Macro 5 Flashcards
When were the seeds of financial crisis planted? and why?
1970s onwards, with many financial innovation
What were the type of financial innovations?
New types of securities
New ways to borrow short term
New ways to insure against falling asset values
(similar to deposit insurance)
Increased importance of non-bank financial institution (NBFI)
What is securitisation? What is the process like?
turning loans into debt securities
- Bank makes mortgage loans, with home as colalteral
- Bank bundles the mortgages into a mortgage- backed security (MBS). Owner of MBS gets regular interest payments from the mortgages
- Bank sells the MBS to another financial institution. BANK CAN WRITE OFF MORTGAGE FROM BALANCE SHEET. WHOEVER OWNS SECURITES ENTILTED TO REPAYMENT OF LOANS
What is considered long term in securitisation?
20-30 years
What is the process of slicing and dicing? What is the purpose behidn each step?
- Financial institution buys many different MBS (mixture of high risk subprime and low risk prime)
2 .Chops up each MBS into slices
- Combines slices from various MBS to form Collateralized Debt Obligations (CDOs). Security created that pays high interest and has low risk due to diversification
- Sell CDOs to other banks( other bank get regular interest payment from MBS slices)
How to create CDO squared?
do another round of slicing and dicing
What is the new way of borrowing short term?
Repurchase Agreement(repo)
other party is reverse repo
When will the repos act as collateral?
If the seller of the CDO defaults, then the buyer of the CDO keeps security
CDOLenders prefer liquid and safe assets as collateral in repos
Short term govt securities are considered very good collateral
What are credit default swaps?
Form of insurance against seller of CDO default
will top up remaining amount
What are shadow banks?
NBFIs that take on short term liabilities (such as repos) to purchase long term assets (such as MBS’s, CDOs)
highly leveraged
What were the primary function of shadow banks?
Supposed to help companies to arrange ipo
Advice on financial dealing
How were shadow banks and traditional banks similar?
- Assets are long term
- Liabilities are short term
- Highly leveraged
How were they shadow banks different from traiditonal banks?
- Insurance is not provided by government
- Lightly or not regulated
- Has no lender of last resort
What caused the financial crisis ?
- US nationwide housing market downturn
- rising mortgage default
- prices of MBS’s, CDO fell drastically
- Lenders, fearing that borrowers are insolvent, became less willing to enter into repos, and to accept these securities as collateral
- banks and NBFI’s tried to deleverage i.e. sell assets to pay off liabilities (BUT ALL AT SAME TIME)
What is deleveraging ?When is deleveraging good and bad? Why?
deleveraging: sell assets to pay off liabilities
- works when few firms do it
- but bad when all sell at same time, cause price of MBS and CDO to fall further, closer to insolvency ( similar to bank run)
What is the positive feedback loop for mortgage default rise?
- Mortgage default rise
- Price of MBS fall
- Price of CDO fall
- Banks and NBFI see eqwuity fall
- Lenders fear that borrowers may be insolvent
- Repo market stalls, banks and NBFIs can’t borrow
- Banks and NBFIs sell MBS, CDOs
- Go back to step 2/ step 3
What were the actions that were taken by Fed and treasury to restore financial stability?
- Persuaded healthier financial institutions to buy troubled ones (JP morgan persuaded to buy Bear stearns)
- Bought securites to raise asset prices (bought large qty of MBS)
- Gave NBFI access to emergency Fed loans (goldman and morgan stanley turned into bank holding company)
- injected equity into troubled financial intermediaries (US treasury took over ownership of AIG,paid off liabilities)
How has shadow banking industry grown in China?
- Wealth management products: sold to savers by banks so bank balance sheet dont include thenm
- Entrusted loans : loans between 2 companies with banks as agent for lender
- Trust companies: firms that sell securities to investotrs to buy risky high interest asset
What have the chinese authorities done?
imposed regulations on sector, result in shrinking assets
What are the 2 financial assets that people can hold their wealth i n? What are the assumptions?
money: no interest; used for transactions; safe
bonds: pay interest, not used for transactions, risky
assumption: interest rate is fixed(both nominal and real ir move together)
What is money demand?
amount of wealth households choose to hold as money
When do people want to hold more money?
Nominal interest rate falls : opp cost of holding money falls , have to give up bonds
the Price Level rises: need more money for transcations
Output rises: more gns bought and sold
What causes a movement along money demand and shift in money demand?
When does money supply shift?
movement: change interest rate
shift: change in P or Y
Money supply curve shifts when Central Bank decides to change the quantity of money
How do moeny market clear if ir above eqm?
If ir above eqm level,
Excess supply of money (people would rather hold less money)
Excess demand for bonds(people would rather hold more bonds)
With excess demand for bond, bond price will increase in bond market. As bond price increase, interest rate decrease until people are satisfied with holding qty of money
In keynesian model, _____ if Y rises, money demand _________
other things equal
rises and shift right
(cause there is excess demand, bond prices fall)
What is the full range of intereactions when Y increases?
if eqm increase, money demand increase, interest rate increase.
This causes Ip and a to decrease, AE decrease, Y star decrease
Money demand decrease again
expenditure multiplier becomes smaller becasue interest rate incresae and crowidng out(which reduce size of multipler).
What does eqm depend on?
how interest sensitive ae is
how output sensitive money demand is
What is monetary policy? What can the fed generally do to increase AE? What are the benefits of monetary policy compared to fiscal?
central bank’s actions and communications
to manage the money supply to influence economic activity
increasing the money supply sufficiently to reduce the interest rate
monetary policy: faster to enact and easier to reverse
How does monetary policy accomodate fiscal policy?
An expansionary fiscal policy leads to a rise in the interest rate –> the resultant crowding out reduces the policy impact
If Central Bank wants to accommodate the expansionary fiscal policy, it can eliminate crowding out by preventing the interest rate from rising
What does the fed do to target short term interest rate?
targets the Fed Funds Rate (FFR) = rate at which banks lend reserves to one another overnight, act as benchmark for other interest rate
Other assets pay higher rates, due to being longer-term and higher risk, thus earning term premiums and risk premiums.
Difference (spread) between these rates and the FFR is usually stable
What is the relationship between IOR, Fed Funds Rate and Discount rate?
How to get banks to reduce reserves
By manipulating ceiling (discount rate), and floor( IOR) , Fed can control ffr
FFR: Interest rate in the interbank market for reserves. Fed use open market operations to affect the interbank rate
IOR: Ir paid on reserves. Banks will not lend reserves to other banks if IOR > interbank rate Thus, IOR is the floor for the FFR
Discount rate:Interest rate charged by central bank for lending reserves. Banks will not borrow reserves from other banks if discount rate < interbank rate. Thus, discount rate is the ceiling for the FFR
In a deep, prolonged slump, conventional monetary policy may hit the __________
zero lower bound
What do Fed’s do as monetary policy? What are the objectives?
Quantitative Eaisng: large scale purchase of financial assets, paying with newly created reserves
inverse relationshoip between financial asset and interest rate
Objective: boost asset prices and reduce long-term interest rates, reduce pressure on financial institution to deleverage
What were the problems of QE?
did not lead to a massive increase in deposit creation
BECAUSE Banks wanted to hold excess reserves
What other methods does the fed hve?
Forward guidance
- communicating of future monetary policy
- to influence business and household expectations of the future interest rate
What are the disadvantages of QE?
Helped combat the slump, but effect is weak
Doesn’t directly help the unemployed or people who have lost their homes; may have worsened inequality
need to use fiscal policy in tandem
What happens when nominal aggregate expenditure rises relative to real potential output, for long and short run?
short : economy can produce above its potential
long: prices and wages rise until real aggregate expenditure falls back to equal real potential output
What is stagflation?
high inflation and high unn
What ar ethe ingredients of sustained high inflatiuon?
1.
Central banks being hesitant to tighten monetary policy
- People grow to expect high inflation to persist :
- Unions push for cost-of-living adjustments to wages every year
- Firms raise prices of their products as costs increase
- Governments raise transfers to help people cope with inflation.
- Indexation becomes more common
EXPECTATION OF HIGH INFLATION THEN BECOMES SELF FULFILLING
What lessons can be learnt from Volcker disinflation?
- high inflation involves doing contractionary monetary policy until the job is done
- Central bank’s credibility is important for influencing inflation expectations
- Pre-emption: best to keep inflation low and stable, rather than to let it ramp up
