Final - unit 3, 4, 5

Question 1

Bank vs NBFI ex

Answer 1

banks:
-a financial institution with Fed account and deposit insurance
-commercial banks
-savings and loan institutions
-credit unions

nbfis:
- a financial institution without a Fed account and deposit insurance
-collective investment vehicles
-pension funds
-insurance companies

Question 2

Credit card money creation

Answer 2

-A cardholder is given X amount of dollars, so a bank issues them a license to create X dollars inside of money
-merchant delivers goods/services in exchange for an IOU
-bank settles cardholders debt with the merchants bank using reserves
-when cardholder uses deposits to pay their bill, money is destroyed

Question 3

Functions of the Federal Reserve Board

Answer 3

1. Votes on conduct of OMOs
2. Sets reserve requirements/IOR
3. Reviews/determines discount rates
4. Regulation
   
   • decides okay bank activities
   • approves bank mergers
     -sets margin requirements
     -supervises foreign banks in the US
5. Reviews each FRB’s budget

Question 4

What are the conventional tools?

Answer 4

1. Open Market operations (OMO)
2. Reserve Requirements (RR)
3. Discount Rate (DR)
4. Interest on Reserves (IOR)

Question 5

Disconut window and Discount rate

Answer 5

Discount window: overnight lending from the Fed to banks that is collateralized
-borrowed reserves are temporary, is the sum of all reserves borrowed through the Fed through the discount window
-non borrowed reserves are permanent, is total reserves minus borrowed reserves
Discount rate: the administrative rate at which the Fed lends to depository institutions through the discount window

Question 6

Interest on reserves

Answer 6

-the admin rate the Fed pays to banks on their reserves
Fed Funds: reserves that banks borrow from each other uncollateralized overnight to meet liquidity needs
-the federal funds rate is the rate that banks pay to each other on uncollateralized overnight loans in reserves

Question 7

Market for Fed Funds theory

Answer 7

-the market for fed funds should always produce a FFR that weakly exceeds interest on reserves because no bank should be willing to lend below IOR

Question 8

Illiquidity

Answer 8

-by the very nature of it’s business every bank is illiquid
-although demand deposits can be withdrawn at a moments notice, only a few are actually withdrawn
-the difference between a good bank is not its liquidity but its solvency

Question 9

Silicon Valley Bank: Takeaways

Answer 9

1. FDIC: 250k deposit insurance is insufficient to prevent runs
2. Fed: for various reasons including but not limited to its antiquated setup, the discount window does not work, or no longer works, as intended

Question 10

Fiscal Policy

Answer 10

The use of government spending and taxation to influence the economy
Spending:
-expenditures
-transfer payments
-investments
Taxation

Question 11

How to stimulate labor N

Answer 11

1. by lowering the income tax, households have a stronger incentive to work, which stimulates labor supply
2. by lowering the corporate tax, firms have a stronger incentive to hire, which stimulates labor demand

Question 12

How to stimulate labor productivity Y/N

Answer 12

1. by lowering the income tax, households have a stronger incentive to become entrepreneurs, which stimulates technological advancement
2. by lowering the corporate tax, firms have a stronger incentive to expand which stimulates capital investment

Question 13

Expenditures limitations

Answer 13

1. Legislative Delay:
   -both discretionary and supplemental spending require congressional approval
2. Implementation Delay:
   -once approved, government expenditures may take months or even years to roll out
3. Crowding out:
   -once rolled out, government expenditures absorb resources which, in turn, cannot be used by the private sector

Question 14

Two ways a government can finance an expenditure

Answer 14

1. Finance intratemporally (immediately) by way of tax income
2. Finance intertemporally (later) by way of issuing new debt

Question 15

QTOM implication

Answer 15

Since the Fed chooses the rate of growth of the money supply, it effectively causes inflation

Question 16

FTPL implication

Answer 16

Since congress chooses the growth rate of the national debt, it effectively causes inflation

Question 17

Describe how the fed used to influence FFR under the old limited-reserves regime. In your answer be sure to explicitly state which of the four unconventional tools (OMO, IOR, DR, RR) was used for this purpose

Answer 17

-To influence FFR the Fed used OMO (open market operations) that involved buying and selling on the open market
-To lower FFR, they would purchase a government or financial security
-This would add money into the bank system which would increase the reserves available causing excess
-This excess would decrease FFR
-To increase the FFR the Fed would sell securities to other banks leading to a reserve shortage
-This would cause banks to fight for the remaining reserves and push up FFR

Question 18

Describe how the Fed influences FFR under the current ample-reserves regime. In your answer, be sure to explicitly state which of the four conventional tools (OMO, IOR, DR, RR) is used for this purpose. Also, why does the old way no longer work?

Answer 18

-Under the current ample-reserves regime FFR is influenced using IOR
-This is done because in ample-reserves regime, banks have plenty of reserves so the other methods would be less effective
-Using IOR the Fed can set the interest rate that it pays on reserves or not, so they control the raising and lowering of FFR
-The old way doesn’t work anymore because the Fed used to have to use OMO to buy or sell securities which would affect the reserves
-But because the banks already have excess reserves OMO wouldn’t have as big of an effect on FFR

Question 19

To influence the broader economy, the Fed uses both short and long term rates. With reference to expenditures C and capital investment I, describe why an increase in interest rates leads to a decrease in aggregate demand Y=C+I+G+NX

Answer 19

-When the Fed increases interest rates it affects both the short and long term interest rates
-For C, higher interest rates makes consumers borrow more, and as it becomes more expensive to borrow consumers are likely to hold off on making purchases which directly affects C in the equation
-In regards to capital investment I, higher interest rates also affect how businesses cost for borrowing, and when this cost of borrowing rises, businesses may hold off or reduce their plans for investment
-These both result in a decrease to aggregate demand Y

Question 20

The US federal budget consists of three categories: mandatory, discretionary, and (net) interest spending. In what sense are interest expenses, unlike mandatory and discretionary spending, unproductive?

Answer 20

-Interest expenses are different than mandatory and discretionary spending because they do not contribute to the production of goods and services
-Interest spending is the cost of borrowing money, so when the government pays interest it is paying for money that has already been spent instead of anything in the future
-Mandatory spending are things like social security because there is money specifically set aside for them
-Discretionary spending pays for things like defense and education, and these amounts of funding can be changed

Question 21

Describe how the US government’s cost of borrowing depends on the Federal Reserve’s monetary policy. In your answer, be sure to describe the tradeoff banks face when deciding what to do with or how to invest their reserves.

Answer 21

-The US government’s cost of borrowing depends on the federal interest rates
- The federal reserve chooses the federal funds rate and this affects other interest rates
-When the Fed increases the federal funds rate, borrowing costs more for everyone, and when they lower the rate borrowing costs less
-Another way the US government’s cost of borrowing depends on the Fed’s monetary policy is through quantitative easing, this means that the Fed buys government securities
-This action increases demand for government securities and increases their prices
-The tradeoff banks face with their reserves is that banks have to choose between potential profits from investments against their ability to be liquid

Question 22

Typically the quantity theory of money (QTOM) and the fiscal theory of price level (FTPL) are viewed as competing economic theories. With reference to the inflationary episode following the coronavirus pandemic, explain how inflation can be both “always and everywhere a monetary phenomenon” (QTOM) and, at the same time, be caused by a lack of fiscal discipline (FTPL). In your answer, be sure to state explicitly who created what type of money (real vs banking) in response to the crisis

Answer 22

-The Quantity theory of money (QTOM) says that inflation is a result of changes in the money supply
-The Fiscal Theory of the Price Level (FTPL) says that fiscal policy can also drive inflation
-During the inflationary episode following the covid pandemic, central banks across the world reacted by creating alot of real money
-This increase in the money supply combined with a decrease in production and supply across the world affected inflation which supports QTOM
-When thinking about fiscal policy however, the government handed out stimulus payments which increased debt, and caused people to spend more
-This inflationary episode because of these pieces of evidence, is a monetary phenomenon because both theories contributed

Question 23

In mid 2009, when the Great Recession hit it s peak, acting Fed chair Ben Bernanke’s preferred Taylor rule suggested that the Federal Funds Rate be set to -4%. Explain why the Fed was unwilling to follow the Taylor rule and did not set FFR to -4%.

Answer 23

-The Taylor rule would have led to low or negative FFR
-The great recession was so unprecedented that it required unconventional measures beyond the Taylor rule.
-The Fed was also constrained by the zero lower bound on interest rates, because when interest rates approach zero, conventional monetary policy is less effective
-lowering interest rates could have made financial instability worse

Question 24

The unconventional tools introduced by the Fed following the 2008 financial crisis - quantitative easing, forward guidance, and operation twist - were all designed to depress long term interest rates so as to provide additional stimulus for the US economy (since FFR was already at zero). Describe how a decrease in long-term interest rates might stimulate the economy

Answer 24

Decreasing long-term interest rates can stimulate the economy in several ways.
1. Lower cost of borrowing: when long term interest rates decrease, it becomes cheaper for businesses and individuals to borrow money
2. Boost Asset Prices: lower long term interest rates can drive up asset prices like stocks and real estate, higher asset prices can make consumers feel more financially stable making them spend more
3. Stimulus to investment and innovation: with lower borrowing costs, businesses are incentivized in new technology and development, which can contribute to long term growth

Question 25

Ceteris paribus (i.e. holding all else constant), an increase in government expenditures G leads to a one for one increase in aggregate demand Y^D. Discuss why the assumption of ceteris paribus is almost sure inappropriate when assessing the effects of a government spending program on aggregate demand. In particular, how might an increase i G influence consumer spending C and/or capital investment I?
Y^D=C+I+G+NX

Answer 25

-It’s unrealistic/ inappropriate because:
1. Crowding out: when the government increases spending, it needs to finance spending through borrowing, this can increase interest rates, reducing C
2. Government spending can directly affect incomes which can lead to increased spending C and increased government spending can also increase research and development for business and can boost capital investment I

Question 26

Explain how Japan has been able to sustain a debt to GDP ratio of over 200% without defaulting (i.e. Japan has never missed a scheduled interest payment). In your answer, be sure to include the unconventional way in which Japan uses the money it receives for issuing new debt

Answer 26

Japan can maintain a debt to GDP ratio of over 200% for a couple reasons:
1. Domestic ownership of debt: a big portion of Japans debt is held by them, meaning a lot of debt is owed to citizens and the bank
2. The bank of Japan has kept interest rates very low so the cost of borrowing is less
3. Japan has a very stable economy
4. Unconventional use of debt: Japan uses money it receives from issuing new debt for the infrastructure and technological investments rather than for the budget, by using debt funds for things that stimulate economic growth, Japan creates new revenue, and this has also contributed to its ability to avoid defaulting

Question 27

With reference to the various types of money discussed in class, why is it unsurprising that QE4 in 2020 ended up be inflationary, whereas QE1 in 2008 was not?

Answer 27

It’s unsurprising that QE4 ended up being inflationary compared to QE1 for several reasons:
1. Economic conditions: QE programs were implemented very differently, in 2008 there was a lot of unused capacity in the economy, which meant that pushing money into the economy in 2020 could’ve led to inflation
2. Magnitude of QE: the scale of QE4 in 2020 was much larger than in 2008, the reserves balance sheet expanded in 2020 to support the economy which could’ve fueled inflationary pressures
3. Fiscal Policy: the coordination between monetary and fiscal policy could also contribute to inflationary pressures

Question 28

When the fed buys financial assets it ________ reserves

a. creates
b. destroys

Answer 28

a. creates

Question 29

Which of the Fed’s four conventional tools is most closely related to its function as a lender of last resort?

a. open market operations
b. reserve requirements
c. interest on reserves
d. discount rate

Answer 29

d. discount rate

Question 30

In its most recent statement, the FOMC announced that “the Committee will continue reducing its holdings of treasury securities” select all actions that reduce the size of the Fed’s balance sheet

a. buying financial assets
b. selling financial assets
c. neither buying nor selling financial assets

Answer 30

b. selling financial assets

Question 31

Operation twist, also known as maturity extension program, was a sterilized version of quantitative easing. In particular, this is because the Fed _____________

a. bought an equivalent amount of short and long term assets
b. sold an equivalent amount of short and long term assets
c. bought long term assets while selling an equivalent amount of short term assets
d. bought short term assets while selling an equivalent amount of long term assets

Answer 31

c. bought long term assets while selling an equivalent amount of short term assets

Question 32

In its role as a lender of last resort, the Fed

a. lends to fundamentally solvent, but illiquid banks
b. lends to fundamentally liquid, but insolvent banks
c. only lends to banks that are both solvent and liquid
d. only lends to banks that are both illiquid and insolvent

Answer 32

a. lends to fundamentally solvent, but illiquid banks

Question 33

A government expense in which a good or service is paid for is _________

a. a government expenditure
b. a transfer payment
c. an investment

Answer 33

a. a government expenditure

Question 34

In terms of stimulating the economy, a fiscal multiplier ________ implies that a particular program’s positive indirect effects outweigh the corresponding negative indirect effects.

a. equal to 1
b. smaller than 1
c. greater than 1

Answer 34

c. greater than 1

Question 35

Comparing the number of dollars which the US government’s spends on unproductive interest outlays to the corresponding number from prior years is misleading because it fails to account for which of the following

a. the debt level
b. population growth
c. inflation
d. economic growth

Answer 35

a. the debt level
b. population growth
c. inflation
d. economic growth

Question 36

Interest outlays as a fraction of GDP have been rising pretty rapidly, but they are still well below the 5% level reached in the 1980’s. Why were interest outlays so high in the 1980’s even though the debt per GDP was rather low?

a. Because US debt was perceived as risky
b. because the Fed had set interest rates to very high levels (to combat inflation)
c. because US debt was very long term

Answer 36

b. because the Fed had set interest rates to very high levels (to combat inflation)

Question 37

Wholesale central bank digital currency (CBDC) is electronic currency issued by a country’s central bank, held and used by banks to settle interbank debts. Which of the following is a wholesale CBDC?

a. currency in circulation
b. vault cash
c. demand deposits
d. reserves

Answer 37

d. reserves

Question 38

The fact that a dollar bill can be used to buy goods and/or services represents which type of value?

a. nominal intrinsic value
b. nominal market value
c. real intrinsic value
d. real market value

Answer 38

d. real market value

Question 39

When using a credit card, since the merchant is credited bank deposits before deposits are debited from the cardholder’s bank account, the cardholder effectively creates money out of thin air

a. true
b. false

Answer 39

b. false

Question 40

Select all the assets in exchange for which banks issue deposits

a. cash
b. reserves
c. deferred payment

Answer 40

a. cash
b. reserves
c. deferred payment

Question 41

Banks fund loans by _____, whereas NBFI’s fund loans by ________

a. creating previously non-existing deposits; transferring their existing deposits
b. transferring their existing deposits; creating previously non-existing deposits

Answer 41

a. creating previously non-existing deposits; transferring their existing deposits