Exam 2

Question 1

Classical Gold Standard

Answer 1

Countries pegged their currencies to gold

Question 2

What did WW1 do

Answer 2

Imposed massive fiscal burden on participating countries. Lots of deficit spending

Most countries stopped gold redeemability, essentially making their notes (fiat)
Monetary expansion resulted in bursts of inflation
Inflationary finance

Question 3

Gold Exchange Standard

Answer 3

Monetary system under which a nation’s currency may be converted into bills of exchange drawn on a country whose currency is convertible into gold at a stable rate of exchange.
Less need for large domestic gold reserves
Precursor to Bretton Woods Monetary System

Question 4

Bretton Woods

Answer 4

European Countries fixed their countries to the US dollar
The US dollar was redeemable in gold
Hence, a gold-exchange standard

Some capital controls

Question 5

Problems with Bretton Woods

Answer 5

`At the end of WW2 US output accounted for nearly half of world output.
The US exported heavily to Europe and a lot of US dollars flowed overseas in the Marshall plan.

By the 1970’s, many European central banks held large reserves of USD.
Many began to question the potential of a “run” on the Treasury, where they would ask dollars to be redeemed for gold.
US expansionary fiscal and monetary policy during the Vietnam war only worsened the outlook.

By the time Nixon closed the gold window, it was readily apparent that the US could not have been ready to redeem even a fraction of foreign held dollars for gold.

Question 6

Post-Bretton Woods

Answer 6

Developed countries tend to let their exchange rates float

Developing countries tend to fix their currencies to a premier currency (Dollar, Euro, Pound).

There is also a good deal of intermediate regimes
Dirty floats
Crawling pegs with bands

Question 7

Costs and Benefits of Floating exchange rate

Answer 7

control of monetary policy, currency attacks less likely, more day to-day uncertainty, immunization from foreign shocks

Question 8

Costs and Benefits of Fixed exchange rate

Answer 8

partial control of inflation, currency attacks, less day-to-day exchange rate uncertainty, “excessive” disturbances

Question 9

Different degrees of “Fixed”

Answer 9

-Floating
-Intermediate regimes
Dirty float
Fixed with crawling pegs
Fixed with bands
-Fixed
Currency Board
Currency Union/Dollarization

Question 10

Integration

Answer 10

Concerns towards integration lead to a fixed exchange rate regime
Lower transactions costs and more trade

Question 11

Similarity

Answer 11

Concerns regarding similarity push toward floating exchange rates
If economic shocks are asymmetric, countries want policy flexibility to deal with it

Question 12

Integration Benefits

Answer 12

Economic integration: growth of market linkages in goods, capital, and labor markets among regions and countries.

Lower transaction costs, a fixed exchange rate might promote integration and hence increase economic efficiency.

More integration = more volume of transactions between the two countries (or geographic areas)

More integration -> efficiency benefits of a fixed exchange rate increase.

Illustration: There is more trade between Washington and Oregon, than between Washington and British Columbia (Canada).

Question 13

Integration Costs

Answer 13

If the region (i.e. the two countries) face different shocks: fixed exchange rate can be costly.

Example: Black Wednesday
Germany wanted tight monetary policy to offset a boom, but UK did not because they did not have the same shock.

If shocks are asymmetric, fixed exchange rates can amplify output shocks

Question 14

First Generation Currency Crisis models

Answer 14

These models show that a speculative attack on a fixed exchange rate regime can occur due to the rational expectations of investors and arbitrageurs.
This is due to excessive deficit financing, often with central bank credit

Investors will hold the currency as long as the peg is deemed credible. Once they believe that the central bank will no longer defend the peg (at some point in the future) they run.

Central bank loses reserves and is forced to abandon the peg. The domestic currency floats.

Question 15

Fiscal Dominance

Answer 15

Fiscal dominance serves as one mechanism which propagates first generation currency crises.
Without independence, the fiscal authority can force the central bank to directly finance new debt issue from the treasury.
Inflationary finance and seigniorage

Question 16

Implication of fiscal dominance

Answer 16

First generation crises are often caused by fiscal/monetary policies that are inconsistent with maintaining fixed exchange rates.

Question 17

Second Generation Models of Currency Crises

Answer 17

Occurs when a government is pursuing a fixed exchange rate regime concurrently with another policy goal (normally boosting output/employment).P

Question 18

Problem of contingent commitment

Answer 18

The public knows that the government of weighs the costs and benefits of maintaining a fixed exchange rate.

Investors know that there are conditions which could force the government to abandon the peg.

Potential for multiple equilibria

Question 19

Loanable Funds Theory of Interest Rates

Answer 19

Wicksellian natural interest rate: The rate that leads to a stable price level

Interest above the natural rate= contraction and deflation

Interest below the natural rate = expansion and inflation

This means that the interest rate affects the price level but isn’t determined by it.

Question 20

Keynesian liquidity preference theory for interest rates

Answer 20

Interest is a result of money demand/supply

Purely monetary phenomenon

Question 21

In classical economics the interest rate was determined solely by

Answer 21

the confluence of savings and investment

Higher savings, lower interest rate

Higher demand for investment, higher interest rate

Question 22

Irvin Fisher interest rate theory

Answer 22

Interest coordinates markets intertemporally

Fisher: Interest theory is relative price theory
-“The rate of interest expresses a price in the exchange between present and future goods.”
-However, money plays no role in Fisherian interest theory (intertemporal barter only)
-The interest rate reflects the relative scarcity of present and future goods, and productive possibilities

Question 23

Liquidity Preference

Answer 23

The rate of interest rises with the demand for money, and falls with the supply of money

Interest is a reward for parting with liquidity

No role in coordinating markets intertemporally

Since money demand/supply can be managed, no natural rate of interest either.

Can be managed by CB to be whatever rate is deemed desirable

Question 24

Time Preference

Answer 24

the future is discounted relative to the present.
That is, future goods are discounted subjectively, relative to present goods

Question 25

Subjective Time Preference

Answer 25

People have varying levels of time preference

Question 26

High-time preference

Answer 26

present wants dominate

Question 27

Low-time preference

Answer 27

willing to delay present gratification and tend to future wants

Question 28

Meaning of Time Preference

Answer 28

An individual is more willing to trade for future goods when present goods are relatively abundant relative to claims for future goods

Question 29

Loanable Funds Framework

Answer 29

Savings = households’ supply of present goods net of consumption (Fisherian)
Change the units from goods into monetary funds, and “present goods” become “loanable funds”

Investment is firm’s demand for present goods

The supply of LF comes from real savings and additions to the stream of money

The market interest rate equates the current supply and demand for “loanable funds”.
Meaning present funds offered in exchange for claims to future funds
Supply of LF = demand for claims
Demand for LF = supply of claims

Question 30

Demanders of Loanable Funds

Answer 30

Firms: Borrow to invest, Increased eagerness to invest shifts DLF out. Ditto for better investment opportunities
Government: Governments are net borrowers, Treasuries no longer hold treasure

Both entities are net sellers of claims: Stock and bonds issues

Question 31

Suppliers of Lf

Answer 31

Households: Subtract borrowing (consumption) and dissaving households, This implies that an increased demand to hold money shifts the LF suppy curve to the left, while a reduction in desired money balances shifts it to the right

Central Banks:New money created through open market purchases comes on the market as additional demand for bonds (shifts SLf to the right). Open market sales (QT) do the opposite

Question 32

A one-shot increase in the MS

Answer 32

1) SR (Liquidity Effect): An increase in the money supply shifts out the Slf curve, reducing the nominal interest rate R
1a) Assume the nominal interest rate equals the real rate since inflation is zero at this point

2) LR (nominal income effect): The increase in the money supply causes Dlf to shift out
2a) High M leads to higher nominal income (Y) and price level (P)
2b) At higher P, firms demand to borrow more dollars to finance the same production
2c) Input and output prices have risen
2d) Real dollars borrowed are the same as before

3) The nominal income effect restores R to its original level

Question 33

Effects under an increased M growth rate

Answer 33

1) Liquidity effect: Gradually rising M gradually shifts out Slf curve, reducing R1

2) Nominal income: Pushes R back up and P and Y rise, shifting out Dlf

3)The inflation expectations effect:
3a) This occurs once a higher inflation rate is expected
3b) Lenders demand an inflation premium, raising R above the original R0
3c) To lend/borrow the same number of real dollars
3d) The inflation premium compensates for the loan being paid back in dollars with reduced purchasing power

Question 34

Wicksell’s Natural Rate

Answer 34

Short-term real interest rates can vary from the LR natural rate, due to monetary disturbances.

LR neutrality

Recall, if market rates are below the natural rate, economic boom (output, prices up)

If market rates are above the natural rate (output, prices down)

Question 35

Austrian Theory of Business Cycle (ABCT)

Answer 35

Utilizes Wicksell’s concept of the natural interest rate

Increases in the money supply and the provision of cheap credit undertaken by central banks temporarily lowers the real rate of interest

Question 36

Results of the Austrian Theory of Business Cycle

Answer 36

Economic boom that gives way to a bust

Question 37

Risk Premia

Answer 37

Default risk

Risk that you lend to an entity that can’t pay you back.
-Bank loans
-Government bonds
-CD’s and banking panic

Question 38

Inflation/Interest Rate Risk

Answer 38

In order to shore up a constant return: The risk of inflation/interest fluctuations must be priced into interest rates
Gold standard and thicker bond markets.

Question 39

Inflation

Answer 39

increase in the general level of prices

Question 40

Hyperinflation

Answer 40

when inflation reaches an very high level

Question 41

Costs of inflation

Answer 41

Shoe-leather Coats, Menu Costs, Complicates Financial Planning, unpredictability of relative prices, rigid tax laws, unexpected inflation makes consequences of contracts unpredictable

Question 42

Shoe-leather Costs

Answer 42

the time and effort spent to minimize the effects of inflation on the eroding purchasing power of money.

Question 43

Menu Costs

Answer 43

the transaction costs of changing menu prices in response to inflation.

Question 44

How do unexpected inflation makes consequences of contracts unpredictable?

Answer 44

Redistributes from debtors to creditors and hurts people on fixed pensions

Question 45

Causes of hyperinflation

Answer 45

Hyperinflation happens through excessive growth in the money supply.

Typically initiated to finance government debt.

Hyperinflation causes tax revenue to fall, as there is a delay between time taxes are issued and the time tax revenue is received.

Thus, there is a greater need for the gov’t to finance the debt by increasing the money supply.

Deadly Downward Spiral Ensues!!

Question 46

Consequences of hyperinflation

Answer 46

Menu prices become incredibly large.

Extreme inconvenience and shoe-leather costs.

Hyperinflation could decrease revenue due to lags between the issuing of taxes and the retrieval of tax revenue.

Relative prices are distorted, affecting the ability to reflect relative scarcity.

Currency ceases to function, as barter becomes more feasible as a means of exchange.

Question 47

Quantity theory and meaning

Answer 47

MV=PT

𝑀 is the quantity of money, and 𝑉 is the transactions velocity of money per period of time, so 𝑀𝑉 is also the number of dollars exchanged in a year.

𝑇 represents the amount of transactions per period of time, and 𝑃 represents the price of a transaction, so 𝑃𝑇 represents the number of dollars exchanged in a year.

This relationship is an identity, which is true BY DEFINITION.

Question 48

Quantity Theory transitioning from Transactions to Income

Answer 48

MV=PY

𝑌 refers to total income (output), and 𝑃𝑌 refers to the dollar amount of output.

𝑉 now refers to the income velocity of money, or the amount of times a dollar bill enters someone’s income in a given period of time.
By definition: V= P *Y/M

Question 49

Currency (C)

Answer 49

is defined as the amount of paper money and coins in circulation in the economy

Question 50

M1 before May 2020

Answer 50

M1 money stock = 𝐶 PLUS…
Demand deposits at commercial banks (i.e., funds that people hold in checking accounts)
excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions.

Traveler’s checks (antique before ATMs)

Other checkable deposits (OCDs)
Consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, share draft accounts at credit unions, and demand deposits at thrift institutions

Question 51

M2 before may 2020

Answer 51

M2 money stock = 𝑀1 PLUS…
Savings deposits (including money market deposit accounts)
Small-denomination time deposits (time deposits less than $100,000)
Balances in retail money market funds (MMFs)

Question 52

M1 after 2020

Answer 52

savings deposits not considered in both M1 and M2

thus

M1=C+demand deposits at commercial banks+traveler’s checks+other checkable deposits+saving deposits

Question 53

Y=

Answer 53

Y=nominal aggregate income = annual money expenditure on final goods (GDP, GNP etc.) in $ per year

Question 54

By combining the P’s and y’s Y=

Answer 54

Y=Py

Where P is an index of prices in $ per basket

y= an index of real output in baskets/year

Normalize to one basket at base year prices

National income accounts do this when they calculate real GDP by using base-year prices paired with the current year’s output quantities.

Question 55

Measures of P

Answer 55

CPI and GDP deflator

Question 56

The Quantity Theory of Money

Answer 56

1. Take equation of exchange, PLUS some assumptions:
   -Assume that velocity is constant (𝑉=𝑉̅; %∆𝑉=0)
   -This is a simplification, but this is a USEFUL simplification.
   -It means that the dollar amount of an economy’s output (𝑃𝑌) is ONLY affected by the money supply (𝑀).
2. The desired ratio of money balances to income (M/Py) is determined by real factors, independent of the nominal quantity of money, except for the transitory effects of money growth.
   Marshall worked with k = M/Py
   Fisher with V = Py/M
3. Real income is determined by real factors independent of the nominal quantity of money (long-run neutrality), barring transitory short-run effects that money might have on income.

Question 57

Results of QTM

Answer 57

1. Exogenous changes in the level of M cause endogenous (equilibrating) changes in the price level.
2. The price level is proportional to the nominal quantity of money, ceteris paribus
3. Money is neutral in the long run
   It cannot permanently change V or y
   i.e. M only affects nominal variables in the long-run, not real variables

Question 58

Nominal Variables

Answer 58

Measured in current $
Without reference to the purchasing power of the dollar
Ex) Price level, nominal income (Py), nominal money stock (M)

Question 59

Real Variables

Answer 59

Measured in “real” or “constant” dollars of defined purchasing power, or in non-monetary units.
Ex) Real income (y), real money stock (m), unemployment rate

Question 60

Money Balances

Answer 60

Serve as a buffer stock (think inventory) that are useful since we live in a world of positive transaction costs.

With income, we let money balances rise within some range

With purchases, we let money balances fall within some range

We do this instead of immediately offsetting purchases or sales to maintain our exact amount of desired MB

Question 61

Nominal Quantity of Money (M)

Answer 61

Dollars, pounds, Euros

Question 62

Real Quantity of Money (m)

Answer 62

Expressed in purchasing power

Real money balances relative to real income can be expressed as how much income is being held (M/Py or m/y)

Question 63

Assuming MV is fixed what is the relationship between Y and P?

Answer 63

if Y increase , P decrease , and vice versa.
Real supply shocks affect scarcity, and therefore prices.

Question 64

Assumning Py is fixed what is the relationship between M and V

Answer 64

if M increase, V decrease, and vice versa.
If more money is introduced to the economy, the speed at which individual units circulate will decline.

Question 65

Nominal Income Targeting

Answer 65

-Offset changes in V with changes in M, to maintain stable Py (nominal income
i.e. Velocity increases as the economy re-opens during Covid, contract M.

-Allow changes in y to to manifest in P changes, to reflect
Real income falls while the economy is shut-down, allow prices to rise.

Question 66

Demand to hold money

Answer 66

the desired average level of nominal money balances

Question 67

Phi desired M/Py is a function of

Answer 67

Real income or wealth
- if the quantity of money needed to serve the buffer stock role doesn’t increase with income
+ in shopping-time models of money demand

These models take the time costs of “shopping” or engaging in consumption into account.
Higher real money balances reduces the time or costs associated with shopping
Higher income = more consumption = more shopping time = higher real money balances

Opportunity costs: interest rates on alternative assets (-)

Pecuniary interest yield on money deposits (+)

Transaction costs of moving in and out of higher-yielding assets (+)

Payment technology factors

Simplified real money demand:
Y is “scale”, r is “opportunity cost”

Question 68

How sensitive is money demand to changes in the interest rate?

Answer 68

Demand deposits:
-If the interest on deposit accounts moves with interest yields on substitute assets, such as short-term time deposits, bonds, or money market mutual funds, then perhaps hardly at all.
-However, some policies reduce interest yields on checkable deposits
-Increasing reserve requirements
Increases banks demand for M0 instead of deposits
-Regulation
Due to “Regulation Q”, commercial banks were banned from paying interest on demand deposit accounts from 1933-2011.

Cash:
Currency pays no interest and therefore has a 0% rate of return.
Therefore, paper currency will be much more interest-sensitive

Question 69

Role of the Central Bank

Answer 69

1.Banker’s bank
2.Monopoly of note issue
3.Regulator of commercial banks
4.Lender of last resort
5.Monetary policy

Question 70

Whenever a bank receives some amount of money from a saver, it could so two things…

Answer 70

The bank could lend the money out to borrowers, who are seeking money from the bank.

The bank could deposit the money in a reserve for the saver.

Question 71

The bank could initiate one of two reserve policies…

Answer 71

100-percent reserve banking (i.e., 0% of the deposit is lent out to others)

Fractional reserve banking (i.e., some non-zero percentage of the deposit is lent out to others)

Question 72

With fractional reserve banking, there exists some

Answer 72

financial intermediation (the process of transferring money from savers to borrowers)

Question 73

Monetary Base (B)

Answer 73

is the total amount of money held by the public as currency (𝐶) and by the banks as reserves (𝑅) such that 𝐵=𝐶+𝑅. The monetary base is directly controlled by the Federal Reserve.

Question 74

The monetary base is directly controlled by who?

Answer 74

The federal reserve

Question 75

The reserve-deposit ratio (𝑟𝑟)

Answer 75

is the fraction of deposits (𝐷) that banks hold in reserve (i.e., 𝑟𝑟=𝑅/𝐷). It is determined by business policies of banks and the laws regulating banks.

Question 76

The currency-deposit ratio (𝑐𝑟)

Answer 76

is the amount of currency (𝐶) people hold as a fraction of their holdings of demand deposits (𝐷; i.e., 𝑐𝑟=𝐶/𝐷)

Question 77

Formula for money multiple (m)

Answer 77

m = (cr+1)/(cr+rr)

Question 78

Conclusions from the model of money supply

Answer 78

(1) The monetary base (𝐵) is proportional to the money supply (𝑀), and grows by the same percentage rate.

(2) As the reserve-deposit ratio (𝑟𝑟) decreases, the more loans banks make, and the more money banks create from every dollar of reserves. Therefore, a decrease in 𝑟𝑟 INCREASES 𝑚 and 𝑀.

(3) As the currency-deposit ratio (𝑐𝑟) decreases, the fewer dollars of the monetary base the public holds as currency, the more base dollars banks hold as reserves and the more money banks can create. Thus, a decrease in 𝑐𝑟 INCREASES 𝑚 and 𝑀.

Question 79

Tightening or contractionary Monetary Policy

Answer 79

Increases the policy rate FFR and IOR
If using OMO, quantitative tightening

Increases market interest rate

Reduces the money supply

Question 80

Easing or Expansionary Monetary Policy

Answer 80

Lowers the policy rate (FFR) and IOR
If using OMO, quantitative easing

Lowers market interest rates

Increases the money supply

Question 81

Whats on the Fed’s Balance Sheet

Answer 81

Assets: Securities, loans to financial institutions

Liabilities: currency in circulation, reserves

Question 82

What two ways can the Fed influence the money supply (M)

Answer 82

Influencing the monetary base and influencing the reserve-deposit ratio

Question 83

Ways of influencing the monetary base

Answer 83

(𝐵; recall 𝐵↑⇒𝑀↑)

Open market operations, lender of last resort, discount rate

Question 84

Ways of influencing the reserve-deposit ratio

Answer 84

(𝑟𝑟; recall 𝑟𝑟↑⇒𝑚,𝑀↓)
reserve requirements and interest on reserves

Question 85

Open Market Operations

Answer 85

(𝐵; recall 𝐵↑⇒𝑀↑)

Buying bonds -> “selling” currency -> 𝐵 increases.

Selling bonds -> “buying” currency -> B decreases

Question 86

Discount Rate

Answer 86

(interest rate the Fed charges on loans)
If the rate falls, it’s cheaper for banks to borrow from the Fed, so 𝐵 increases.

Question 87

Reserve Requirements

Answer 87

(banks have to have a minimum reserve amount)
An increase in requirements tends to increase 𝑟𝑟, but is less effective when banks hold excess reserves.

Question 88

Interest on Reserves

Answer 88

(paid to banks for holding reserves)
If the rate rises, it’s more beneficial for banks to hold reserves, so 𝑟𝑟 increases.

Question 89

FDIC Insurance

Answer 89

The Federal Deposit Insurance Corporation (FDIC) protects deposits up to $250,000 when a bank fails.

It is intended to preserve public confidence in the banking system.

Therefore, mitigates large swings of the currency-deposit ratio (𝑐𝑟), and allow the Fed to have more control over the money supply.

Question 90

Moral Hazard of FDIC Insurance

Answer 90

Bail out insolvent savings and loans institutions (1980s and early 90s)

Moral Hazard.

As the likelihood of being bailed out for risky behavior increases, the cost of engaging in risky behavior decreases.

Question 91

Instrument Independence

Answer 91

A central bank is given a task or goal to pursue but is allowed to achieve that goal in whatever manner it sees fit.
That is, the central bank can use any monetary policy tool, or combination of tools to achieve it.

Seems to be intuitively a good thing
I.e. Central banks should know better which levers to pull to achieve a given policy outcome, in comparison to politicians.

Question 92

Goal Independence

Answer 92

The central bank is free to choose what monetary policy goals it pursues
Activist or stabilization policy
Rule-based monetary policy
Choice of rule and implementation

Question 92

Benefits of Goal Independence

Answer 92

A central bank with goal independence is ostensibly immune to pressure from the government or treasury

Without goal independence, this pressure often results (especially in developing countries) in the central bank being forced to directly finance government deficits
Inflationary finance
Currency, debt, and banking crises

Being immune to political pressures has benefits

Question 93

Costs of Goal Independence

Answer 93

Political economy
Lack of political accountability
A central bank with goal independence is a technocratic institution
It runs afoul of basic democratic notions regarding citizens in a representative democracy being able to directly/indirectly choose government policy.

Public choice considerations
Central banks hire loads of economists. If constrained to the enforcement/implementation of a simple monetary policy rule, the payroll could be decimated.
The fact that inflation generates seigniorage presents an eternal conflict of interest
And the Fed doesn’t send 100% of seigniorage revenue back to the treasury
Fedwatching industry

Time Inconsistency