Quiz 2 Flashcards
1
Q
Classical political economy
A
- individuals are rational (self-interest)
- economies tend to operate at full capacity
- markets and price system as allocators of resources (relative prices)
- long-term economic growth
- A. Smith, J. B-. Say, D. Ricardo, T. Malthus
2
Q
Currency vs Banking school time period
A
1825-1844
3
Q
Currency school key players
A
Lord Overstone
Robert Torrens
George Warde Norman
4
Q
Banking school key players
A
John Fullarton
Thomas Tooke
John Stuart Mill
5
Q
Bullionists
A
- currency school
- Quantity theory and price specie flow
6
Q
Antibullionists
A
- Banking School
- Law of reflux and real bills doctrine
7
Q
Quantity theory
A
In its simplest form, it states that if the amount of money in circulation increases, while everything else remains constant, then prices will rise. Conversely, if the money supply decreases, prices will fall.
- Proportionality: prices vary in proportion to changes in quantity of money
- Causality: money supply causes change in price level, not vice versa
- neutrality: changes in money supply do not lead to changes in real economic variables
- Price level: only changes in money supply cause disturbances in price level (in long run)
- exogeneity: money supply is fixed
8
Q
Price-Specie Flow: X>Y
A
inflow of gold–>inflation–>Y>X (domestic goods relatively more expensive)–> X=Y
9
Q
Price-Specie Flow: Y>X
A
outflow of gold–>deflation–>X>Y (domestic goods relatively cheaper) –> X=Y
10
Q
Long run price-specie flow
A
- automatic self-correction of BoT
- quantity of gold ( and circulating medium) determined by needs of circulation
11
Q
Real Bills Doctrine
A
Paper money overissue is impossible as long as banks make loans representing claims to real goods in the production process, and will not cause inflation.
12
Q
Law of Reflux
A
Excess notes would return to banks
13
Q
Real Bills Doctrine and Law of Reflux
A
Not the same, but both challenge the validity of transmission mechanism propounded by quantity theory
14
Q
Currency school arguments
A
- based on price-specie flow, any outflow or inflow of gold (species) resulted in a corresponding decrease or increase in quantity of currency
- gold needs to match amount of paper currency, amount of money in circulation needed to match amount of gold reserves
15
Q
Banking school arguments
A
- besides gold and paper money, things like bank deposits and bills of exchange should also be considered part of the currency. These operated in the economy similarly to banknotes and gold coins.
-changes in the amount of gold hoarded might not always lead to changes in the amount of currency in circulation. - limiting the amount of banknotes in circulation wouldn’t be enough to ensure that the amount of currency matched the country’s gold reserves. They argued that controlling the hoarding of gold and the amount of deposits in banks was also necessary to achieve this balance.
16
Q
Currency school policy
A
- rules-based approach based upon QTM. Stability raised from currency principle
- mixed currency should be made to operate as would purely metallic currency i. e.
making sure every issue of banknotes is 100% backed by gold for currency to keep
its value
17
Q
Banking school policy
A
- discretionary approach through law of reflux. Stability arises from Banking principle
- control of deposits and regulation of note issue were impossible and undesirable. Amount of paper money in circulation adequately controlled by competitive banking, and under convertibility, could not exceed needs of business for long time. So long as there is confidence for acceptability of banknotes, market will operate smoothly.
18
Q
Conclusion of Banking vs Currency school debate
A
- Currency school won the DEBATE (1844 Peel’s Act)
- gave exclusive note-issuing powers to BoE i.e., monopoly over issuance of notes
– banknotes issue 100% backed by gold reserves to avoid inflation
– separation between banking department and issue department (in charge of convertibility between gold and banknotes)
– Failed to guarantee stability given that in 1857 and 1866 convertibility was halted to prevent exhaustion of BoE gold reserves - monetarism derives from currency school
19
Q
why banking school won ARGUMENT
A
money supply is endogenous
– Credit is demand constrained - if there are no borrowers, banks do not lend
– Anyone can issue monetary or credit instrument, problem is getting it accepted
– Instruments which are not money at some particular moment could be so at some other moment
– Banking school approach to credit creation is how financial system operates
20
Q
Fed uses its control of money to…
A
…influence expansion of credit
21
Q
Feds job is to balance:
A
elasticity and discipline in the monetary system as a way of controlling flow of credit
22
Q
Lender of last resort
A
In banking, LLR is a role usually taken on by the central bank during times of panic in the fractional reserve banking system. Its job is to reassure people by promising to provide whatever money is needed to prevent a crisis, either by letting banks borrow easily (with a high-interest rate) or by injecting money into the system through asset purchases.
23
Q
Thronton’s View
A
BoE’s responsibility in time of panic is to serve as LLR, providing liquidity to market and discounting freely paper of all solvent banks …
* but denying aid to insolvent banks no matter how large or important
24
Q
Bagehot’s view
A
LLR consists of four principles:
* Lend, but at a penalty rate: “Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.” (Bagehot 1873)
* Make clear in advance BoE’s readiness to lend freely
* Accommodate anyone with good collateral
* Prevent illiquid but solvent banks from failing
25
Bagehot's Principle Unclear
- Not stating clearly when central bank should intervene
- Not giving specific guidelines to distinguish between sound and unsound banks
- Not realizing that provision of LLR facility to individual banks would encourage them to take greater risks ☞ moral hazard!
26
Feds epic failure
The Fed didn't act effectively during 1929-33. If they had done things like buying and selling securities in the market during 1930-31, they could have prevented many bank failures and stopped a big drop in the amount of money available.
27
Narrow view of Lender of Last Resort
Definition: According to this view, the central bank, acting as the lender of last resort (LLR), should not support financially unsound borrowers.
Duty of the Lender: The central bank's main duty is to prevent panics from spreading to healthy institutions, rather than bailing out unhealthy ones.
Encouraging Responsibility: Allowing insolvent banks to fail is seen as important to discourage excessive risk-taking by financial institutions.
28
Broader View of LLR
Definition: In this perspective, the central bank sees itself as responsible for the stability of the entire financial system.
LLR's Responsibility: The LLR's duty is to safeguard the overall financial system, rather than focusing solely on specific institutions.
Purpose of LLR: The LLR's role isn't just to prevent crises, but to minimize the impact of financial shocks when they occur.
Confidence and Support: Any bank failure, especially a significant one, can erode confidence in the financial system. Therefore, supporting insolvent banks, even temporarily, may be necessary to maintain stability.
29
Public Authority's Role in LLR
- Prevention of Panics: Authorities adhering to the principles of Thornton and Bagehot can avert banking panics.
- Public Responsibility: The function of lender of last resort (LLR) must be fulfilled by a public authority.
- Central Bank Preferred: It's preferable for the LLR function to be carried out by the central bank.
30
Derivative context
- Risk Management Concerns: Financial institution managers became increasingly focused on reducing risk to protect their assets.
- Role of Financial Innovation: Financial innovation emerged as a solution, introducing new assets designed to manage risk more effectively.
- Introduction of Financial Derivatives: These new assets, known as financial derivatives, have payoffs linked to previously issued securities and are highly beneficial in risk management strategies.
31
If derivatives are open to abuse, why do they exist?
They can be used as insurance (allowing traders to transfer risk to another party)
32
What is a derivative?
Characteristics: A derivative is a financial instrument whose value is tied to the value of another financial instrument, known as the underlying asset.
Zero-Sum Game: In derivative transactions, one person's loss always corresponds to another person's gain. It's akin to two individuals playing poker.
Risk Transfer: Derivatives enable the buying and selling of risk. The primary purpose is to transfer risk from one entity to another, whether it's an individual or a firm.
33
What is an option?
Options are agreements between two parties: the seller, also known as the option writer, and the buyer, referred to as the option holder.
- Option writers take on obligations, while option holders obtain rights.
34
The option seller is the ____ and the option buyer is the ____
1. option writer
2. option holder
35
Call option
Right (not obligation) to buy given quantity of underlying asset at predetermined price (strike price or exercise price), on or before specific date
36
call option phrases
- Whenever underlying asset price above strike
price of call option, exercising option is profitable
for holder, option is in the money
- if underlying asset price equals strike price, option
is at the money
- If strike price exceeds market price of underlying
asset, option is out of the money
37
Put option
Right (but not the obligation) to sell underlying asset at
predetermined price on or before fixed date. Again, writer is obliged to buy shares should holder choose to exercise option
38
Put option phrases
- Because buyer of put obtains right to sell stock, put is in the money when option’s strike price above market price
- It is out of the money when strike price is below market price
39
American options
can be exercised on any date from time they are written until day they expire
- As a result, prior to expiration date, holder has three
choices: (1) continue to hold option, (2) sell it to
someone else, or (3) exercise it immediately
40
European options
can be exercised only on day they expire
- Thus, prior to expiration date, holder of has two
choices: hold or sell
41
Who buys and sells options?
Hedging Reminder: A hedger is essentially buying insurance.
Call Option Buyers: Individuals who plan to purchase an asset (like a bond or stock) in the future buy call options. This ensures that the cost of buying the asset will not rise beyond a certain price.
Put Option Buyers: Individuals who plan to sell an asset in the future buy put options. This ensures that the price at which the asset can be sold will not decrease below a certain price.
42
exercising options as insurance
Think of the relationship between a driver and an insurance company.
The call option can only be exercised if the car is damaged in an accident before the insurance policy expires.
43
2 Parts of Option Price
- value of the option of it is exeerciesed immediately (intrsitic value)
- Fee paid for potential benefit from buying the option (time value)
option price =intristic value + time value
44
Value of any financial instrument depends on four attributes:
- Size of promised payment,
- timing of payment,
- likelihood that payment will be made
-circumstances under which payment will be
made
45
Option Value Cannot Be Negative
Explanation: When someone holds an option, they never have to pay more money to exercise it.
Implication: Therefore, the value of an option cannot be less than zero.
46
Intrinsic value
difference between price of underlying asset and
strike price. This is the size of payment that the option represents, and it must be greater than or equal to zero—the intrinsic value cannot be negative
47
Call intrinsic value equation
C = max(0, S - X)
48
Put intrinsic value equation
P = max(X - S, 0)
49
How time matters with options
The more time there is before an option expires, the greater the potential payoff when it finally does expire. So, options with more time left are usually more valuable.
50
Risk and value with options
Just like with insurance, the bigger the risk being covered, the more valuable the insurance is. Similarly, the more time an option has to protect against changes in the stock price, the more valuable it becomes.
51
Who was Keynes?
- math mathematician turned economist
- doctoral thesis on probability theory
- believed economy needed greater regulation
52
WWI Political Chaos
- revolutions in Russia and Germany
- rise of socialism and fascism
- hyperinflation, mass unemployment
53
Economic chaos
Prosperous 1920s
- Wall Street Crash of 1929
- unemployment never fell below 10% until 1941
54
Objectivist
Initially thought one could act on basis of future
through knowledge of objectively defined
probabilities
55
Subjectivist
People follow herd and make estimates of future
hoping what crowd thinks can protect them
56
Mimestism
If fellow investor loses confidence, this could cause
collapse in value of one’s own investments
57
Effects of uncertainty
- uncertainty about future movement of interest rate
- uncertainty about effects on yield of investment in assets
58
Marginal efficiency of capital
Definition: MEC represents the expected rate of profitability of new investments (I).
Investment Reality: When entrepreneurs invest in goods, they're essentially purchasing the rights to a series of future incomes they expect to earn.
Dependence on Future Profits: Investment decisions rely on anticipated future profits rather than realized ones. This makes them highly uncertain and prone to volatility.
59
MEC trend
Marginal Efficiency of Capital (MEC) declines as investment (I) increases. This decline occurs because as a firm invests more, the returns from each additional investment diminish. Initial projects usually yield higher returns, but subsequent projects yield lower returns.
60
investment and Interest rate relationship
inverse relationship between the rate of interest (r) and investment. When the interest rate is low, firms find it more favorable to invest because they can earn higher returns than the interest rate.
61
when do producers invest
when MEC > r
62
Keynes and interest rate
Interest Rate Explanation: According to Keynes, the interest rate is the reward for giving up liquidity, or the ease of accessing cash.
Interest Rate Determination: It's determined by the balance between the demand for and the supply of money.
63
Keynes and demand for money
Keynes describes the demand for money as liquidity preference, which is the public's desire to hold cash.
64
Keynes 3 motives for holding money
- transaction
- precautionary
- speculative
the first two depend on the level of income and the third depends on the interest rate
65
Transaction motive
- demand for money or need of cash for current transactions. Individuals hold cash in order to bridge gap between receipt of income and expenditure
- highly income elastic
M1 = L1 (Y)
66
Precautionary motive
- desire to hold cash balances for unforeseen contingencies (illness, accidents, unemployment...)
- M1 = L1 (Y)
67
Speculative motive
- desire to hold one’s resources in liquid form to take advantage of future changes in rate of interest (or bond prices)
- The higher the rate of interest, the lower the
speculative demand for money; the lower the rate of
interest, the higher the speculative demand for money
- M2 = L2 (r)
68
total liquidity preference function
M = L (Y, r)
69
Money supply
- refers to total quantity of money, considered to be fixed, controlled by monetary authorities
- money supply curve perfectly inelastic
- interest rate determined at level where demand for money equals supply of money
70
Money Market
graph where Ms is perfectly inelastic
71
Principles of good monetary policy (3)
- easily observable
- controllable and quickly changed
- tightly linked to the policymakers' objectives
72
Central bank Assets
securities
foreign exchange reserves
loans
73
liabilities
currency
governments account
accounts of the commercial banks (reserves)
74
securities
- primary assets of most central banks
- Fed exclusively held treasury securities, mostly short-maturity
- How many securities is controlled through open market operations
75
Foerign exhange reserves
central banks balances of foreign currency held in the form of bonds issued by foreign governments
76
foreign exchange interventions
when officials attempt to change market values of currencies
77
Loans
extended to commercial banks
78
discount loans
loans Fed makes when commercial banks need short-term cash
79
Currency
currency circulating in hands of nonbank public is principal liability of most central banks
80
governments account
central bank provides gov with account into which it deposits funds (primary tax revenues) and from which gov writes check and makes electronic payments
81
Reserves
deposits at central bank + cash in bank's own vault (assets of commercial banks and liabilities of central bank)
82
importance of reserves
- crucial role in deciding the amount of money and credit available in the economy.
- Effect of Increases: When reserves increase, it causes deposits to rise and leads to more money and credit becoming available.
- Effect of Decreases: Conversely, when reserves decrease, it has the opposite effect, r
83
Monetary Base
Currency in hands of public + reserves in banking system (Privately held liabilities of central bank)
84
4 types of transactions
-open market operation
- foreign exchange intervention
- discount loan
- cash withdrawal
85
effect size of balance sheet and change size of monetary base
- open market operation
- foreign exchange intervention
- discount loan
86
shift components of monetary base, changing composition of balance sheet but leaving its size unaffected
Cash withdrawal
87
Increase in liability is balanced by...
either by decrease in another liability or by increase in asset
88
when reserves rise in response to sale of securities...
most natural thing to do is to lend out the excess
89
who can create and destroy monetary base
central bank/fed
90
who determines how much of the monetary base ends up as reserves in banking system and how much is in currency
nonbank public
91
what can commercial banks do with monetary base
move reserves they have around among themselves
92
deposit expansion multiplier
inrease in commercial bank deposits following increase in reserves
93
what do banks do as people's account balances rise
hold more cash
93
what does money multiplier show
how quantity of money is related to monetary base
93
Money =
Currency + checkable deposits
93
Monetary base =
Currency + reserves
94
reserves =
requires reserves + excess reserves
95
Currency =
96
Final money equation
97
arithmetic of money multiplier tells us that economy depends on (4)
- monetary base, controlled by central bank
- reserve requirement imposed by regulators on banks that accept deposits
- desire on part of banks to hold excess reserves
- demand for currency by nonpublic bank
98
If MB increases...
M increases
99
increase in either RR or ER holdings...
decreases money multiplier
100
an increase in {C/D}...
contracts money supply
101
Target federal funds rate
interest rate charged in overnight loans between banks
102
discount rate
interest rate charged by Fed on loans to commercial banks
103
deposit rate
interest rate paid by fed on reserves held by banks
104
reserve requirement
Fraction of deposits that banks must keep either on deposit at the Fed or as cash in their vaults
105
Market Federal Funds Rate:
The MFF, published daily by the Fed, is the average interest rate on market transactions in federal funds, weighted by the size of the transactions.
106
Discount Lending
The Federal Reserve's main tool for short-term financial stability, aiming to prevent bank panics and save troubled institutions. During crises, discount lending increases significantly.
107
Modern Use of RR
mainly used to stabilize the demand for reserves and assist the Fed in keeping the market federal funds rate (MFF) within its target range.
108
Case against Reserve Requirement
Concerns: The Federal Reserve Board worried that high levels of ER could fuel rapid expansion of deposits and loans, leading to inflation.
Action Taken: In August 1936, the Fed doubled the reserve requirement, halving the $3 billion ER to $1 billion.
Unexpected Response: However, the Fed underestimated banks' desire to hold ER to protect against potential bank runs. Bank executives spent the next year rebuilding their reserve balances, returning ER to pre-requirement levels.
Consequences: This led to a sharp decline in the money multiplier, causing decreases in measures of money supply like M1 and M2. As a result, from spring 1937 to the end of 1938, real GDP fell by more than 10%.
109
foreign exchange interventions
when officials attempt to change market values of currency
