Exam 2 Flashcards
3 monetary policy tools
- Open market operations
- Discount rate
- Reserve requirements
Major link by which monetary policy impacts the macroeconomy
Federal Reserve influencing the market for bank reserves
What does the federal reserve’s monetary policy seek to influence?
The demand for or supply of excess reserves at depository institutions and in turn the money supply and level of interest rates
How do depository institutions trade excess reserves held at their local federal reserve banks?
Among themselves
Fed funds rate
Rate of interest or price on the transactions between depository institutions trading excess reserves between themselves
Financial Services Regulatory Relief Act of 2006
Authorized the federal reserve to pay interest on reserve balances
Two basic approaches to affect the market for banks’ excess reserves
- Target the quantity of reserves in the market
- Target the interest rate on those reserves (the fed funds rate)
open market operations
The Federal Reserve’s purchase or sale of securities in the U.S. Treasury securities market
what happens when a targeted monetary aggregate or interest rate level is determined by the FOMC
forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York through a policy directive
how does the Manager of the Trading Desk use the policy directive
to instruct traders on daily amount of open market purchases or sales to transact
what is the primary determinant of changes in bank excess reserves in the banking system
open market operations
what directly impacts the size of the money supply and or the level of interest rates (fed funds rate)
open market operations
discount rate
second monetary policy tool used by the Fed to control the level of bank reserve or the money supply or interest rates
Raising the discount rate
signals a desire to see a tightening of monetary conditions and higher interest rates in general
Lowering the discount rate
signals a desire to see more expansionary monetary conditions and lower interest rates in general
two reasons the Federal Reserve has rarely used the discount rate as a monetary policy tool
- is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes
- Because of its “signaling” importance, a discount rate change often has great effects on the financial markets
three discount lending programs
- Primary credit is available to generally sound DIs on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds
- Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution
- Seasonal credit is available to DIs that can demonstrate a clear pattern of recurring intrayearly swings in funding needs
reserve requirements (reserve ratio)
determine the minimum amount of reserve assets that DIs must maintain by law to back transaction deposit accounts held as liabilities on their balance sheets
A(n) decrease (increase) in the reserve requirement ratio
means that DIs may hold fewer (must hold more) reserves against their transaction accounts, allowing them to lend out a greater (smaller) percentage of their deposits and increasing (decreasing) credit availability in the economy
Decrease in the reserve requirement
results in a multiplier increase in the supply of bank deposits and thus the money supply
Increase in the reserve requirement
results in a multiple contraction in deposits and a decrease in the money supply
three expansionary activities
- Open market purchases of securities
All else constant, reserve accounts of banks increase - Discount rate decreases
All else constant, interest rates in the economy decrease - Reserve requirement ratio decreases
All else constant, bank reserves increase
three contractionary activities
- Open market sales of securities
All else constant, reserve accounts of banks decrease - Discount rate increases
All else constant, interest rates in the open market increase - Reserve requirement ratio increases
All else constant, bank reserves decrease
Federal Reserve can successfully target only one of these two variables at any one moment
money supply or interest rates
If the money supply is the target variable used to implement monetary policy
interest rates must be allowed to fluctuate relatively freely
If an interest rate (e.g., fed funds rate) is the target
bank reserves and the money supply must be allowed to fluctuate relatively freely
Taylor rule
which states short-term interest rates should be determined by three conditions:
1. Where actual inflation is relative to the Fed’s targeted level
2. The extent to which the economy is above or below its full employment level
3. What short-term interest rates should be to achieve full employment
Central banks
guide the monetary policy in virtually all countries
Independence of a central bank
generally means that the bank is free from pressure from politicians who may attempt to enhance economic activity in the short term at the expense of long-term economic growth
Banks with less independence
People’s Bank of China
Reserve Bank of India
Central Bank of Brazil
four systemwide rescue programs employed during the financial crisis
- Expansion of retail deposit insurance was widely used during the crisis to ensure continued access to deposit funding
- Capital injections by central governments were the main mechanism used to directly support bank balance sheets
- Debt guarantees allowed banks to maintain access to reasonably priced, medium-term funding.
They also reduced liquidity risk and lowered overall borrowing costs for banks - Asset purchases/guarantees removed distressed assets from bank balance sheets
The primary policy tool used by the Fed to meet its monetary policy goals is:
a) changing the discount rate
b) changing reserve requirements
c) devaluing the currency
d) changing bank regulations
e) open market operations
e) open market operations
The Fed Funds rate is the rate that:
a) banks charge for loans to corporate customers
b) banks charge to lend foreign exchange to customers
c) the Federal Reserve charges on emergency loans to commercial banks
d) banks charge each other on loans of excess reserves
e) banks charge security dealers to finance their inventory
d) banks charge each other on loans of excess reserves
The discount rate is the rate that:
a) banks charge for loans to corporate customers.
b) banks charge to lend foreign exchange to customers.
c) banks charge each other on loans of excess reserves.
d) banks charge securities dealers to finance their inventory.
e) the Federal Reserve charges on loans to commercial banks.
e) the Federal Reserve charges on loans to commercial banks.
A decrease in reserve requirements could lead to an:
a) increase in bank lending.
b) increase in the money supply.
c) increase in the discount rate.
d) increase in bank lending and an increase in the money supply.
e) increase in bank lending and an increase in the discount rate.
d) increase in bank lending and an increase in the money supply
If the Fed wishes to stimulate the economy, it could:
I. buy U.S. government securities.
II. raise the discount rate.
III. lower reserve requirements.
a) I and III only
b) II and III only
c) I and II only
d) II only
e) I, II, and II
a) I and III only
The Fed offers three types of discount window loans. ______________ credit is offered to small institutions with demonstrable patterns of financing needs, _____________ credit is offered for short-term temporary funds outflows, and _____________ credit may be offered at a higher rate to troubled institutions with more severe liquidity problems.
a) Seasonal; extended; adjustment
b) Extended; adjustment; seasonal
c) Adjustment; extended; seasonal
d) Seasonal; primary; secondary
e) Adjustment; seasonal; extended
d) Seasonal; primary; secondary
Money markets
trade debt securities or instruments with maturities of less than one year
once issued, money market instruments trade in
active secondary markets
why does the need for money markets arise
because the immediate cash needs of individuals, corporations and governments do not necessarily coincide with their receipts of cash
5 basic characteristics of money market instruments
1) Generally sold in large denominations ($1m to $10m units)
2) Issued by high-quality (i.e., low default risk) economic units that require short-term funds
3) Low default risk, the risk of late or nonpayment of principal and/or interest
4) Short maturity - original maturity of one year or less
5) High marketability
6 money market instruments
1) Treasury bills (T-bills)
2) Federal funds (fed funds)
3) Repurchase agreements (repos or RP)
4) Commercial paper (CP)
5) Negotiable certificates of deposit (CD)
6) Banker’s acceptances (BA)
4 money market yields
1) Bond Equivalent Yield
2) Discount Yields
3) Effective Annual Return
4) Single-Payment Yields
bond equivalent yield
the quoted nominal, or stated, yield on a security, the rate used to calculate the PV of an investment
treasury bills (t-bills)
short-term debt obligations issued by the U.S. government to cover government budget deficits and to refinance maturing government debt
treasury bill auction
the formal process by which the U.S. treasury sells new issues of these
who submits the bids in a treasury bill auction
government securities dealers, financial and nonfinancial corporations, and individuals
two types of bids
1) competitive
2) non-competitive
competitive bids
specify the amount of par value of bills desired and the discount yield, rather than the price
who are competitive bids used by
1) large investors
2) government securities dealers
non-competitive bids
limited to $5m for a single bidder; they specify only the desired amount of the face value of the bills
What type of bidders get preferential allocation and agree to pay the lowest price of the winning competitive bids
noncompetitive
stop-out yield
The cut-off yield of the last accepted bid - is the highest accepted discount yield, all bids above this are rejected
what is the largest of any us money market security
secondary market for t-bills
who purchases most of the t-bills sold competitively at auction
FI’s
How do primary dealers “make a market” for T-bills
by buying and selling securities for their own account and by trading for their customers
How are secondary market T-bill transactions between primary government securities dealers conducted
over the Federal Reserve’s wire transfer service — Fedwire
how are t-bills sold
on a discount basis
federal funds
short-term funds transferred between financial institutions, usually for a period of one day
How do commercial banks trade fed funds
in the form of excess reserves held at their local Federal Reserve Bank
fed funds rate
the interest rate for borrowing fed funds
primary risk of an interbank lending system
the borrowing bank does not have to pledge collateral for the funds it receives, which are usually in the millions
fed funds market
highly liquid and flexible source of funding for commercial banks and savings banks
correspondent banks
those with reciprocal accounts and agreements
repurchase agreement (repo or rp)
an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date
overnight repos
one day maturity
term repos
longer maturity
reverse repurchase agreement (reverse repo)
involves the purchase of securities by one party from another with the promise to sell them back
commercial paper
unsecured short-term promissory note issued by a company to raise short-term cash, often to finance working capital requirements
What is one of the largest (in terms of dollar value outstanding) of the money market instruments, with nearly $1.1 trillion outstanding as of December 2019
commercial paper
Companies with strong credit ratings can generally borrow money at a lower interest rate by _______ than by directly borrowing (via loans) from banks
issuing commercial paper
what denominations is commercial paper sold in
Generally sold in denominations of $100,000, $250,000, $500,000, and $1 million
What are the maturities of commercial paper
generally range from 1 to 270 days—the most common maturities are between 20 and 45 days
When is commercial paper generally held by investors
from the time of issue until maturity
How is commercial paper sold to investors
either directly using the issuer’s own sales force or indirectly through brokers and dealers
What type of commercial paper is more expensive to the issuer
underwritten and issued through brokers and dealers
negotiable certificate of deposit (CD)
bank-issued, fixed maturity, interest-bearing time deposit that specifies an interest rate and maturity date and is negotiable
how often can negotiable cds be traded in the secondary market
any number of times
what are the denominations of negotiable cds
$100,000 to $10 million; $1 million being the most common
banker’s acceptance (ba)
time draft payable to a seller of goods, with payment guaranteed by a bank
where are bas traded
secondary markets
8 money market participants
1) The U.S. Treasury
2) The Federal Reserve
3) Commercial banks
4) Money market mutual funds
5) Brokers and dealers
6) Corporations
7) Other financial institutions
8) Individuals
capital markets
involve equity and debt instruments with maturities of more than one year
bonds
long-term debt obligations issued by corporations and government units
4 bond market securities
1) Treasury Notes and Bonds
2) STRIPS
3) Municipal Bonds
4) Corporate Bonds
treasury notes and bonds
long-term securities issued by the U.S. Treasury to finance the national debt and other federal government expenditures
t-bill maturity
one year or less
t-note maturity
1 to 10 years
t-bond maturity
over 10 years
Separate Trading of Registered Interest and Principal Securities (STRIPS)
A Treasury security in which the periodic interest payment is separated from the final principal payment.
municipal bonds
securities issued by state and local governments; primary reasons for issuances are the following:
to fund imbalances between expenditures and receipts
to finance long-term capital outlays
Why are municipal bonds attractive to household investors
because interest is exempt from federal and most state/local income taxes
3 types of municipal bonds
1) General obligation bonds– backed by taxing power of political entity.
2) Revenue bonds– financed and paid back from a specific project.
3) Industrial development bonds (IDB) – public financing of private business.
corporate bonds
long-term obligations issued by corporations
bond indenture
the legal contract that specifies the rights and obligations of the bond issuer and the bond holders, Contains several covenants associated with a bond issue
bond covenants
describe rules and restrictions placed on the bond issuer and bond holders
bearer bonds
have coupons attached to the bonds, and the holder presents the coupons to the issuer for payments of interest when they come due
registered bonds
are those in which the owner is recorded by the issuer and the coupon payments are mailed to the registered owner
term bonds
are those in which the entire issue matures on a specific date
serial bonds
mature on a series of dates, with a portion of the issue paid off on each date until it is fully redeemed
mortgage bonds
are issued to finance specific projects, which are pledged as collateral for the bond issue
debentures
bonds backed solely by the general credit worthiness of the issuing firm, unsecured by specific assets or collateral
subordinated debentures
bonds that are unsecured and are junior in their rights to mortgage bonds and regular debentures
convertible bonds
may be exchanged for another security of the issuing firm at the discretion of the bond holder
stock warrants
give the bond holder the option to detach the warrants to purchase common stock at a prespecified price up to a prespecified date
call provision
which allows the issuer to require the bond holder to sell the bond back to the issuer at a given (call) price— usually set above the par value of the bond
call premium
The difference between the call price and the face value on the bond
sinking fund provision
a requirement that the issuer retire (set aside) a certain amount of the bond issue each year (to help pay previous issues)
2 secondary markets that trade corporate bonds
1) Exchange market (e.g., NYSE Bonds)
2) Over-the-counter (OTC) market
three major bond rating agencies
1) Moody’s
2) Standard & Poor’s (S&P)
3) Fitch Ratings
AAA
The highest credit quality (lowest default risk) that rating agencies assign
Bonds rated below Baa
speculative grade bonds and are often termed junk bonds, or high-yield bonds
Which of the following situations would require an increase in the coupon rate for a bond selling at par?
A) The addition of a call provision
B) The addition of a convertibility option
C) The increase in the rating from BBB to AA
D) The addition of a sinking fund provision
E) All of these choices are correct
A) The addition of a call provision
