MBFINAL

Question 1

What is the Fisher equation?

Answer 1

Nominal interest rate = Real interest rate + expected inflation

Question 2

What are the 5 monetary theories? QLIMR

Answer 2

QLIMR

• Quantity theory of Money
• Liquidity Preference Theory
• IS-LM model
• Modern Monetarism
• Rational Expectations

Question 3

What is the quantity theory of money?

Answer 3

Mt * Vt = Pt * Yt

M = money supply

V = velocity of money

P = price level

Y = real output/GDP

t = period of interest

Real output is constant. Hence velocity of money must be constant. Thus Mt = Pt ⇒ Increases in money supply increases the price level (inflation).

Question 4

What is the liquidity preference theory?

Answer 4

Money is better now than later.

The higher the short-term interest, the smaller money demand will be.

Question 5

What is the IS-LM model?

Answer 5

Question 6

What is modern monetarism?

Answer 6

Friedman.

Monetary authorities should focus SOLELY on maintaining price stability by increasing monetary supply with the exact same pace as economic growth of the economy.

Question 7

What is the theory of rational expectations about?

Answer 7

That all agents are rational.

Meaning that they act with the long-run in mind and take all available information into expectations. Maximizing utilities based on rational expectations.

Question 8

Which three players affect the money supply?

Answer 8

• Central Bank: monetary policy
• Banks (depository institutions): holding deposits and giving loans
• Depositors

Question 9

What are on the Central Bank’s asset and liabilities relevant to the money supply?

Answer 9

• Assets:
  
  • Securities
  • Loans to financial institutions
• Liabilities:
  
  • Currency in circulation
  • Reserves (deposits by banks in the CB)

Question 10

What does the monetary base / high-powered money consist of?

Answer 10

Central bank liabilities

Currency in circulation + Reserves (deposits by banks in the CB)

MB = C (currency) + Reserves)

Question 11

What is an open market purchase and what happens on the t-account?

CB / FED’s purchase of bonds in the market (banking system)

Answer 11

Question 12

What is an open market sale and what happens on the t-account?

CB / FED’s sale of bonds in the market (banking system)

Answer 12

Question 13

What is the nonborrowed monetary base?

Answer 13

MBn = MB - BR (borrowed reserves from the FED)

Borrowed reserves from the FED is the part of the monetary base, which FED has less control of.

The FED has full control of the nonborrowed monetary base.

Question 14

What is the simple deposit multiplier and its equation?

Answer 14

Measures the multiple increase in deposits generated from an increase in the banking system’s reserves.

Change in D (checkable deposits) = 1 /rr (required reserve ratio) * change in R (reserves for the banking system)

For example: if reserves increases by 100 and the required reserve ratio is 10 %:

change in D = 1/0.1 * 100 = 1,000.

Note: in real life it is not this simple as FED cannot completely control the monetary base. However, at large it works.

Question 15

Which 5 factors affect the monetary base (MB) and are they positively or negatively related to MB?

Answer 15

• Changes in the nonborrowed monetary base, MBn (positive relation)
  
  • Essentially open market purchases/sales
• Changes in borrowed reserves, BR, from the FED (positive relation)
  
  • Loans from the FED to financial institutions
• Changes in the required reserve ratio, rr (negatively related)
  
  • Change in D = 1 / rr * change in reserves. When rr increases, the effect is smaller.
• Changes in excess reserves (negatively related)
  
  • When banks hold more excess reserves, they make less loans and thus reduce the multiplier effect
• Changes in currency holdings (negatively related)
  
  • Currency holdings reduce the multiplier effect. The multiplier effect is strongest when all is deposited.

Question 16

What does the money multiplier, m tell us?

Answer 16

The size of the change in money supply from a change in the monetary base, MB

MS = m * MB

m = 1 + c / (rr + e + c)

• c = currency in circulation (C) / checkable deposits (D)
• e = excess reserves (ER) / checkable deposits (D)
• rr = required reserve ratio

Question 17

What is velocity?

Answer 17

Velocity of money; the average number of times in a year that a dollar is spent in buying the total amount of goods and services produced in the economy.

V = (P * Y) / M

Velocity = (Price * Output) / Quantity of Money

Question 18

What, according to Fisher’s theory, determines the demand for money?

Answer 18

Only income level.

Md = k * (P*Y)

(not interest rates)

Question 19

What is the equation for inflation in the quantity theory of inflation?

Answer 19

Inflation = % growth rate of money supply - % increase in aggregate output

Inflation = % change in M - % change in Y

(not really a good theory in the short run but holds better in the long run)

Question 20

How can budget deficits source inflationary monetary policy?

Answer 20

Governments can just as individuals increase income (working = through taxes) or increase borrowing (bank loans = issuing bonds) to finance deficits.

Moreover, governments has a third option, create more money to use as payment (increase money supply).

DEF = G - T = Change in MB + Change in Bonds

If deficit is financed by an increase in bond holdings, there is no effect on MB. If not financed by bond holdings, both the monetary base and money supply increases = increases inflation.

Question 21

What is the equation for money demand (Keynesian theory)?

Answer 21

Md / P = L (i, Y) (i is negatibely related, Y is positively related)

Question 22

What are the 7 factors that affect the demand for money and how are they related? (Keynesian + portfolio theories). IIPWRIL

Answer 22

Question 23

What are the main objectives of CBs?​

Answer 23

• Price stability
  
  • And then
    
    • High employment and output stability
    • Economic growth
    • Stability of financial markets
    • Interest-rate stability
    • Stability in foreign exchange markets

Question 24

What does Okun’s law say?

Answer 24

Okun’s law states that a one point increase in the cyclical unemployment rate is associated with two percentage points of negative growth in real GDP.

(Output - Potential output) / Potential output = c * (Unemployment % - Natural unemployment %)

(Y - Y*) / Y* = c * (U - U*)

c = around 2 depending on the country and time period.

Question 25

What does the Phillips Curve say?

Answer 25

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).

Question 26

How does an increase in the federal funds rate reduce output?

Answer 26

Question 27

How is the demand and supply market for reserves regulated?

Answer 27

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

Question 28

How do Open Market Operations affect the Federal Funds rate?

Answer 28

• 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.

Question 29

How does the Discount rate changes (discount lending) affect the Federal Funds rate?

Answer 29

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.

Question 30

How do the reserve requirements affect the Federal Funds rate?

Answer 30

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

Question 31

How does the interest on reserves affect the Federal Funds rate?

Answer 31

(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

Question 32

How are the Federal Reserve’s operating procedures limiting fluctuations in the Federal Funds rate?

Answer 32

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.

Question 33

What are the three conventional monetary tools?

Answer 33

• 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)

Question 34

What are open market operations?

Answer 34

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.

Question 35

What are the two forms of open market operations?

Answer 35

• 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.

Question 36

What are the two types of defensive open market operations?

Answer 36

• 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)

Question 37

What is the discount window?

Answer 37

• 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

Question 38

What are primary credit loans?

Answer 38

• 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

Question 39

What are secondary credit loans?

Answer 39

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

Question 40

What are seasonal credit loans?

Answer 40

• 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

Question 41

When did the FED start paying interest rate on reserves?

Answer 41

In 2008.

Question 42

Is the discount rate or the federal funds target rate typically highest?

Answer 42

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.

Question 43

What are the 4 advantages of open market operations?

Answer 43

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.

Question 44

What are the two situations in which other tools have advantages over open market operations?

Answer 44

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.

Question 45

What are non-conventional monetary policy tools?

Answer 45

Tools that do not affect the short-term interest rates. These are:

• Liquidity provision
• Asset purchases
• Commitment to future monetary policy actions

Question 46

What is liquidity provision?

Answer 46

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.

Question 47

What are large-scale asset purchases?

Answer 47

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.

Question 48

What is the difference between quantitative easing and credit easing?

Answer 48

• 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.

Question 49

What is a nominal anchor?

Answer 49

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.

Question 50

What is the time-inconsistency problem?

Answer 50

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.

Question 51

Although the primary goal of monetary policy is price stability, what are the 5 other goals?

Answer 51

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

Question 52

What are hierarchical and dual mandates?

Answer 52

• 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.

Question 53

What are the advantages of inflation targeting?

Answer 53

• 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

Question 54

What are the disadvantages of inflation targeting?

Answer 54

• 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.

Question 55

What is the Taylor rule?

Answer 55

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.

Question 56

What does the Taylor rule say about when the federal funds rate should be raised?

Answer 56

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

Question 57

What is “just do it” monetary policy?

Answer 57

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

Question 58

What are the advantages of the “just do it” monetary policy strategy?

Answer 58

• 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

Question 59

What are the disadvantages of the “just do it” monetary policy strategy?

Answer 59

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

Question 60

What is the liquidity trap?

Answer 60

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)

Question 61

How should you read E(HKD/$) and how should you read E(DKK/SEK)?

Answer 61

E(Home currency / foreign currency)

E(HKD/$) = 0.128 (0.128 USD = 1 HKD)

E(DKK/SEK) = 1.28 (1.28 SEK = 1 DKK)

Question 62

If E(H/F) increases, what do we then have?

Question 63

If E(H/F) decreases, what do we have?

Question 64

What is a dollarization?

Answer 64

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

Question 65

How has the use of different exchange rate regimes in fraction of countries changed over time?

Answer 65

Question 66

What are the different exchange rate regimes and which are most fixed vs. floating?

Answer 66

(slightly old list)

Question 67

What are the three desirable properties of an international monetary regime and what is the trilemma?

Answer 67

1. Exchange rate stability
2. Monetary Policy Autonomy
3. Freedom of financial flows

Only two properties can be reached simultaneously.

Question 68

What is the nominal exchange rate? (direct and indirect)

Answer 68

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

Question 69

What are the keywords regarding fluctuations of exchange rates?

Answer 69

• Depreciations and appreciations.
• Devaluation and revaluations.

Question 70

What is the real exchange rate and how do you calculate it?

Answer 70

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.

Question 71

What is the real rate of return?

Answer 71

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

Question 72

What is the rate of depreciation and rate of appreciation?

Answer 72

• 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.

Question 73

How do you calculate the expected rate of return? (in this case on a euro deposit measured in terms of dollars)

Answer 73

Question 74

What is the interest parity condition?

Answer 74

Question 75

What is the uncovered interest parity condition equation with exchange rate E($/Euro) as standpoint?

Answer 75

Question 76

What do we expect the future exchange rate to be if the currency is appreciation now?

Answer 76

We expect it to appreciate further

Question 77

What do we expect for the currency if it is depreciating now?

Answer 77

We expect it to depreciate further.

Question 78

Explain what will happen if we are in point 2?

Answer 78

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)

Question 79

What happens to the dollar if FED increases the interest rate on deposits and how can this be shown graphically?

Answer 79

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

Question 80

What is the law of one price?

Answer 80

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.

Question 81

What is the theory of PPP?

Answer 81

Question 82

What is the difference between the law of one price and the PPP theory?

Answer 82

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

Question 83

Aspiri: Trade policy; when working with MD-XS-curves, what does the slope indicate?

Answer 83

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

Question 84

Aspiri: Trade policy; what assumption is important to state when imposing a tariff?

Answer 84

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

Question 85

Aspiri: Trade policy; What is the primary difference between import tariffs and the other trade policy tools?

Answer 85

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.

Question 86

Aspiri: Trade policy; why do all countries have a positive optimal tariff?

Answer 86

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)

Question 87

Aspiri: Trade policy; Why don’t all countries impose their “optimal positive tariff”?

Answer 87

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.

Question 88

Aspiri: Exchange rate determination; What is E?

Answer 88

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.

Question 89

Aspiri: Exchange rate determination; what has happened if E increased?

Answer 89

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.

Question 90

Aspiri: Exchange rate determination; What is the exchange rate determined by in the short run?

Answer 90

Question 91

Aspiri: Exchange rate determination; If domestic interest rate is given as 7 % and foreign interest rate is 5 % and the current exchange rate is 5, how would you find the expected exchange rate?

Answer 91

Question 92

Aspiri: Exchange rate determination; If domestic interest rate is given as 6 % and foreign interest rate is 5 % and the expected exchange rate is 5.1, how would you find the exchange rate?

Answer 92

Question 93

Aspiri: What does the Law of one price say?

Answer 93

Question 94

Aspiri: What does PPP say?

Answer 94

Question 95

Aspiri: What does relative PPP say?

Answer 95

Question 96

What is the real exchange rate and how do you calculate it?

Answer 96

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.

Question 97

How does a change in money supply affect the long-run levels of interest rate and real output?

Answer 97

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)

Question 98

How does a change in money supply affect the long-run exchange rate level?

Answer 98

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.

Question 99

For what 3 reasons will price adjust in the medium-/long run? (one of the reasons is directly related to money supply increases)

Answer 99

• 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

Question 100

What is exchange rate overshooting?

Answer 100

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

Question 101

Assume we are USA: What happens in the well-known money market and foreign exchange market graph if the money supply if ECB increases money supply?

Answer 101

Question 102

What are the short-run and long-run effects of an increase in the money supply?

Answer 102

• 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.

Question 103

Can a permanent change in the money supply affect the long-run exchange rate?

Answer 103

• 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.

Question 104

How does money supply, interest rates and output levels affect the exchange rate in the long run?

Answer 104

• 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

Question 105

What is the main implication of PPP and Quantity theory of money?

Answer 105

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

Question 106

What are the 4 most important monetary policy strategy lessons from the financial crisis in 2008?

Answer 106

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).

Question 107

What are the 2 types of asset bubbles?

Answer 107

• 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

Question 108

What are the arguments AGAINST Central Banks trying to prick/pop asset price bubbles?

Answer 108

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.

Question 109

What are the arguments FOR Central Banks trying to prick/pop asset price bubbles?

Answer 109

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

Question 110

Can the Central Bank both target the federal funds rate and nonborrowed reserves?

Answer 110

Not at the same time.

Only one at a time can be targeted.

Question 111

What are the two types of exchange transactions?

Answer 111

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

Question 112

What are 4 factors that affect the exchange rate in the long run and how do they affect the exchange rate?

Answer 112

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.

Question 113

How does domestic i, foreign i and expected future exchange rates Ee affect the short-run exchange rate?

Answer 113

• 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.

Question 114

What is an example of a unsterilized foreign exchange intervention?

Answer 114

Question 115

What is an example of a sterilized foreign exchange intervention?

Answer 115

Question 116

How does unsterilized foreign exchange interventions affect the exchange rate?

Answer 116

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.

Question 117

How does sterilized foreign exchange interventions affect the exchange rate?

Answer 117

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.

Question 118

What are the main items of the balance of payments?

Answer 118

• 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.

Question 119

For what reasons might industrialized countries adopt exchange-rate targeting?

Answer 119

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

Question 120

For what reasons might emerging countries adopt exchange-rate targeting?

Answer 120

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

Question 121

What are the two popular ways in which emerging market countries can deal with adopting exchange-rate targeting? and what are the costs?

Answer 121

• 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).

Question 122

What are the pros and cons of capital controls?

Answer 122

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.

Question 123

How does a financial crisis occur?

Answer 123

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.

Question 124

What are the direct and indirect costs of financial crisis?

Answer 124

• 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.

Question 125

What is stage 1 of a financial crisis?

Answer 125

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.

Question 126

What is stage 2 of a financial crisis?

Answer 126

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

Question 127

What is stage 3 of a financial crisis?

Answer 127

• 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.

Question 128

In which ways do the collapse of financial institutions or asset price falls affect output?

Answer 128

Question 129

What were according to the book the main causes behind the financial crisis of 2007-2009?

Answer 129

• 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).

Question 130

Which regulatory actions have been taken post the 2007-2009 crisis?

Answer 130

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

Question 131

How can you stabilize the global financial system? (long-term)

Answer 131

• 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

Question 132

What are four essential categories for financial reforms and what could be done?

Answer 132

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

Question 133

What is stage 1 of a financial crisis? EMERGING MARKET

Answer 133

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

Question 134

What is stage 2 of a financial crisis? EMERGING MARKET

Answer 134

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

Question 135

What is stage 3 of a financial crisis? EMERGING MARKET

Answer 135

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 %.

Question 136

What can help emerging market economies prevent financial crisis?

Answer 136

• 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.

Question 137

Why does FED have more control of the monetary base than of reserves?

Answer 137

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.

Question 138

How does the monetary base change when FED gives loans to financial institutions?

Answer 138

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

Question 139

What are 2 things that are out of the FED’s control regarding the monetary base?

Answer 139

• 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.

Question 140

What were the two main reasons to why the FED was not established before 1913 following the disastrous bank run in 1907?

Answer 140

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

Question 141

How many regional banks does FED consist of and which are the largest?

Answer 141

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.

Question 142

Who are FOMC?

Answer 142

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.

Question 143

What does FED independence refer to?

Answer 143

Independence from economic, bureaucratic, and political powers.

• Instrument independence: ability to set monetary policy instruments
• Goal independence: ability to set goals of monetary policy

Question 144

What are the arguments FOR FED independence?

Answer 144

• 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

Question 145

What are the arguments AGAINST FED independence?

Answer 145

• 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

Question 146

Which central bank is the most independent of the world’s CBs?

Answer 146

ECB

Question 147

What are some other multi national central banks? (other than FED and ECB)

Answer 147

• 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

Question 148

How independent is the FED?

Answer 148

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.

Question 149

What does the theory of bureaucratic behavior imply?

Answer 149

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.

Question 150

What is the general trend towards independence of Central banks around the world?

Answer 150

Independence is increasing.

Question 151

Explain two reasons why the Fed does not have complete control over the level of bank deposits and loans. Explain how a change in either factor affects the deposit expansion process.

Answer 151

• 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

Question 152

Explain the time-inconsistency problem. What is the likely outcome of discretionary policy? What are the solutions to the time-inconsistency problem?

Answer 152

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.

Question 153

What is the Taylor rule?

Answer 153

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.

Question 154

What does the Taylor rule say about when the federal funds rate should be raised?

Answer 154

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

Question 155

Describe the basic aspects of the originate-to-distribute model of banking. What are the advantages and disadvantages of this model, compared to the traditional originate-to-hold model?

Answer 155

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