Chapter 6 Flashcards
1
Q
Nominal interest rates
A
expressed in units of currency, such as the 6.8% T-bill rate.
2
Q
Real interest rates
A
- expressed in a basket of goods and represent the value of payment in the future.
- to calculate, we must adjust nominal rates for expected inflation.
- The derivation involves adjusting nominal rates to pay for the value of goods, not just currency
- based on the price of goods, such as bread
3
Q
distinction between nominal and real interest rates
A
- depends on expected inflation.
- Nominal interest rate is the interest rate charged, and
- the real interest rate is the nominal interest rate except corrected for expected inflation in the future.
4
Q
implications of equation (6.4)
A
- real interest rate is typically LOWER than the nominal interest rate because expected inflation is typically positive.
- When expected inflation equals ZERO, the nominal and the real interest rates are the SAME
- For a given nominal interest rate, the HIGHER the expected inflation rate, the LOWER the real interest rate.
5
Q
All the equations interpretation
A
- real interest rate is based on expected inflation, so it is sometimes called the ex-ante (“before the fact”) real interest rate.
- The realized real interest rate (1 − π) is called the ex-post (“after the fact”) interest rate.
- The interest rate that enters the IS relation is the real interest rate.
- The zero lower bond of the nominal interest rate implies that the real interest rate cannot be lower than the negative of inflation.
6
Q
Risk premia
A
determined by:
1.1 The probability of default
1.2 The degree of RISK AVERSION of bond holders
7
Q
Probability of default
A
The higher the default probability and the greater the risk aversion, the higher the necessary risk premium.
8
Q
degree of risk aversion
A
- contributes to the risk premium.
- If people become more risk averse, the risk premium increases even if the probability of default hasn’t changed.
9
Q
The role of financial intermediaries
A
- receive funds from investors and lend them to others.
- borrow and lend, charging a slightly higher interest rate than the rate at which they borrow to make a profit.
- They have specialized expertise about specific borrowers and can tailor lending to their needs
10
Q
capital ratio
A
the ratio of its capital to its assets
11
Q
leverage ratio
A
- the ratio of assets to capital.
- A HIGHER leverage ratio implies a HIGHER expected profit rate, but also a HIGHER risk of bankruptcy and INSOLVENCY
12
Q
Risk of liquidity on financial intermediaries
A
- Low liquidity of assets implies a high risk of being sold at FIRE SALE PRICES (below true value)
- higher liquidity of liabilities (demand deposits) ), the higher the risk of fire sales. This may lead to insolvency and facing BANK RUNS
13
Q
Bank Runs
A
- occur when depositors panic and withdraw their money.
- A bank with good loans can fail due to rumours about its financial health.
14
Q
solution to bank runs
A
- Narrow banking, which restricts banks to safe government bonds, could eliminate bank runs.
- The Fed also implemented liquidity provision so that banks could borrow overnight from other financial institutions.
15
Q
To limit bank runs
A
- Federal Deposit insurance is a common way of preventing bank runs in advanced countries.
- SARB and National Treasury are reviewing a deposit insurance scheme (DIS) to address bank failures but such insurance can lead to reckless bank behavior.
