Economic Fluctuation, Monetary policy and The financial system

Question 1

Definition of “Monetary transmission mechanism”:

Answer 1

• It is the process through which monetary policy affects output.
• Lags occur between central banks’ policy actions and the actions’ ultimate effects on output and inflation
• These time lags make it harder for central banks to stabilize the economy.

Question 2

The expectations theory (again)

Answer 2

• i₁(t) is the current one-period rate
• E₁(t +􏰁 1) is the one-period rate expected at t 􏰁 1,
• “r” is a term premium
• “n” stand for periods

Question 3

The Federal Funds Rate and the 1-Year Rate: An Example (graph)

Answer 3

Question 4

Effect of a Cut in the Federal Funds Rate on the Yield Curve (graph)

Answer 4

Question 5

How a surprise change in the fed interest rate affect “The One-Year Rate” in bonds and stocks ?

Answer 5

• When the Fed raises the interest rate, the direct effect on the 1-year rate is small. (bonds and stocks)
• The secondary effects is that the new current federal funds rate affects expected future rates.
• Remember that the funds rate usually stays constant between FOMC meetings, which occur every 42 days (6 weeks).
• The Fed rarely reverses course quickly after an interest rate change.
• Indeed, an increase in the funds rate is often followed by further increases as the Fed slowly tightens policy.

Question 6

How a surprise change in the fed interest rate affect “Long-Term Rates” of bonds and stocks?

Answer 6

• A surprise change in the federal funds rate also affects rates at maturities beyond a year.
• It may be several years before the policy change is reversed.
• Fed actions have less effect on very-long-term interest rates, such as 30 year loans

Question 7

what happens when the fed applied expected polcies changes?

Answer 7

• If everyone expects that the FOMC will raise the funds rate, then bond traders learn nothing new when the increase occurs.
• They have no reason to change their expectations about the future, and it is those (already change) expectations that determine longer-term rates.

Question 8

Why might people expect a change in the federal funds rate?

Answer 8

• Fed officials never announce precisely what future rates will be, but they offer hints.
• When the FOMC sets the current federal funds target, it issues a statement discussing its action and what it might do in the future.
• Bond traders can sometimes infer what the Fed will do from the state of the economy.
• The Fed’s actions still matter if they are expected, but their effects occur before the actions themselves.

Question 9

Typical Effects on the Yield Curve of an Unexpected Rise in the Federal Funds Rate (graph)

Answer 9

Question 10

why components of the financial markets and banks influence aggregate expenditure ?

Answer 10

1. Events in the financial system are one initial cause of output fluctuations.
   * Asset-price declines and banking crises have caused many recessions
2. The financial system is part of the monetary transmission mechanism.
   * Actions by the central bank affect not only interest rates but also asset prices and bank lending.
   * These effects magnify the response of output to policy actions.

Question 11

what asset prices may affect the aggregate expenditure ?

Answer 11

• Wealth and Consumption

A rise in asset prices raises consumption, one of the four components of aggregate spending.

• Stock Prices and Investment

Firms can finance investment by issuing new stock

• Effects on Net Worth and Collateral

Banks require borrowers to post collateral or maintain certain levels of net worth.

Higher real estate prices raise the value of buildings that firms use as collateral

Question 12

Why might banks change their lending policies?

Answer 12

1. Risk Perception
2. Regulations
3. Capital

Question 13

Why the Risk Perception of the banks might change their lending policies?

Answer 13

• Banks refuse to lend to borrowers who appear too risky. Sometimes events cause banks to change their assessment of risk.

Question 14

Why the banks Regulations might change their lending policies?

Answer 14

• Bank regulators usually discourage lending with too much risk, but regulations change over time, becoming more or less stringent.

Question 15

Why capital might change the bank lending policies?

Answer 15

• A capital crunch is one possible cause of a credit crunch.
• Capital requirements set a minimum for a bank’s equity ratio, the ratio of capital to assets

Question 16

what is “Capital crunch”

Answer 16

• It is a fall in capital that forces banks to reduce lending

Question 17

what is Investment multiplier?

Answer 17

• It is an effect of firms’ earnings on investment, which magnifies fluctuations in aggregate expenditure

Question 18

The Investment Multiplier (graph)

Answer 18

Question 19

The Monetary Transmission Mechanism When Policy Tightens (graph)

Answer 19

• “Y” stand for output

Question 20

When the federal funds rate rises, what effect have in the financial markets?

Answer 20

• The rise in the funds rate causes longer-term interest rates to increase.
• Increases in interest rates reduce the present value of future earnings from assets.
• Higher interest rates attract capital inflows from abroad and reduce capital outflows. As a result, the exchange rate appreciates.

Question 21

When the federal funds rate rises, what secondary effects have in the “Bank Lending” system? (financial market but more specific for bank)

Answer 21

• A rise in interest rates worsens the problems of adverse selection and moral hazard in loan markets.

A larger proportion of loan applicants becomes risky. Banks respond by reducing their lending.

• The fall in asset prices also reduces lending, because it reduces borrowers’ collateral and net worth.

Question 22

When the federal funds rate rises (affecting the banks), what effect have in the aggregate expenditure?

Answer 22

• Higher interest rates discourage firms and consumers from borrowing, so they spend less.
• Lower asset prices reduce consumption by reducing consumers’ wealth.
• Lower asset prices reduce investment by making it more expensive for firms to raise funds by issuing new stock.
• The decrease in bank lending also reduces investment.
• The appreciation of the exchange rate reduces net exports.

Question 23

When the federal funds rate rises, how the multiplayers affect the AE?

Answer 23

• The consumption multiplier: lower spending means lower income for consumers, which produces a further fall in consumption.
• The investment multiplier: lower spending means lower earnings for firms. With lower earnings, firms reduce investment.

The loop continue

Question 24

The AE/PC Model with Time Lags (graph)

Answer 24

Question 25

What is disinflation ?

Answer 25

• A disinflation is a temporary rise in the real interest rate that reduces infla- tion

Question 26

A Disinflation with Time Lags (graph)

Answer 26

Question 27

Countercyclical Policy with Time Lags (graph)

Answer 27

Question 28

Definition of Fiscal policy: (simple)

Answer 28

• the government’s choice of taxes and spending

Question 29

Two Types of Countercyclical Policy (graph)

Answer 29

Question 30

Definition of “Inside lag”:

Answer 30

• time between a shock and the policy response

Question 31

Definition of “Outside lag”:

Answer 31

• time between the policy response and its effects on the economy