Final Flashcards

Question

Given the fed has a balance sheet roughly two times bigger, what tools does it have to maintain control of growth of the monetary base and the fed funds rate as the economy recovers?

Answer 1

1. Provide interest on reserves (incentivizes banks to hold reserve balances rather than lend them out). 2. Offer interest-bearing deposits for excess reserves (which commits the bank to keep its reserves with the fed for a specified period of time). 3. Traditional tool of reverse repurchase agreements (drains reserves directly from the system)

Answer 2

False. Bear Stearns, Merrill lynch and Lehman were not commercial bank holding companies. The downfall of wamu, indymac and wachovia was primarily due to risky choices and concentrations in mortgage origination and lending, unrelated to investment banking

Answer 3

1. solves Byzantine generals problem- established trust between otherwise unrelated parties 2. low to nonexistent fees - great for small businesses and remittance population 3. Eliminates risk of credit card fraud

Answer 4

Pillar I: minimum capital requirements Pillar II: Supervisory review process Pillar III: disclosure & market discipline

Answer 5

1. Consolidation (small, low capital, low profit, community banks disappeared) 2. Increased diversification (lower volatility) 3. Increased competition

Answer 6

1. New business formation 2. More credit available 3. Lower interest rates/borrowing costs 4. Positive impact on state GDP (volatility of state gdp growth declines)

Answer 7

If the CB waits, inflation expectations will already be embedded in the wage and price setting policy process, creating an inflation momentum that will be hard to halt.

Answer 8

Because higher inflation expectations become ingrained in various types of long term contracts and pricing agreements. There is a long lag (up to two years) before inflation policy takes effect.

Answer 9

It puts downward pressure on longer term interest rates and thereby lowers the cost of credit for businesses and home buyers.

Answer 10

1. Resilience & structural stability (flexible & efficient markets for capital & labor helps) 2. Entrepreneurial tradition 3. Healthy, well-regulated banking system

Answer 11

General decline in prices

Answer 12

Once nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept negative interest rates and instead will hold cash.

Answer 13

Price stability (long run goal) and maximum employment (short term focus). There is no long run trade off between the two. In the short run, the fed may have to sacrifice output and increase interest rare instability to prevent the economy from overheating (due to inflation).

Answer 14

1. Public announcement of medium term numerical targets for inflation 2. An institutional commitment to price stability as the primary, long run goal of monetary policy and the commitment to achieve the inflation goal 3. Information approach in making decisions about monetary policy 4. Increase transparency of monetary policy strategy to public & markets 5. Increased accountability of CB for attaining inflation objectives

Answer 15

Rate at which banks borrow from each other overnight. It is the base rate that determines the level of all other interest rates in the us economy.

Answer 16

The FOMC can reduce the supply of reserves. Banks have to hold a minimum level of reserves, and when the supply falls, they have to pay more to borrow them. They then pass that rate on to their customers.

Answer 17

It can raise the rates it pays on excess reserves. Then, banks won't want to lend for anything less.

Answer 18

Agreement to buy a security and sell it in the future. If fed starts doing this and offers a relatively high rate, broker dealers would be forced to compete and offer higher rates.

Answer 19

Puts a floor on interest rates even as the fed is increasing its balance sheet. If banks can earn 25bps by holding reserves at the fed, then they will be unwilling to lend at a rate below 25bps. But not all banks can benefit from holding reserves at the fed, so the rate is below 25 bps.

Answer 20

1. Friedman viewed permanent income (Yp) as more important than current income in determining money demand 2. Friedman considers multiple rates of return and considers the relative returns to be important (Interest rate on M is positive & can vary) 3. Friedman viewed money and goods and substitutes (more than just bonds compete with money as store of value)

Answer 21

1. Transactions motive 2. Precautionary motive 3. Speculative motive

Answer 22

Money is a medium of exchange, and people hold money to buy stuff. So as income rises, people have more transactions and will hold more money. This doesn't factor in advanced in payment technology, which reduces the demand for money.

Answer 23

People hold money as a cushion against unexpected wants or emergencies. Precautionary money demand is again expected to rise with income.

Answer 24

The opportunity cost of holding money (which earns no interest) is the nominal interest rate on bonds, i. As the interest rate i rises, the opportunity cost of money rises and the quantity of money demanded falls. Thus, money demand is negatively related to the interest rate.

Answer 25

1. Money and bonds are the only assets | 2. Money pays no interest but bonds pay interest

Answer 26

MV=PY | The aggregate nominal income equals the money stick times the average rate of money's turnover.

Answer 27

Average number of times per year that a dollar is spent purchasing the total amount of final goods and services produced in the economy.

Answer 28

V=PY/M M=nominal stock of money Y=real aggregate output in one year P=an index of prices

Answer 29

1. Md is purely a function of nominal income (PY) | 2. Interest rates play no role

Answer 30

``` Md=k x PY, where k is roughly constant and k=1/V Md=money demand k= some constant variable P=price level Y= aggregate output/income ```

Answer 31

1. Velocity is constant in the short run. This is bc velocity is affected by institutions and technology that change slowly over time. 2. Flexible wages and prices guaranteed output, Y, to be at its full employment level, so Y was also constant in the short run.

Answer 32

A change in the money supply, M, results in an equal percentage change in the price level, P.

Answer 33

Keynes places importance on interest rates. Since interest rates fluctuate quite a bit, then velocity must too.

Answer 34

1. Permanent income is very stable, and 2. The spread between returns will also be stable since returns would tend to rise or fall at once, causing the spreads to stay the same. So in friedman's model, interest rates have little or no impact on money demand. This is not true in Keynes model.

Answer 35

The government does not have the right to issue currency to pay for its bills. The government must finance its deficit by first issuing bonds to the public to acquire extra funds to pay for its bills. If the public doesn't pay for the bonds, the central bank will purchase them through an open market purchase, which increases the monetary base and supply.

Answer 36

QTM provides long run theory of inflation bc it is based on the assumption that wages and prices are flexible. Classical assumption that wages and prices are completely flexible may not be a good assumption for short run fluctuations in inflation and aggregate output.

Answer 37

If a bank becomes insolvent, the depositors can "put" the bank to the FDIC and then receive dollar for dollar payment for their deposits, up to the insured limits.

Answer 38

Flat rate deposit insurance means that regardless of the riskiness of the portfolio, all institutions pay the same rate for insurance. Since depositors were 100% insured, riskier institutions did not have to pay higher rates in order to attract deposits. The flat rate structure of the deposit insurance increased the moral hazard problem associated with any insurance contract. Bank owners may choose a risky portfolio bc the bank can "put" losses to the FDIC but keep the gains.

Answer 39

Became a problem in the early 80s due to economic & regulatory shocks. Interest rates rose dramatically. When interest rates rise, the value of long term, fixed rate bonds and mortgages declines. Thrift institutions were structured to have the bulk of assets in long term, fixed rate mortgages, so it destroyed the capital in these institutions.

Answer 40

In the long run, no. In the short run, the fed may need to sacrifice output by increasing interest rates, which will increase price stability at the expense of higher employment levels.

Answer 41

1. Wealth (positive correlation) 2. Expected return relative to another asset (positive correlation) 3. Risk of asset (negative correlation) 4. Liquidity of asset (positive correlation)

Answer 42

Higher expected interest rates in the future lower the expected return for long term bonds, decrease the demand, and shirt demand curve left.

Answer 43

An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to decline and shift demand curve to the left.

Answer 44

1. Central bank 2. Banks 3. Depositors 4. Borrowers

Answer 45

Assets: securities and loans to financial institutions Liabilities: currency in circulation and reserves

Answer 46

An increase in the Fred's liabilities (either an increase in reserves or an increase of currency in circulation)

Answer 47

The sum of the Feds liabilities (currency in circulation and reserves) and the treasury's monetary liabilities (treasury currency in circulation, primarily coins).

Answer 48

Deposits held at the fed

Answer 49

The rate the fed charges banks to borrow money from the fed.

Answer 50

The way in which the fed exercises control over the monetary base through its purchase or sale of securities in the open market

Answer 51

When the fed purchases bonds, which increases securities (asset) and reserves (liabilities)

Answer 52

It could result in inflationary expansion of money and credit in the future if banks decided to lend out those reserves.

Answer 53

Consumption + investment + government purchases + net exports

Answer 54

1. Decrease in autonomous monetary policy 2. Increase in government purchases 3. Decrease in taxes 4. Increase in net exports 5. Increase in autonomous investment 6. Decrease in financial fractions

Answer 55

The net worth of the thrift went to roughly zero. For owners, the value of the put option is greatest around zero (when owners have nothing to lose and everything to gain by taking risks). Before the shocks, owners would be risking the positive net worth of the bank if they took excessive bets. Only after the shock hit did owners have an incentive to take advantage of the put option of deposit insurance.

Answer 56

Additionally, regulatory "forbearance" made problems worse by permitting owners to continue to gamble even when institution was insolvent. The 1982 st. Germaine act, for example, gave regulators more discretion to engage in forbearance & permitted thrifts to become involved in risky activities. Both of these regulatory shocks helped to increase the value of the put option of deposit insurance.

Answer 57

In Keynes model of money demand, the real demand for money is a function of the real volume of purchases, Y, and the level of the nominal interest rate, i. The opportunity cost of holding money is the rate of interest received on bonds (i). In this approach, the negative relationship between interest rates and money demand can be motivated either through Keynes (unsatisfying) "speculative motive" or baumol-Tobin-allays model of optimal cash management.

Answer 58

The demand for real money balances increases with Y and is inversely related to the opportunity cost i: M/P = f(Y,i). Using the definition of velocity, in this approach, V=Y/f(Y,i), so velocity increases when interest rates rise. Interest rates are pro cyclical, that is, the demand for loanable funds rises during boom times, interest rates tend to rise, and vice versa in econ downturns. Thus, GDP rises in a boom, interest rates rise, money demand falls, hence velocity rises.

Answer 59

In the monetarist model, real money demand is a function of the permanent income and the differentials between the return on money and on other assets that carry purchasing power across time, such as bonds, equities, and non-perishable commodities. Money can and does pay interest. The opportunity cost of holding money balances is the difference between the return on money and the return on alternatives. Friedman claims that empirically these interest rate differentials do not fluctuate significantly. In friedman's view, expenditures are roughly proportionate to permanent income. Thus, for Friedman, money demand effectively is a positive function of permanent income and interest rates do not enter: M/P=f(Yp). Velocity thus is V=Y/f(Yp). As current income Y rises (falls) over the business cycle, permanent income Yp rises (falls) by much less than 1:1; hence, velocity rises (falls). The monetarist explanation of the pro cyclicality of velocity has nothing to do with interest rate movements.

Answer 60

False. In the absence of legal reserve requirements banks will still choose to hold some level of reserves to meet deposit demand and new loan requests. And, private individuals wish to hold some portion of the money balances in the form of currency. Both of these factors prevent the banking system from expanding the money supply without limit through the multiple deposit expansion process. The money supply multiplier is likely to be higher in the absence of legal reserve requirements, but it will not be infinitely large.

Answer 61

The economic logic rests on: (I) the recognition that the nominal interest rate equals the real interest rate plus the expected inflation rate (the fisher effect) and (II) a distinction between the liquidity effect and the expected inflationary effect of a deflationary monetary policy

Answer 62

1. A deflationary monetary policy will initially raise nominal and real rates due to the liquidity effect. 2. The liquidity effect, however, is temporary and persists only until the price level adjusts in full proportion to the change in money supply.

Answer 63

In a recession, the fed will increase the money supply to make credit more readily available. The liquidity effect describes how expansionary monetary policy affects three elements of the economy: 1. Interest rates (decrease) 2. Income and 3. Inflation (increase)

Answer 64

The expected inflation effect works in the opposite direction and is long-lived. A deflationary money policy will cause a decline in the rate of inflation and, as expectations adjust, a decline in the expected rate of inflation. Borrowers will then offer, and lenders will accept, a lower nominal interest rate. Hence, the nominal interest rate will eventually fall to low levels under a deflationary monetary policy - even though this policy "would have to start out what seems like the opposite direction" when viewed solely in terms of the liquidity effect.

Answer 65

Real interest rates plus expected inflation

Answer 66

1. Increase reserve requirements 2. Reduce money supply of reserves, thereby increasing interest rates 3. Increase interest rates

Answer 67

False. The cross-country evidence shows greater independence of the CB from the rest of government is associated with lower inflation rates and lower variability of inflation. The direct influence of the treasury at the CB increase the pressure in the CB to monetize government debt, thereby leading to inflation.

Answer 68

Using our "positive theory" of the CB actions, the presence of the treasury at the FOMC meetings is likely to reduce the credibility of the Feds anti/inflation stance, leading the public to expect higher inflation. The fed realizes that the public expects this and will likely "validate" these expectations by choosing a higher inflation rate than it would have w/o the loss of credibility due to direct treasury influence at the FOMC.

Answer 69

An increase to 20% would increase the opportunity cost of holding non-interest bearing forms of money. To the extent that the return on interest bearing forms of money does not increase 1:1 with increase in market rates, the opportunity cost of holding interest-bearing forms of money would increase.

Answer 70

The BTA model of money demand indicates that total costs equal the opportunity cost of holding money plus the costs of exchanging money for other, less liquid, assets like bonds. An increase in the opportunity cost of holding money encourages people to economize on their money balances at the expense of greater bond-money exchange costs. When people behave in this way, their average money balance over a given interval declines; alternatively, the rate at which money turns over- it's velocity - rises. The prediction: this rise in interest rates would lead to an increase in the income velocity of money.

Answer 71

If brokerage and conversion fees decline to near zero, individuals will focus primarily on their foregone interest costs in deciding how much money to hold. Individuals are likely to hold little cash and simply undertake a bond-to-money conversion each time they wish to make a purchase. The prediction of the BTA model would be that the income velocity of money would increase.

Answer 72

The opportunity cost of holding money plus the costs of exchanging money for other, less liquid, assets like bonds.

Answer 73

rrD*DD + rrT*TD

Answer 74

R=rrD*DD+rrT*TD R=rrD*DD+rrT*2DD R=(rrD+2*rrT)*DD

Answer 75

B=C+R, and C=DD B=DD+(rrD+2*rrT)*DD B=(1+rrD+2*rrT)*DD

Answer 76

C+DD, or 2*DD, or M1

Answer 77

Since the fed engaged in no open market transactions, the banks can meet their increased reserve requirements only by calling in loans. As banks call in loans, the money supply reduces and the composition of the monetary base shifts toward greater reserves and a smaller currency component. The level of the monetary base remains unchanged at 116. M1, however, falls to roughly 196.

Answer 78

Reserves + Currency

Answer 79

DD=B*1/(1+rrD+2*rrT) M1=C+DD=2*DD= B*2/(1+rrD+2*rrT)

Answer 80

1. IOER 2. Term deposit facility 3. Aggressive reverse repos 4. Cautious reverse repos

Answer 81

1. Fed can raise rates by raising interest rates on excess reserves 2. Simplest & cheapest option 3. No direct control over market rates bc not every market player can deal with the fed

Answer 82

Reserves at the fed are $3trillion greater than the regulatory requirement. No banks need to borrow them. The fed could reduce the supply and it wouldn't make any difference.

Answer 83

1. TDF turns reserves into longer term deposits at the fed 2. Pro: keeps change to a minimum & tight control over fed funds rate 3. Con: expensive 4. Too expensive and cumbersome for now

Answer 84

1. Aggressive version would be to offer a high interest rate 2. Pro: tight control of fed funds rate at moderate cost 3. Encourages shadow banking by giving money market funds an attractive place to deposit. Fed doesn't want to encourage MMFs bc it didn't reform them.

Answer 85

1. Control over fed funds within a range. Minimal cost | 2. Fed funds rate won't be pinned down and will fluctuate between IOER and red verse repo floor.

Answer 86

Rule says that for each one percent increase in inflation, the CB should raise the nominal interest rate by more than one percentage point. 2. Failure to increase interest rates leads to inflation spiral.

Answer 87

1. 100% reserves against checking accounts | 2. Give the Fed the sole power to create money (remove banks from the equation)

Answer 88

1. reduce boom-bust credit cycles. The plan would reduce cyclicality by preventing banks from creating their own funds during times of prosperity and eliminating funds during economic downturns 2. It would eradicate bank runs bc there is no incentive to withdraw with 100% reserve requirements 3. Banks would borrow from treasury to meet reserve requirements, thereby increasing Feds assets & reducing amount of public debt O/S

Answer 89

2. Banks would have to charge depositors a fee for holding their money 2. Pushes lending activities into unregulated shadow banking system 3. Doesn't address excess leverage

Answer 90

1. Could alter amount in circulation (so far it hasn't bc operates on prepaid basis - is exchanged in and out of real money) 2. Limited network of users and relatively low volume of transactions. Has not had significant impact on velocity of money for this reason.

Answer 91

A financial institution whose failure, due to its size, complexity and financial interconnectedness, could result in a financial crisis. SIFS are subject to higher capital requirements, leverage restrictions, and reallocation of resources to comply with heightened reporting requirements.

Answer 92

Yes, cautiously they should. Designating an institution as "too big to fail" imposes a moral hazard. 1. Size (Fannie would be number 1. Freddie would be number 4) 2. Involvement in mortgage securitization render them complex and interconnected 3. Highly levered (each well over 100x)

Answer 93

Inflation rate + equilibrium real fed funds rate + .5 (inflation gap) + .5 (output gap). Equilibrium real fed funds and inflation target are 2%

Answer 94

Taylor said monetary policy was too accommodative in the early 2000s, which led to the housing bubble. Bernanke says no, we were worried about slipping into deflation and had to keep rates low. Changes in mortgage contracts ultimately led to bubble.

Answer 95

1. Sell securities and loans 2. Call in loans 3. Borrow from other banks in the fed funds market 4. Borrow from the fed (discount window lending) 5. Issue short term securities (CP) 6. Engage in repos

Answer 96

1. Demand for money rises less than proportionately with income because there are economies of scale associated. 2. Key variables include: 1. Nominal interest rate, 2. Level of real income, 3. Fixed transaction costs

Answer 97

1. Changes in definition of M2 2. Technological & financial innovation (credit card, ATM, MMFs) 3. Economic volatility

Answer 98

A change in the nominal quantity of money affects only nominal variables, such as the price level and nominal interest rates, and leaves real variables, such as unemployment rate or real gross domestic product, unaffected. The traditional Phillips curve implies that money was non-neutral.

Answer 99

1. Interest rates were already near zero, so open market operations would not have been enough 2. Allowing banks to borrow overnight did not assure the market that banks would remain solvent

Answer 100

1. Extended maturity of loans (up to 90 days) - TAF 2. Accepted broader range of collateral (CP and repos) 3. Expanded counter parties (MMMFs)

Answer 101

No. Prohibit prop trading and forces institutions to divest covered funds. These measures will improve the effectiveness of capital requirements, reduce risks associated with failure of covered funds, and increase awareness of risks being taken, these measures are forward looking & wouldn't have prevented the crisis. Crisis due to exposure to mortgages, banks that engaged in prop trading did better than those that didn't (wamu). Prohibition of prop trades reduces diversification of cash flow and pushes these activities into the shadows.

Answer 102

1. It was highly levered with a thin capital cushion 2. Relied heavily on wholesale funding rather than retail deposits. Deposit sources weren't sticky and quickly dried up due to exposure of the subprime market 3. Interconnectedness to subprime lending market that affected the health of their funders.

Answer 103

Requiring banks to hold more capital against risky activities provides an incentive to reduce risk taking and more protection to taxpayers if bank gets into trouble. Be careful though - Basel I classified zero risk weight on high yield sovereign debt that may not be safe.

Answer 104

1. Better performance if state economies 2. Higher rate of new business formation 3. Macro economic stability improved 4. Local economies become less sensitive to local banks 5. Improved capitalization of small banks 6 more competitive pricing of loans

Answer 105

1. Banks relied on trust and developed Chinese Walls between commercial and investment banks to maintain that trust 2. Default rates for bonds underwritten by commercial banks were lower than I-banks.

Answer 106

Shifts supply of loans right (lower interest rate, higher quantity)

Answer 107

Demand shifts left, which will decrease quantity of funds and reduce interest rates.

Answer 108

1. Divisibility 2. Portable 3. Standardized 4. Scarcity 5. Durable 6. Verifiable

Answer 109

1. Store of value 2. Medium of exchange 3. Unit of account

Answer 110

Services provided by financial intermediaries are essential for technological innovation and ecocide development. Others say it increases volatility. The data says schumpter is right. It allows for consumption smoothing and diversification. But it also leads to interconnections and exposure to common risks.

Answer 111

Both shift loan supply curve right

Answer 112

Supply curve left

Answer 113

1. Raise quality, consistency and transparency of capital base and strengthen risk coverage of capital framework

Answer 114

1. Benefit is that it's a simple tool | 2. Complication is how you define the denominator (banks assets can be difficult to measure)

Answer 115

1. Economies of scale & scope 2. Delegates credit monitoring 3. Diversification benefit 4. Search costs and transaction costs are reduced

Answer 116

Space to the left of vertical axis, below solid line. The 45 degree angle

Answer 117

Left of vertical line, above solid line, below dotted line

Answer 118

The amount it FSLIC assistance necessary to cover net worth deficit

Answer 119

Currency & demand deposits

Answer 120

C+DD+time deposits + MMDA

Answer 121

Monetary base equals liabilities of fed (currency in circulation & reserves). An increase in either of these two will increase the supply.

Answer 122

An increase in securities on the asset side corresponds with a simultaneous increase in reserves on the liability side. An increase in reserves increases the supply.

Answer 123

1. Lending to financial institutions 2. Provide liquidity to credit markets 3. Purchase longer term securities (traditional tools aimed at short term)

Answer 124

Actual inflation

Answer 125

Expected inflation

Answer 126

Fed kept interest rates low bc inflation was low and didn't want to slip into deflation. Deregulation caused crisis.

Answer 127

Dropped the program too soon. Foot in mouth. Said they would drop it once rates were close to zero (just as prices started rising).

Answer 128

Make smooth adjustments to avoid market disruption

Answer 129

1. Spur lending & fight deflation 2. Hurt fragile institutions 3. Lower value of euro, making it cheaper to export 4. Won't fight demand for new loans

Answer 130

Bc fed will be willing to make as many discount loans as banks want at Rs

Answer 131

1. Increase in required reserves 2. Increase in currency holdings 3. Increase in excess reserves

Answer 132

1. Increase in nonborrowed monetary base (is reserves through open market operations) 2. Increase in loans to banks from fed 3.

Answer 133

1. Open market operations 2. Extension of loans to financial systems It has better control over monetary base than reserves.

Answer 134

Bank can make loans up to the amount of its excess reserves, thereby creating an equal amount of deposits. As each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make more loans and deposits.

Answer 135

If depositors increase their holdings of currency or banks hold excess reserves, there will be smaller expansion of deposits.

Answer 136

At bottom of graph. Interest paid on reserves. If the fed funds falls to this rate, it is horizontal bc banks would keep adding to their excess reserves indefinitely rather than lend overnight at a lower rate. Banks can either lend to each other or accumulate reserves.

Answer 137

The discount rate the fed charges banks to borrow reserves. Borrowing from other banks (at Iff) is a substitute for borrowing from the fed. If fed funds raises to discount rate, banks will want to borrow more and more and lend out the proceeds at the fed funds rate.

Answer 138

B. Currency = 100 Reserves = 16 C. Since the fed engages in no open market operations, the bank can meet their increased reserve requirements only by calling in loans. As banks call in loans, the money supply contracts and composition of monetary base shifts toward greater reserves and a smaller currency component. Base remains unchanged at 116, M1 falls to 196

Answer 139

Inflation + equilibrium + .5 (inflation gap) + .5 (GDP gap)

Answer 140

Concise, terse, forcefully expressive Pithy quote