Final Flashcards
Unexpected inflation
- Transfers from creditors to debtors (debtor pays 6% on loa an either way, so inflation negatively impacts creditor)
- Reduction in real wages (salary contract locks you in)
Inflation
Sustained increase in price level
Costs of inflation
- Expected inflation
- Unexpected inflation
- Inflation uncertainty
Expected inflation
Spend more resources (ie brokerage fees) to minimize cash balances
Inflation uncertainty
- Adds a risk premium to interest rates
2. Can make investment planning difficult (effectively a tax on investment)
Causes of inflationary monetary policy
- Inflation tax
- Faulty central bank policies
- Attempts to monetize government debt
- Political explanations
Why is the potential for instability greater in financial services than in non-financials?
- Leverage- different standards for financial institutions (average was 10:1), which leaves them with a thinner cushion to respond to negative shocks
- Liquidity- short term deposits finance long term transactions, making them more vulnerable to liquidity squeezes
- High degree of interconnectedness to other institutions
Inflation tax
Tax the holders of government money by increasing the growth rate of the money supply. The real revenue from government money creation can be expressed as the difference between the money stock today and the money stock last period divided by the price level today: (Mt-Mt-1)/Pt
Faulty central bank policies
Policies by the fed to:
(I) accommodate high wage demands (II) accommodate increases in other input prices (eg oil)
(III) achieve too low of an unemployment
(IV) achieve too high of a GDP target
-all could lead to inflation
Attempts to monetize government debt
Budget deficits have no impact on monetary base or supply. If the CB, however, decides to increase its purchases of government debt when the government is running large deficits, then this policy choice can lead to inflation. Note it is the political pressure that is the cause of inflation, not the deficit itself.
Political explanations
The desire of a Fed chairman to be reappointed and the desire of a politician to be reelected can put pressures on the monetary authority to inflate in order to achieve a short-term goal of the appearance of improved economic conditions
What causes deflation?
Consistent decline in aggregate demand
What is crucial difference between ‘normal recession’ in which the inflation rate is at least modestly positive and deflationary recession?
- Delay consumption
- If wages are sticky, real costs of production increase, aggregate supply shifts back
- Real debt burdens rise
Describe real debt burden increase cycle
- Real debt burden rises ->
- increase real costs of debt and debt service. ->
- Demand is reducing, so you get less per unit & sell fewer units ->
- bankruptcy ->
- asset value declines ->
- unemployment rate increase ->
- AD reduces even further ->
- steeper deflation ->
- increase in debt burden
What policy actions can try to prevent deflation?
- Preemptively reduce interest rates and provide reserved to system to increase money supply
- Buffer zone for target inflation rate (during normal times do not try to push inflation all the way to zero). Normal inflation target is around 2%
- Use forward guidance to convince people the fed will fight deflation
- Act as lender of last resort -> provide liquidity to maintain a functioning financial system
Once monetary policy is at the zero interest rate lower bound, what are the actions a central bank can undertake to cure the deflation or prevent it from taking hold?
- Push interest rates further down, slightly below zero, which is what the ECB is considering
- Large scale asset purchases “QE”- buy long term assets bc short term rates are already at zero
- Forward guidance- commit to low interest rates for long horizon
- Expand maturity of lending, collateral that’s accepted, and counter parties
- Buy foreign bonds
Phillips curve
- Describes the relationship between a measure of real economic activity (unemployment rate x axis) and a nominal variable (rate of changes of prices or nominal wages y axis) in the short run.
2 In the long run, it is vertical since unemployment level returns to its natural rate. - Graphs trade off between inflation and unemployment
Source of inflation
Only money supply growth leads to continually rising general price level. While supply shocks and changes in government expenditure can lead to one-time increases, they cannot cause inflation
How has the financial system evolved to increase the layers/chains of intermediation and what are the implications for financial fragility?
- interconnections
- more involvement in a variety of markets
- over-the-counter derivatives -C.D.S.
- globalization
- consolidation in the industry
- securitization
- credit rating agency (conflict of interest- who was issuing the security was paying the CRA to advise them on how to structure the security)
What are some of the key contributing factors to the financial crisis?
- High reliance on short term external finance (commercial paper and repo agreements)
- Excess risk taking and poor risk management (false sense of confidence with Freddie & Fannie guarantees), moral hazard (large banks assume fed will step in & find a partner for them), lack of transparency & complexity of securities
- Over allocation of resources in real estate (global savings glut- a lot of capital was flowing in from emerging markets), poor mortgage underwriting (permitting high loan to value ratios, high leverage and very little skin in the game)
What are traditional crisis responses by central banks?
- Direct lending (discount window lending)
- Open market operations
- Reserve requirements (rarely used)
- no guarantees that these bank reserves will revive lending
What was the motivation for the non-traditional responses by the federal reserve and how can those “non-traditional” uses of the asset side of the Fed balance sheet be categorized?
Motivation: With interest rates at zero, you aren’t going to spur more investment. Lower bound interest rate at zero bc people would rather hold cash than earn a negative ROI.
- intermediation by banks “broken”- give $ to banks and they’ll allocate it out but banks were so concerned with their own survival, they were hoarding liquidity.
- non-banks became crucial
Non traditional uses of the asset side
- Expand collateral that was accepted (ie commercial paper market)
- Expand counter parties
- Lengthen maturity- stabilize system- need to guarantee that money isn’t going to disappear tomorrow
What did the fed do to remove the stigma associated with discount window borrowing?
- It put the term auction facility in place. It initially made 28-days available and eventually increased to as long as 84 days.
- It can also bring the fed funds rate and the discount rate closer together
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?
- Provide interest on reserves (incentivizes banks to hold reserve balances rather than lend them out).
- Offer interest-bearing deposits for excess reserves (which commits the bank to keep its reserves with the fed for a specified period of time).
- Traditional tool of reverse repurchase agreements (drains reserves directly from the system)
True or false: reinstating glass steagall would insulate banks from financial market shocks and help promote stability
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
Bitcoin advantages
- solves Byzantine generals problem- established trust between otherwise unrelated parties
- low to nonexistent fees - great for small businesses and remittance population
- Eliminates risk of credit card fraud
Basel II
Pillar I: minimum capital requirements
Pillar II: Supervisory review process
Pillar III: disclosure & market discipline
Impacts of the end of bank branching restrictions across states on the banking industry?
- Consolidation (small, low capital, low profit, community banks disappeared)
- Increased diversification (lower volatility)
- Increased competition
Is there an impact on banking deregulation on entrepreneurship?
- New business formation
- More credit available
- Lower interest rates/borrowing costs
- Positive impact on state GDP (volatility of state gdp growth declines)
Why does monetary policy need to be forward-looking and preemptive?
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.
Why does inflation become harder to control once it has been allowed to gain momentum?
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.
Why is forward guidance important?
It puts downward pressure on longer term interest rates and thereby lowers the cost of credit for businesses and home buyers.
In what way is the us economy insulated from inflation?
- Resilience & structural stability (flexible & efficient markets for capital & labor helps)
- Entrepreneurial tradition
- Healthy, well-regulated banking system
Define deflation
General decline in prices
Define ‘zero bound’
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.
Dual mandate of the Fed
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).
Inflation targeting
- Public announcement of medium term numerical targets for inflation
- An institutional commitment to price stability as the primary, long run goal of monetary policy and the commitment to achieve the inflation goal
- Information approach in making decisions about monetary policy
- Increase transparency of monetary policy strategy to public & markets
- Increased accountability of CB for attaining inflation objectives
Fed funds rate
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.
How can the fed raise interest rates under normal circumstances?
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.
Considering the $3 trillion in excess reserves, how will the fed eventually raise interest rates?
It can raise the rates it pays on excess reserves. Then, banks won’t want to lend for anything less.
Reverse repurchase agreements
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.
Impact of IOER (interest on excess reserves)
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.
How does friedmans approach differ from the Keynesian approach?
- Friedman viewed permanent income (Yp) as more important than current income in determining money demand
- Friedman considers multiple rates of return and considers the relative returns to be important (Interest rate on M is positive & can vary)
- Friedman viewed money and goods and substitutes (more than just bonds compete with money as store of value)
The three primary motives for holding money according to Keynes:
- Transactions motive
- Precautionary motive
- Speculative motive
Transactions motive
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.
Precautionary motive
People hold money as a cushion against unexpected wants or emergencies. Precautionary money demand is again expected to rise with income.
Speculative motive
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.
Keynes made the following assumptions:
- Money and bonds are the only assets
2. Money pays no interest but bonds pay interest
Equation of exchange
MV=PY
The aggregate nominal income equals the money stick times the average rate of money’s turnover.
Income velocity of money
Average number of times per year that a dollar is spent purchasing the total amount of final goods and services produced in the economy.
Income velocity of money equation
V=PY/M
M=nominal stock of money
Y=real aggregate output in one year
P=an index of prices
Classical quantity theory assumptions
- Md is purely a function of nominal income (PY)
2. Interest rates play no role
Classical quantity theory equation
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
What two assumptions did fisher make regarding the quantity theory of money?
- Velocity is constant in the short run. This is bc velocity is affected by institutions and technology that change slowly over time.
- Flexible wages and prices guaranteed output, Y, to be at its full employment level, so Y was also constant in the short run.
If V and Y are constant, what does the quantity theory of money say?
A change in the money supply, M, results in an equal percentage change in the price level, P.
What is the big difference between fisher and Keynes theories?
Keynes places importance on interest rates. Since interest rates fluctuate quite a bit, then velocity must too.
Why is friedman’s money demand more stable than Keynes?
- Permanent income is very stable, and
- 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.
Monetizing the debt
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.
The quantity theory of money is a good theory of inflation in the long run, but not the short run.
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.
How can deposit insurance be described as a put option?
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.
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 1
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.
Given the flat rate federal deposit insurance (that is, same premium rate for all institutions regardless of risk) has existed from the 1930s until the early 1990s, why did the savings and loan crisis happen in the 1980s rather than earlier? Part 2
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.
Is there a trade off between price stability and employment?
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.
What determines the demand for an asset (such as money or bonds)? (Theory of portfolio choice)
- Wealth (positive correlation)
- Expected return relative to another asset (positive correlation)
- Risk of asset (negative correlation)
- Liquidity of asset (positive correlation)
Impact of expected interest rates on demand for bonds
Higher expected interest rates in the future lower the expected return for long term bonds, decrease the demand, and shirt demand curve left.
