MBFINAL Flashcards

Question

**What does the Phillips Curve say?**

Answer 1

A historical inverse relationship between rates of _unemployment_ and corresponding rates of _inflation_ that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of _inflation_. % change in Wage level = expected change in wage level - f(unemployment rate) ==\> Higher unemployment = less wage increase. Short run (does not hold in the long run).

Answer 2

Through the Federal Funds rate (rate on overnight loans) * Demand increases as the rate on overnight loan decreases, as the opportunity cost of holding excess reserves decreases (Federal Funds Rate vs. interest rate on reserves) until the point in which the federal funds rate charged is lower than the interest rate paid on reserves, banks stop lending in the overnight market and keep on adding to their holdings of excess reserves (demand curve for reserves flattens out) * Supply (nonborrowed reserves and borrowed reserves) increases as the Federal funds rate increases * Banks can either borrow from the FED or from other banks * As long as the Federal funds rate is lower than the discount rate (interest rate charged by the FED on loans to banks), the supply curve will be vertical and consist of only nonborrowed reserves. * As soon as the Federal Funds rate is higher than the discount rate, the supply curve will be horizontal

Answer 3

* Purchases ⇒ Supply increase as NBR increases ⇒ Federal Funds rate * Decreases if they intersect on the downward sloping demand curve * Nothing happens if they intersect on the horizontal demand curve * Sale ⇒ Supply decreases as NBR decreases ⇒ Federal Funds rate * Increases if they intersect on the downward sloping demand curve * Nothing happens if they intersect on the horizontal demand curve NOTE: the interest rate paid on reserves, Ior, sets a floor for the federal funds rate.

Answer 4

An **decrease in the discount rate leads to a decrease in supply (shifts down) ⇒** * A decrease in the federal funds rate * No effect on the Federal Funds rate * As the discount rate normally is kept above the Federal Funds rate target, most changes in the discount rate has no effect on the federal funds rate. Most changes in discount rate have no effect on the federal funds rate.

Answer 5

When the required reserve ratio increases, required reserves increase and hence the quantity of reserves demanded increases for any given interest rate ⇒ Demand shifts right Thus, a rise in the required reserve ratio shifts the demand curve to the right and raises the federal funds rate. Conclusively, when **FED raises reserve requirements, the federal funds rate rises**

Answer 6

(The interest rate paid by the FED on reserves) When FED **increases the interest rate on reserves, the Federal Funds rate will** * _Be unchanged if_ the interest rate paid on reserves is lower than the Federal funds rate * _Increase if_ the interest rate paid on reserves is equal to the Federal Funds rate (such that they follow each other) * The interest rate on reserves can not be higher than the Federal Funds rate, as the Federal funds rate will follow an increasing interest rate on reserves

Answer 7

As both the demand and supply curve have a horizontal point. Hence, the Federal Funds rate can not fluctuate that much, thereby making the market more stable. * _Rightward demand shift_: Thus, a rightward shift of the demand curve raises the federal funds rate to a maximum of the discount rate * _Leftward demand shift_: A leftward shift of the demand curve lowers the Federal funds rate to a minimum of the interest rate on reserves.

Answer 8

* Open market operations (the most important) - monetary base * Discount lending (and LOLR) - monetary base * Reserve requirements - money multiplier (NOT interest rate on reserves: something only from 2008 onwards: money multiplier)

Answer 9

The primary determinant of changes in interest rates and the monetary base. Open market purchases (buying securities) expand reserves and the monetary base, thereby increasing the money supply and lowering short-term interest rates.

Answer 10

* _Dynamic open market operations_: intended to change the level of reserves and the monetary base * _Defensive open market operations_: intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury deposits with the Fed or changes in float.

Answer 11

* _Repurchase agreement (repo):_ * Fed purchases securities with an agreement that the seller will repurchase them in a short period of time (1-15 days) * _Matched sale-purchase transactions (reverse repo):_ * Fed sells securities and the buyer agrees to sell them back to the Fed in the near future (1-15 days)

Answer 12

* Primary credit: * Healthy banks borrow all they want at very short maturities (usually overnight). * The interest rate are usually higher (around 1 %) than that of inter-bank lending, as the FED wants banks to lend from each other, thereby incentivizing them to monitor each other's’ credit risk * Secondary credit: * Credit given to banks in financial trouble * Interest rate on these loans is higher * Seasonal credit: * Given to a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. * Is not as important anymore and might be deleted soon

Answer 13

* Primary credit: * Healthy banks borrow all they want at very short maturities (usually overnight). * The interest rate are usually higher (around 1 %) than that of inter-bank lending, as the FED wants banks to lend from each other, thereby incentivizing them to monitor each other's’ credit risk

Answer 14

* Secondary credit: (from FED to banks) * Credit given to banks in financial trouble * Interest rate on these loans is higher

Answer 15

* Seasonal credit: (from FED to banks) * Given to a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. * Is not as important anymore and might be deleted soon

Answer 16

The discount rate. Doing so encourage banks to borrow and lend in the Federal funds market so that banks monitor each other. The interest rate on reserves have not yet been used as a monetary tool, but it provides a floor under the federal funds rate.

Answer 17

1. Occur at the **initiative of FED, which has complete control of the volume** 2. **Flexible and precise**: no matter how small a change that is desired, open market operations can achieve it with a small purchase or sale of securities 3. **Easily reversed**: if a mistake is made, the Fed can immediately reverse it 4. **Fast**: can be implemented quickly. No administrative delays.

Answer 18

1. Raising the interest rate on reserves can be used to raise interest rates after banks have accumulated large amounts of excess reserves (like now after 2008 crisis) 2. When discount policy can be used to perform its role as LOLR.

Answer 19

Tools that do not affect the short-term interest rates. These are: * Liquidity provision * Asset purchases * Commitment to future monetary policy actions

Answer 20

Increase in lending facilities to provide liquidity to financial markets (done post-2008 crisis) * Discount window expansion * **Lowering the discount rate** so it gets closer to the federal funds rate * **Term auction facility**: to encourage additional borrowing, FED made a temporary term auction facility, in which it made loans at a rate determined through competitive auctions. * **New lending programs**: lending to new types of banks including investment banks as well as lending to promote purchases of commercial paper, mortgage-backed securities, and other asset-backed securities.

Answer 21

A nonconventional monetary tool used by the FED post the 2008 crisis wherein assets are bought to decrease interest rate in the long run ⇒ quantitative easing * **FED purchased mortgage-backed securities** (especially from Fannie Mae and Freddie Mac) to lower interest rates on residential mortgages to stimulate the housing market * **Purchasing long-term treasury securities**: used when the short-term interest rate hit the zero-level floor.

Answer 22

* Quantitative easing: * CB purchases government securities and other securities from the market in order to lower interest rates and increase the money supply. * Credit easing * CBs increasing liquidity by buying private sector assets. The aim is to boost liquidity in a troubled market so that the flow of credit and lending in the economy increases.

Answer 23

A nominal variable, such as the inflation rate or the monetary supply, that ties down the price level to achieve price stability. Adherence to a nominal anchor that keeps the nominal variable within a narrow range promotes price stability by directly promoting low and stable inflation expectations. A more subtle reason for a nominal anchor’s importance is that it can limit the time-inconsistency problem, in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-term outcomes.

Answer 24

That CBs would want to increase monetary supply to boost the economy although it has long-term consequences. Thus, it is important to have a goal of a low price inflation all the time that you anchor to.

Answer 25

1. High employment and output stability 1. (but not too high employment - should still allow for frictional unemployment) 2. Economic growth 3. Stability of financial markets 4. Interest-rate stability 5. Stability in foreign exchange markets

Answer 26

* **Hierarchical mandates**: * When price stability is stated as primary goal and then other goals such as employments and growth can be perceived afterwards * Bank of England, European Central Bank, Bank of Canada, Reserve Bank of New Zealand * **Dual mandates:** * Trying to achieve two objectives at the same time (they are equal): price stability AND maximum employment (output stability) * Federal Reserve System Hierarchical mandates are often preferred by central bankers as there is a higher risk of dual mandates leading to high inflation as the focus is equally high on employment.

Answer 27

* **Reduction of the time-inconsistency problem** * Increased **transparency**: easily understood by the public * Increased **accountability** * Consistency with **democratic principles** * Improved **performance**: Historically proven effect on price stability

Answer 28

* **Delayed signaling**: inflation outcomes are revealed only after a substantial lag. Thus, a target does not send immediate signals to the public and the markets about the stance of monetary policy * **Too much rigidity**: limits abilities of monetary policymakers to respond to unforeseen circumstances. * **Potential for increased output fluctuations**: monetary policy might become too tight when inflation is above target and thus may result in larger output fluctuations * **Low economic growth**: potentially lower growth in output and employment. Historically however, as soon as low inflation is achieved, inflation targeting is no longer harmful to the real economy.

Answer 29

Federal Funds rate target = Current inflation rate + equilibrium real fed funds rate + ½\*(Inflation gap) + ½\*(output gap) 4 components * Inflation rate * Equilibrium real fed funds rate ⇒ The real fed funds rate that is consistent with full employment in the long run * Inflation gap ⇒ Current inflation minus a target rate * Output gap ⇒ The percentage deviation of real GDP from an estimate of its potential (natural) level.

Answer 30

* If output gap is positive, RAISE rate * If inflation gap is positive RAISE rate

Answer 31

What we see these days post the 2008 crisis. Monetary policy with an explicit goal, but not an explicit nominal anchor (what I call the "just do it" approach.) * No explicit nominal anchor * Forward looking behavior and periodic “preemptive strikes” * The goal is to prevent inflation from getting started

Answer 32

* Uses many sources of information * Allow for flexibility and creativity * Demonstrated success (especially post 2008 crisis in U.S.) * Forward looking, with legal mandates preventing overly expansionary monetary policy

Answer 33

* Lack of accountability, transparency * Strong dependence on preferences, skills and trustworthiness of individuals at the top, particularly the Chairman * Inconsistent with democratic principles

Answer 34

Where policy rate (Federal funds rate) cannot be lowered any further - zero lower bound Inflation is low and unemployment is high but you cannot do anything through conventional monetary policy as the rate has reached its floor. This is when quantitative easing comes in as solution (unconventional monetary policy)

Answer 35

E(Home currency / foreign currency) E(HKD/$) = 0.128 (0.128 USD = 1 HKD) E(DKK/SEK) = 1.28 (1.28 SEK = 1 DKK)

Answer 36

When a country eliminates their own currency to use dollars instead.

Answer 37

(slightly old list)

Answer 38

1. Exchange rate stability 2. Monetary Policy Autonomy 3. Freedom of financial flows Only two properties can be reached simultaneously.

Answer 39

_Indirect:_ The price of the domestic currency in terms of foreign currency⇒ Number of units of foreign currency per unit of domestic currency. EURO/DKK = 0.13 _Direct:_ The foreign currency in terms of the domestic currency ⇒ Number of units of home currency per one unit of foreign currency. DKK/EURO = 7.45

Answer 40

* Depreciations and appreciations. * Devaluation and revaluations.

Answer 41

The price of domestic goods in terms of foreign goods, denoted by ∈. The real exchange rate determines your choice between consuming domestic or foreign goods. ∈ = EP/(P\* (the foreign price)) When increasing, domestic goods are becoming more expensive relative to foreign goods and NX decrease (Marshall-Lerner) When the real exchange rate = 1 ⇒ We have perfect PPP (however, there are many reasons to why this don’t hold in practice). _Examples_: Selling bike at P = 4000 DKK ⇒ exchanging into euros and get 520 euros ⇒ go to Germany where the price of a new bike is 260 euros (P^\*). Thus EP/P^\* = 520/260=2. or (4000x0.13)/260 = 2.

Answer 42

The expected real rate of return: the rate of return computed by measuring asset values in terms of some broad representative basket of product that savers regularly purchase. In other words, the expected return in terms of actual purchasing power in the future; REAL return. (Value tomorrow - Value today) / Value today ⇒ The good old: (Ee - E) / E

Answer 43

* _Rate of depreciation_: the percentage increase in fx. The dollar/euro exchange rate over a year ((Future exchange rate - Current exchange rate)/Current exchange rate) ⇒ (Ee - E)/ E ⇒ Ee is higher than E. * _Rate of appreciation:_ simply the opposite. It does not matter whether we measure returns in terms of one currency or the other as long as we measure them both in terms of the same currency ⇒ (Ee - E) / E ⇒ Ee is lower than E.

Answer 44

We expect it to appreciate further

Answer 45

We expect it to depreciate further.

Answer 46

In 2; the expected return on dollar deposits is higher than that of euro deposits. All euro deposits owners will want to buy dollar deposits instead but the owners of dollar deposits will not be willing to sell at the current exchange rate as it will give them a lower rate of return. Thus, the euro deposit owners will offer a better exchange rate, which will bring the dollar/euro exchange rate down (euros become cheaper in terms of dollars)

Answer 47

The dollar will appreciate and the green line will shift up/to the right and the new equilibrium will be in point 1’.

Answer 48

The law stating that in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

Answer 49

* Law of one price: applies to individual commodities * PPP theory: applies to the general price level

Answer 50

* The size of the economies * The country with the steepest curve will be most affected by the tariff.

Answer 51

That the country imposing the tariff is large enough to affect world prices ⇒ Pt = Pt\* + t (you start out by calculating Pt\* and then add + tariff to P). If extremely small and can’t affect world prices, then: Pt = Pworld + t

Answer 52

Using the other trade policy tools, the gain will not go to the government but instead someone else, which might be domestic producers or a foreign country’s producers ⇒ Higher cost.

Answer 53

Since all countries can marginally affect the world prices Pw, all countries do in theory have an optimal tariff where E \> B + D. (it would not be the case, if we assume that a country is extremely small so it cannot affect world prices)

Answer 54

Because the concept of all countries having an optimal positive tariff is based on taking all other countries tariffs as given. In the real world, imposing a tariff can lead to a trade-war so we end up in a “race to the bottom”. Therefore, we have organizations such as WTO to make long-term agreements avoiding trade-wars.

Answer 55

E = Home currency / Foreign currency ===\> E(DKK/USD) ⇒ The amount of Home currency it takes to buy 1 foreign currency. ⇒ That is E(DDK/USD) = 6.5.

Answer 56

If E has increased, our own currency has DEPRECIATED relative to the foreign currency. It has become more expensive to buy 1 USD or 1 EURO or 1 GBP etc.

Answer 57

The price of domestic goods in terms of foreign goods, denoted by ∈. The real exchange rate determines your choice between consuming domestic or foreign goods. ∈ = EP/(P\* (the foreign price)) When increasing, domestic goods are becoming more expensive relative to foreign goods and NX decrease (Marshall-Lerner) When the real exchange rate = 1 ⇒ We have perfect PPP (however, there are many reasons to why this don’t hold in practice). _Examples:_ Selling bike at P = 4000 DKK ⇒ exchanging into euros and get 520 euros ⇒ go to Germany where the price of a new bike is 260 euros (P^\*). Thus EP/P^\* = 520/260=2. or (4000x0.13)/260 = 2.

Answer 58

A change in the money supply have _no effect_ on the long-run values of the interest rate or real output. Why? In the long-run, output levels are determined by the economy’s endowments of labor and capital and _not money supply_. (Think back to macroeconomics long-run equilibrium - it’s about capital and human capital)

Answer 59

All else equal, a permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies. Similarly, a permanent decrease in a country’s money supply causes a proportional long- run appreciation of its currency against foreign currencies.

Answer 60

* Excess demand for output and labor (as interest rate decreases, people invest more in Y = C + I + G + CA) ⇒ Labor demand increases ⇒ Wages increase ⇒ Prices increase * Inflationary expectations (Pe \> P) * Raw materials prices

Answer 61

When the exchange rates immediate response to a disturbance is greater than its long-run response ⇒ What happens when money supply increases.

Answer 62

* _Short-run_: As money supply increases, real money supply increases as PRICES are fixed and thus, R (interest rate) decreases and E increases (home currency depreciates) * _Long-run_: In the long-run (medium run in macroeconomics), real money supply returns to its initial level as PRICES increase. * Thus, a 10 % increase in money supply equals a 10 % increase in inflation in the long-run (medium run in macro). * E will be below its initial level due to overshooting. * R is back to initial level + (GNP) ⇒ Neutrality of money.

Answer 63

* YES - the exchange rate E will not go back to its initial level due to either overshooting (Money supply increase) or undershooting (Money supply decrease). The interest rate (R ) will be at its initial level, (GNP will also) and money market will be back at initial equilibrium ⇒ Neutrality of money.

Answer 64

* Money supply; permanent rise in money supply = permanent and proportional depreciation of that currency. * Interest rates: increased interest rate = decreases money demand = increase in the long-run price level ⇒ depreciation of currency. _NOTE: this is the opposite of the short-run where an increase in interest rate is said to make the currency appreciate_ * Output levels: increased output = increased money demand = fall in long-run price level = appreciation of currency

Answer 65

In the long run, monetary policy does not change the real relative price level: only nominal exchange rates.

Answer 66

1. Developments in the financial sector have a far greater impact on economic activity than earlier realized 2. The zero lower bound on interest rates can be a serious problem 1. Discussion: should inflation-targeting be set to 4 % instead of 2 %? 3. The cost of clearing up after a financial crisis is very high 4. Price and output stability do not ensure financial stability (might even enhance financial INstability).

Answer 67

* Credit bubbles: * Easy to lend, more investments, drive asset prices up and makes you profit so you can lend and leverage up even more * 2008 Financial crisis * Bubbles driven solely by irrational exuberance * Bubbles made of over optimism * Less dangerous for the stability of financial markets * IT bubble

Answer 68

1. Asset-price bubbles are nearly impossible to identify 2. Raising interest rate may be very ineffective in restraining asset price bubbles and may even enhance the severity of the bubble’s damage. 3. A bubble may only be present in a fraction of asset markets 1. Hard to target specific asset markets using interest rate 4. Increasing interest rates will have negative effects on output and jobs creating a vicious circle 5. The harmful effects of an asset price bubble can be kept at a manageable level as long as policymakers respond in a timely fashion.

Answer 69

1. Actions should be taken to prick CREDIT-driven asset price bubbles as they are easier to identify and have severe impacts. 1. Higher interest rates 2. More supervision of risk and leverage

Answer 70

Not at the same time. Only one at a time can be targeted.

Answer 71

* Spot transactions * Forward transactions (the rate for the forward transaction)

Answer 72

General: if a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate. 1. Relative price levels: 1. A rise in a country’s price level relative to the foreign price level, causes its currency to depreciate as demand for domestic good will go down 2. Trade barriers 1. Increasing trade barriers causes a country’s currency to appreciate in the long run as the demand for domestic good will go up as foreign goods become more expensive 3. Preferences for domestic vs. foreign goods 1. Increased demand for a country’s exports causes its currency to appreciate in the long run as demand goes up. 4. Productivity 1. In the long run, as a country becomes more productive relative to other countries, its currency appreciates, as its goods will be more competitive and thus cause a higher demand.

Answer 73

* Increase in domestic interest rate increases the return on domestic assets and thus the demand ⇒ Appreciation * UNLESS the increase in domestic interest rate is due to expectations of higher inflation. Then, the demand curve shifts left and the domestic currency depreciates * Increase in foreign interest rate increases the return on foreign assets and thus decreases the demand for domestic assets ⇒ Depreciation * Expected future exchange rates, Ee: A rise in the expected future exchange rate shifts the demand curve to the right and causes an appreciation of the domestic currency.

Answer 74

An unsterilized intervention in which domestic currency is bought and foreign assets are sold leads to a fall in international reserves, a fall in the money supply of domestic currency, and an appreciation of the domestic currency.

Answer 75

No impact on monetary impact as the central bank engages in offsetting open market operations. Thus, no change in money supply. No (or almost no effect) on the exchange rate.

Answer 76

* Current account * Shows international transactions that involve currently produced goods and services. * Trade balance * The difference in imports and exports in merchandise * Capital account * Net receipts from capital transactions (purchases of stocks, bonds, bank loans etc.). * Official reserve transactions balance * The sum of the current account and the capital account. * The net change in government international reserves.

Answer 77

1. Domestic monetary and political institutions are not conducive to good monetary policymaking 1. Seen with Italy pre-EU which is one of the main reasons they were very pro EU. 2. An exchange-rate target has important benefits that have nothing to do with monetary policy 1. Free market and increased trade in EU for example

Answer 78

If having weak political and monetary institutions and maybe even have experienced continuous bouts of hyperinflation.

Answer 79

* Currency board * The domestic currency is 100 % backed by a foreign currency (often dollar) and the note-issuing authority establishes a fixed exchange rate and promise to exchange at the fixed rate at any given time. * Dollarization * Replacing the domestic currency with dollars With both options, the country loses control of monetary policy. With dollarization, the emerging market country’s government loses the revenue from issuing money (called SEIGNORAGE).

Answer 80

Controls on capital _outflows_ receive support for: * Being part of preventing domestic residents and foreigners from pulling capital out of a country during a crisis thereby making devaluation less likely. Controls on capital _inflows_ receive support for: * The theory that if speculative capital cannot flow in, then it also cannot go out suddenly. Thus part of averting crisis. Disadvantages: * Seldom effective * Often lead to corruption * May encourage governments to avoid taking the steps that are necessary to reform their financial systems to deal with the crisis.

Answer 81

A Major disruption of the financial system: * Sharp drop in asset prices * Failures of financial institutions * Large disruption to information flows, resulting in increase in financial frictions and market malfunctions. When information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning ⇒ Economic activity collapses as a result. Asymmetric information problems are not solved properly ⇒ Financial frictions.

Answer 82

* Direct * Asset holders and equity holders suffer losses * Creditors lose the funds they have lent * Uninsured depositors/investors and the FDIC also incur losses * Indirect * Loss of wealth, business and consumer confidence * Reduction in investment and consumption * Declines in borrowing/lending, worsening adverse selections and moral hazard problems.

Answer 83

1. Stage one: Initial phase 1. Credit boom and bust or a general increase in uncertainty caused by failures of major financial institutions 1. Financial innovations and financial liberalization can cause credit booms. 2. Asset-price boom and bust 1. Asset prices (stocks and real estate etc.) can be driven up by investor psychology (dubbed irrational exuberance) 2. The bubble bursts and causes a decline in the value of financial institutions’ assets, thereby causing a decline in net worth and hence a deterioration of their balance sheets. 3. Increase in uncertainty 1. Beginning after the start of a recession, crash in the stock market, or the failure of a major financial institutions.

Answer 84

* Stage two: Banking crisis * Banks become insolvent due to deteriorating balance sheets and tougher business conditions * Risk of bank panics and fire sales

Answer 85

* Stage three: Debt deflation * Economic downturn leads to a decline in the price level * Further deterioration in firms’ net worth because of the increased burden of indebtedness.

Answer 86

* Financial innovation in the mortgage markets * CDOs (Collateralized debt obligations) * Agency problems in mortgage markets * Mortgage brokers did not make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to sell quickly the loans to investors in the form of mortgage backed securities * Originate-to-distribute * Mortgage-backed securities * Financial derivatives * Credit default swaps (CDS) * Asymmetric information and credit-rating agencies * Advised financial institutions on how to structure complex financial instruments, while at the same time rating these products. * Wildly inflated ratings (Others argue the FED’s low interest rate caused the housing bubble and thus the crisis).

Answer 87

* Financial bailouts * Fiscal stimulus spending * Financed by deficit spending

Answer 88

* Global financial regulatory framework * Focus on risk levels and supervision * Policy areas at the national level * A sound monetary policy * Fiscal policy: * Cannot be solely concerned with growth and counter-cyclicality goals, but it must reduce fiscal debt levels so that additional debt be taken on in times of stress * Strengthening financial infrastructure * Transparency and information * Different options for levels of risk * Legal framework to effectively solve conflicts and bankruptcies * Auditing practices * Consumer protection * Focused on explaining the very complex products * Micro and macroprudential policies * Micro * Reduce risk exposure of individual financial institutions * Supervision * Macro * Reduce systemic risk exposure of the entire financial sector

Answer 89

1. Increased regulation of non-bank institutions 2. Avoiding TBTF problem 3. Discourage excessive risk taking 4. New structures for regulatory agencies

Answer 90

**EMERGING MARKET ECONOMIES** * Phase 1: Initial phase * Path A: Credit boom and bust * From financial liberalization and financial globalization as driver of the credit boom (South Korean crisis 1997-1998). * Typically very risky lending practices in the beginning * The problem is not financial liberalization and globalization in itself but the lack of national institutions that successfully navigate the process through prudential regulation and supervision limiting the risk-taking. * Path B: Severe fiscal imbalances * Inappropriate financing of government spending * ⇒ Governments forcing domestic banks to buy their government debt. * When the domestic banks no longer can trust that they will be paid back, they have to unload the bonds at discount prices such that they experience a big decline in net worth. * Bank panics can happen and strengthen the problems of moral hazard and adverse selection even more. * This triggered the Argentine financial crisis 2001-2002 * Path C: Additional factors * Rise in interest rates cause by events abroad such as a tightening of U.S. monetary policy. * When interest rates rise, only the high-risk firms are willing to borrow money, thereby making the economy more risky. * High interest rates reduce firms’ cash flows * Declines in asset market prices * Increased uncertainty due to the failing of a big financial institution, a starting recession etc. * Unstable political systems causing uncertainty

Answer 91

**EMERGING MARKET ECONOMIES** * Stage two: Currency crisis * Players in the foreign exchange market see the opportunity of making profits by betting on a depreciation of the currency. Speculative attacks against emerging economies with pegged exchange rates (typically to the dollar) * Two main reasons (also how/why speculative attacks can occur): * Deterioration of bank balance sheets triggers currency crisis * Government have to find the balance between raising interest rates to encourage capital inflow, while not raising it too much so the banks can’t pay their interest expenses. If they don’t raise the interest however, they won’t be able to maintain the value of their currency. * Severe fiscal imbalances trigger currency crisis * This triggered the Argentine financial crisis 2001-2002

Answer 92

**EMERGING MARKET ECONOMIES** * Stage three: Full-fledged Financial Crisis * Currency mismatch: * Most emerging denominate many debt contracts in foreign currency, leading to what is called currency mismatch. * When domestic currency depreciates or devalues, their debt increases as it is in for example a dollar value ⇒ Net worth decreases * South Korean companies debt in dollars doubled during the crisis in 1997-1998 due to strong depreciation of the Won. * Debt grew threefold in Argentina (2001-2002) as peso fell from $1 to less than $0.30. * Risk of increased inflation * Imported goods become much more expensive and due to the lack of trust in emerging market countries ability to fight inflation, the expected inflation rises and rises. * Inflation went from -1 to 1 % in 2001 to 40 % at its peak in Argentina in 2002 before going down to 3-5 % in 2003-2004. * Interest rates peaking at around 85 % in 2002. Yes 85 %.

Answer 93

* Beef up prudential regulation and supervision of banks * Leverage / risk under control * Can be hard due to corruption in politics when the supervision is made from government agencies instead of more independent regulatory and supervisory agencies. * Encourage disclosure and market-based discipline * Government regulation promoting disclosure of balance sheet positions will force/encourage companies to hold more capital because depositors and creditors will be unwilling to place their money into an institution that is thinly capitalized. * Limit currency mismatch * Implement regulations or taxes that discourage the issuance by nonfinancial firms of debt denominated in foreign currencies. * Regulation of banks also can limit bank borrowing in foreign currencies. * ANOTHER SOLUTION * Shift to a floating exchange rate system. * Sequence financial liberalization * Make financial liberalization in phases with some restrictions on credit issuance imposed along the way while developing the institutional infrastructure.

Answer 94

Because the public can choose to hold more currency, thereby decreasing the amount of reserves (without changing monetary base). Monetary base is both reserves and currency in circulation. The FED can increase/Decrease the monetary base but not control its composition.

Answer 95

Monetary base changed in a one-to-one ratio with the change in the borrowings from the FED.

Answer 96

* Float * Temporary net increases in monetary base due to check-clearing process * Treasury deposits * When Treasury moves deposits from commercial banks to its account Although they undergo substantial short-fed from run fluctuations, they do not prevent the fed from accurately controlling it as it is relatively predictable changes.

Answer 97

* · A fear of centralized power * · Distrust of moneyed interests

Answer 98

**12 Federal Reserve Districts.** 1. New York Fed (around 25 % of all assets) 2. San Francisco 3. Chicago These three together have more than 50 % of all assets.

Answer 99

The Federal Open Market Committee (FOMC) Often wrongly referred to as FED by the media. They are the ones setting the interest rate, the federal funds rate (overnight loan rate) Consist of 7 governors appointed by US President. They usually meet 8 times a year.

Answer 100

Independence from economic, bureaucratic, and political powers. * Instrument independence: ability to set monetary policy instruments * Goal independence: ability to set goals of monetary policy

Answer 101

* Political pressure leads to an inflationary bias to monetary policy ⇒ Short-term thinking governments * Risk of a political business cycle in which politicians demand monetary expansions before elections to decrease interest rate and unemployment

Answer 102

* Undemocratic to have a small group of elite professionals controlling something of utmost importance to the population and economy * Historically, independent central banks have not used their freedom successfully

Answer 103

* ECCB: The Eastern Caribbean Central Bank * 8 members: 6 countries and 2 territories of the U.K. * Small and vulnerable economies that unite to achieve economic development * Banque Centrale des Etats de L’Afrique de l’Quest: The Central Bank of Western Africa * 8 West African nations * Common currency = West African CFA franc * Banque des Etats de L’Afrique Centrale: The Central bank of Central Africa * 6 nations * Use the Central African CFA franc

Answer 104

More independent than most agencies of the U.S. government, but it is still subject to political pressures because the legislation that structures the FED is written by Congress and can be changed at any time.

Answer 105

That powerful institutions might attempt to increase their power and prestige = this should explain CBs actions, although CBs may also act in the public interest.

Answer 106

Independence is increasing.

Answer 107

* Excess reserves * If banks choose to hold on to their excess reserves and not make loans or buy securities, the multiple deposit expansion process will be stopped * Currency holdings * If the public chooses to hold currency/cash instead of depositing money, the deposit expansion process will also be slowed/stopped

Answer 108

That CBs would want to increase monetary supply to boost the economy although it has long-term consequences. Thus, it is important to have a goal of a low price inflation all the time that you anchor to. A more subtle reason for a nominal anchor’s importance is that it can limit the time-inconsistency problem, in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-term outcomes.

Answer 109

Federal Funds rate target = Current inflation rate + equilibrium real fed funds rate + ½\*(Inflation gap) + ½\*(output gap) 4 components * Inflation rate * Equilibrium real fed funds rate ⇒ The real fed funds rate that is consistent with full employment in the long run * Inflation gap ⇒ Current inflation minus a target rate * Output gap ⇒ The percentage deviation of real GDP from an estimate of its potential (natural) level.

Answer 110

* If output gap is positive, RAISE rate * If inflation gap is positive RAISE rate

Answer 111

Focus on passing on the risk to others and earning money on fees. Advantage: - Less risk for banks - In theory less risk for the economy as CDOs are bundles of loans that are resold. More safe than single loans. Disadvantages: - Less incentive to limit credit risk - Less reluctant to lend money out to risky borrowers