Midterm 3 Flashcards
Wartime inflationary finance
Civil War: US wartime inflation was followed by a prolonged period of gradual deflation
WWI: US wartime inflation was followed by two abrupt deflations, separated by almost a decade of stable prices
WWII: US wartime inflation was followed by a period of relatively stable prices
Vietnam War: US wartime inflation was followed by continuing and even accelerating inflation after the war
Postwar deflation required to restore prewar standard
Contraction act of 1866:
- Retired Greenbacks @ up to $4M/mo
- Intended to lower the price level so they could reinstate the gold standard
Repealed 1868: Greenbacks frozen at $347M
Resumption 1879: Gold redemption resumed at $20.67/oz. Prewar standard restored, unnecessarily strengthened by elimination of silver 1873
Fed’s tool of inflationary finance
WWI: fed’s discount window
WWII: open market operations
Civil War: paper money printed by the treasury
Limited Liability
If a corporation has limited liability, its creditors have no claim on the assets of its shareholders beyond their stake in the firm; need only evaluate assets of firm itself
Limited liability effectively gives a corporation a put option to sell its assets at an exercise price equal to its liabilities
- Creditors only care about value of firm’s assets
- If firm defaults, limited liability gives equity owners option to sell assets A to creditors for face value of debt L → option to sell in the future is the characteristic of put option
2 post WW1 deflations
1920-22 caused by an increase in the Fed’s discount rate on war bonds. Discount Rate on War Bonds increased → B decreases, M decreases, P decreases
1922-29 price plateau:
- Europe mostly still off gold
- US: gold at $20.67/oz, yet P_US»P_1914
1929-33: Europe’s abrupt attempt to return to gold standard; inflation was -8.5%/yr for 4 years
- BOE restore dwindles gold reserve 1931
- Gold Bloc countries UK pound sterling reserves →own gold reserve in 1931
- France holds 28.4% of world monetary gold (1928 –France back on gold after 5:1 devaluation →Franc undervalued, big BOP surplus, gold influx)
- 1928 Fed increased discount rate to act against stock market boom →$ undervalued→gold influx
Wage and price ceiling and floors
WWII and Vietnam War: wage and price ceilings
1930s: wage and price floors
National Banking System
National Banking act of 1863 created national banks
Federal charters
-“Free banking”: anyone meeting standards could get charter
-Unit Banking (initially): Only 1 office allowed, no interstate or even intrastate branching, despite federal charters
-Could issue national bank notes: supervised by the office of the comptroller of the currency
Leverage
Leverage enables investors to specialize in stocks or debt instruments according to their level of information about a firm’s prospects and/or their degree of risk aversion. In particular,
- Equity instruments will, in the absence of inflation, tend to be held by investors who are more informed and less risk averse
- Bond then to be held by investors who are less informed and more risk-averse
Leverage calculation
Ex:
Assets =10, liabilities=9, NW=1→leverage ratio 10:1.
If assets gain 1% value to 10.1, equity holders make 0.1 on 1, or +10%
Option
A call option gives its owner the right, but not the obligation, to buy a specified asset at a specified exercise price.
A put option gives its owner the right, but not the obligation, to sell a specified asset at a specified exercise price.
Raising the exercise price on a call option will decrease its value to its holder
Raising the exercise price on a put option will increase its value to its holder
1980s Thrift crisis
During the 1950s-70s, US savings and loan associations typically had
- Long term assets and short term liabilities
- Interest rate risk: ΔNW/A = -Δi(DA-DL)
- ->Interest rate immunization match DA&DL
- DA >DL, i>0 →ΔNW/A <0
- 1950s-70s: increasing inflation →interest rate risk of S&L associations →low or negative NW
How the 1980s crisis began:
-Began 1965-82 as a result of rising interest rates
Post 1980:
- 1989 FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act): Closed FSLIC, many S&L’s bailed out S&L depositors at ~$175B cost to taxpayers
- After the 1980s, the share of thrift institutions in mortgage intermediation declined and was primarily replaced by both the commercial and Fannie Mae and Freddie Mac
Financial Markets in 1900s
The 1932 Federal Home Loan Act:
Gave federal savings and loan associations a lucrative tax advantage provided they would fund 30yr amortized home loans with 0 maturity savings deposits
The 1933 Glass-Steagall Act:
- Separation of commercial banking from investment banking
- Protect commercial bank depositors from risky investment banking operations
- Repealed in 1999
The Depository institutions deregulation and monetary control (DIDMC) act of 1980
- Phased out saving deposit interest ceiling
- Interest bearing personal checking accounts were permitted
House concurrent resolution #290 of 1982:
-Placed full faith and credit of the united states behind insured deposits at banks and thrifts
The 1982 Garn St Germain Act:
-Authorized net worth certificates to keep insolvent thrifts in business
FDIC improvement act (FDICIA) of 1991:
-Tightened capital requirements for banks
1994 interstate banking in the US was permitted
2008 TARP program
- Advanced funds in the form of purchases of new preferred stock
- The primary beneficiaries were shareholders and creditors of bank holding companies
- Advanced $250B funds to BHCs in the form of preferred stock with 5% dividends
Dodd Frank Wall st. reform & Consumer protection act of 2010
- Restricts the Fed from using emergency lending authority to bail out individual companies
- Repeals the 1933 ban on interest on business demand deposits
- Authorized FDIC to guarantee uninsured debt of solvent banks to prevent runs
- Imposes restrictions on purchases of minerals from the DR Congo
- Takes no action on reforming Freddie Mac and Fannie Mae
FDIC
Established 1933
Insured deposits and paid by assessments on individual banks, no cost on taxpayer
Maintains 14000 banks with FDIC, ended free banking era (deny insurance to new competitors)
FDIC bank deposits insurance fund:
-Target 1.25%, negative in 1991 but soon restored by increased fee on insured banks
Underwriting Standard
Median down payment fell from 20% (2000) to <5%(2007)
Ben Bernanke: housing bubble led to the 2008 financial crisis bc of irresponsibly lax home loan underwriting standards
Fannie Mae and Freddie Mac
After the 1980s, the share of thrift institutions in mortgage intermediation declined and was primarily replaced by both the commercial banks and Freddie Mac and Fannie Mae
Between 1996 and 2007, the US department of Housing and Urban Development (HUD) and its office of federal housing enterprise oversight (OFHEO) required Fannie and Freddie to increase the fraction of their loans to LMI borrowers from 30% to 56%
Before 2008, both private corporations regulated by OFHEO, bonds not guaranteed by US government
FX Market D
- Trade D: foreign D for domestic goods
- Lower relative price on domestic goods and services → increase trade demand in domestic goods and services →increase in trade demand for the domestic currency - Investment D
- A decrease in foreign demand for investment → shift FX D left →decreases X_m [foreign/domestic]
- Higher domestic real interest rates relative to the rest of the world is equivalent to higher relative real returns in domestic currency →increase investment demand for the domestic currency - Transfer D: foreign gifts, obligatory payments to US
- Speculative D: pro $
FX Market S
- Trade S: domestic D for foreign goods
- Lower relative price on foreign goods and services →increase trade demand in foreign goods and services→increase in trade supply for the domestic currency - Investment 2:
- A decrease in domestic demand for investment abroad → shift FX S left →increases X_m [foreign/domestic] - Transfer S: US gifts, obligatory payments abroad
- Speculative S: anti $
FX value of Euro in terms of Dollar
$0.86/euro in 2000 doubles to $1.58/euro in 07/08.
Decreases sharply in crisis to $1.27/euro 11/08, relatively the same (w/ ups and downs) until 4/14
Down to $1.08/euro 3/15
Up to $1.14/euro 11/18
$1.21/euro 12/1/20
$1.13/euro 12/3/21
Purchasing Power Parity (PPP)
Exchange rate of Curr1/Curr2 directly proportional to p1/p2
If us inflation is 4% while japanese inflation is 6%:
PPP→ΔX/X [yen/dollar] ≃ π_jp - π_us=2%, $ appreciates
BOP Problems & CB options –demonetize deficit with Specie flow mechanism
Overvalued currency & BOP Deficit problem:
- Domestic CB fixes the exchange rate at a level that overvaluates the domestic currency
- Specie flow mechanism to maintain official rate: add official D→int reserve decreases →B decreases
Undervalued Currency & BOP Surplus problem:
- Domestic CB fixes the exchange rate at a level that undervalues the domestic currency
- Specie flow mechanism to maintain official rate: add official S→int reserve increases → B increases
In the long run, adopting and maintaining a fixed exchange rate requires a CB to give up control over M policy (the domestic nominal money stock, domestic nominal interest rates, the domestic price level)
BOP Problems & CB options –Sterilize
Deficit
- If I decreases, we can maintain B by ΔS=-ΔI
- Equal opposite OMO: OM purchase → Fed pours money in bank →increases B to the original level
- Deficit continues, international reserve continues to decrease
Surplus
- If I increases: OM sell→Fed pull money out of the system →decreases B to the original level
- Surplus continues, international reserve continues to increase
BOP Problems & CB options –Suppress deficit/surplus
Suppress Deficit
- Discourage imports
- Encourage exports
- Discourage investments abroad
- Exchange controls: exchange requires permit, not available to all, terms of trade against domestic country
Suppress Surplus
- Encourage imports
- Discourage exports
- Encourage investment abroad
International Monetary System
Bretton Woods System (1958-68)
- The US bought and sold gold freely at an official mint price, and each other participating country set an official gold price just determine its fixed exchange rate
- Created the IMF: lend reserves to countries with temporary balance of payments problems
Floating Exchange Rates (1973-present)
