and, in turn, extend credit.

Question 32

Disintermediation

Answer 32

Disintermediation is the process by which investors withdraw funds from banks in order to seek higher-yielding investments elsewhere. For example, if money-market mutual funds are yielding 4% while time deposits at banks are yielding 2%, investors may invest money in the funds with bank withdrawals. The higher mutual fund yield may affect the bank’s ability to attract and keep deposits.

Question 33

effect of GDP being higher then predicted

Answer 33

the stock market will typically react positively. Treasuries will generally fall in price because growth that’s faster than expected is inflationary and fuels the perception that fixed-income values will be eroded if such growth numbers persist.
Growth exceeding that number means bonds may be overpriced and an adjustment may be necessary. This type of dynamic is in place for all of the following indices.

Question 34

The three types of economic indicators are

Answer 34

• leading - Leading economic indicators precede the upward and downward movements of the business cycle and may be used to predict the near-term activity of the economy.
• coincident - Coincident indicators typically mirror the movements of the business cycle.
• lagging - The index of lagging indicators represents items that change after the economy has moved through a given stage of the business cycle. The index of lagging indicators should confirm the economic condition portrayed by previous leading and coincident indexes.

Question 35

Leading Economic Indicators

Answer 35

1. Average weekly hours; manufacturing
2. Average weekly initial claims for unemployment insurance
3. Manufacturing new orders; consumer goods and materials
4. ISM Index of New Orders (this reflects the level of new orders from customers)
5. Manufacturers’ new orders, non-defense capital goods excluding aircraft orders
6. Building permits; private housing units
7. The prices for the S&P 500 Index common stocks
8. Leading Credit Index (this index consist of six financial indicators based on various yields)
9. Interest rate spreads, 10-year Treasury bonds less federal funds
10. Average consumer expectations for business conditions

Question 36

Coincident Economic Indicators

Answer 36

1. Employees on non-agricultural payrolls
2. Personal income less transfer payments (transfer payments represent aid for individuals in the form of Medicare, Social Security, and veteran’s benefits, to list a few.)
3. The Index of Industrial Production
4. Manufacturing and trade sales

Question 37

Lagging Economic Indicators

Answer 37

 The average duration of unemployment
 The relationship of inventories to sales, manufacturing, and trade
 Labor cost per unit of output for manufactured goods
 The average prime rate charged by banks
 Commercial and industrial loans outstanding
 The relationship of consumer installment credit to personal income
 The consumer price index for services

Question 38

Economic Indicators

GDP

Answer 38

GDP is the output of goods and services that are produced by labor and property located in the United States without regard to the origin of the producer.

Question 39

Economic Indicators

Real GDP

Answer 39

The most useful variation of GDP is real GDP, which is GDP that’s been adjusted for inflation. This is considered the key measure of aggregate economic activity. In fact, rising GDP signifies economic growth and potential inflation.

Question 40

Existing Home Sales

Answer 40

Existing home sales is a strong indicator of housing demand and a leading indicator of overall economic activity. This report covers the number of existing, privately owned, single-family houses that were sold during the month. Some economists believe this report is more significant than new home sales since it’s based on a much larger sample size and is released approximately one week before new home sales data. A strong upward trend in existing home sales is considered bad for the bond market.

Question 41

Producer Price Index (PPI)

Answer 41

The PPI is the first indication of the level of inflation each month and often leads the way toward a change in sentiment regarding growth in the economy. PPI is a measure of prices at the producer level that generally indexes finished goods at wholesale prices. It also provides an index of commodity prices with no consideration for services in the economy.
A PPI figure that exceeds expectations will typically have a negative impact on the bond market.

Question 42

Foreign Exchange and Trade

Answer 42

Changes in interest rates affect not only the domestic economy, but also international economic activity. If interest rates in the U.S. are higher than interest rates overseas, foreign investors seeking to earn the higher rate will want to invest in the U.S. markets. To invest in the U.S., foreign investors must first convert their funds into U.S. dollars. As demand for dollars increases, the price of dollars (exchange rate) will increase. The result is that higher U.S. interest rates compared to foreign yields may lead to a stronger dollar.

Question 43

Commodity Prices

Answer 43

Another leading indicator of inflation is commodity prices. If prices of commodities (e.g., oil) increase, it’s considered an inflationary sign. In response to this sign, the Fed will raise interest rates.

Question 44

Fiscal Policy

Answer 44

Fiscal policy involves the government’s use of taxation and expenditure programs to maintain a stable, growing economy. If the economy is in a recession or trough, the government can increase its spending to stimulate demand. Alternatively, it can cut taxes, which will increase the disposable income of consumers and also stimulate demand. If the economy is overheated (too much demand), the government can cut its spending or increase taxes.

Question 45

Taxation

Answer 45

Tax policy can be used to stimulate or reduce economic activity. General tax cuts will normally stimulate the economy. On the other hand, specific tax deductions, credits, and loopholes can stimulate particular sectors of the economy.
The main purpose of the tax system is to spread the cost of government throughout society.

Question 46

Expenditure Programs

Answer 46

If the policy is successful, economic activity will increase and the private sector will need funds to expand plant and production. This will also cause a rise in interest rates. However, there’s a limit as to how much interest the private sector (corporations and individuals) can afford to pay.

Question 47

crowding out.

Answer 47

Since the government’s source of funds to pay interest on its debt is essentially unlimited, it’s insensitive to interest rates. Therefore, the government can outbid the private sector for available funds. The private sector is squeezed out of the credit markets by high interest rates. This is referred to as crowding out

Question 48

cyclical deficit

Answer 48

The cyclical deficit is the portion of the total budget deficit that’s caused by the cyclical fluctuation in the economy.

Question 49

structural deficit

Answer 49

The structural deficit is the budget deficit that occurs if the economy is operating at the level of full employment
The structural budget deficit or surplus is a better indication of the direction of the federal government’s fiscal policy than the actual budget or surplus because the cyclical effects on the deficit or surplus have been eliminated. For that reason, the structural deficit serves as an indicator of the stance of fiscal policy. If a structural deficit exists, then fiscal policy is expansionary.

Question 50

Yield Curves

Answer 50

If different maturities are plotted against the corresponding yield for each maturity, the resulting graph is a yield curve. A yield curve is also referred to as the term structure of interest rates. A yield curve can be created for any type of bond, but investors and analysts tend to use yield curves that are derived from securities which are issued by the U.S. government in order to judge the direction in which interest rates are heading.

Question 51

Normal Yield Curve

Answer 51

A positively sloped yield curve is the type that exists under most market conditions and is referred to as a normal, positive, ascending, or upward sloping yield curve. Since yields generally increase as maturities lengthen, the typical yield curve will show lower yields in the shorter maturities and higher yields in the longer maturities.

Question 52

Inverted Yield Curve

Answer 52

The inverted yield curve is also referred to as being a negative, descending, or downward sloping curve and is relatively rare. Notice that yields are the highest for the shortest maturity and decrease as the maturity increases.
. Negatively sloped yield curves tend to appear when interest rates are relatively high, such as in periods of high inflation. When the demand for money (borrowing) far exceeds the supply, there is an inverted yield curve.

Question 53

Flat Yield Curve

Answer 53

A flat yield curve reflects similar demand and supply and, therefore, similar yields, across all maturities.

Question 54

nominal interest

Answer 54

which is composed of the real interest rate plus the inflation
For example, if a 10-year bond is yielding 7% when the inflation rate is 3%, the real rate of interest is 4%. The 7% is composed of a 4% real interest rate, plus a 3% inflation premium.

Question 55

Non-Treasury bond Yields

Answer 55

typically offer higher yields because, in addition to an inflation premium, the market adds another premium for other types of risk, such as credit or default risk, call or early redemption risk, liquidity or market risk, and unexpected changes in the inflation rate.

Question 56

during inflationary times when demand for money (issuers wanting to borrow) exceeds supply

Answer 56

there may be an inverted yield curve. Demand for short-term borrowing will drive yields up while strong demand by bond investors for long maturities drives yields down (due to the buying demand, high prices will push yields down). This may indicate that investors expect interest rates to fall (investors want to take advantage of the short-term rates

Question 57

The Market Expectations Theory

Answer 57

This theory states that there’s a link between current rates and expected rates (forward rates). For example, if today’s yield for a one-year bond is 5%, and if the consensus is that one year from now yields on one-year securities will be 7%, the yield today on a two-year bond should be 6%. An equilibrium is reached because investors should be indifferent to investing for successive one-year periods or for a two-year period. If this theory is correct, the yield curve could be used to predict future interest rates.

Question 58

The Market Segmentation Theory

Answer 58

The market segmentation theory assumes that different groups of investors have preferences for different maturities of bonds.
Therefore, the shape of the yield curve is determined by the changing relationships between the supply of bonds and the demand for them from various investor groups.

Question 59

The Liquidity Preference Theory

Answer 59

Another explanation for the shape of the yield curve states that it illustrates the risk premium demanded by investors who buy long-term bonds. Investors who buy long-term issues face risk of default or interest rate changes for a longer period of time and, as a result, they demand additional yield as compensation. Investors who purchase short-term bonds are willing to sacrifice yield to increase liquidity, which is also referred to as the liquidity preference theory.

Question 60

Yield Spread

Answer 60

Another variable that can create opportunities as well as problems for bond investors is the difference (spread) between yields for different classes of bonds.

Question 61

Yield spreads between classes of bonds can be affected by a variety of factors, including:

Answer 61

 The expectations investors have for the economy (during recessions, investors stay away from risky credits in what’s referred to as the “flight to quality.”)
 Financing activities by various issuers (a large Treasury sale can significantly increase supply.)
 The entry into, or exit from, the market of large classes of investors (e.g., mutual funds and insurance companies)

Question 62

compression.

Answer 62

During times of falling interest rates, the price performance among various types of bonds can differ due to compression. When interest rates fall bond prices increase, but the price of some types of bonds will not increase as much. Instead, the price will be compressed towards par.