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58 Cards in this Set
- Front
- Back
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When people are willing to pay the price and non price parts of a loan but are still turned down, we have CREDIT RATIONING. What are two of these "non price" elements?
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1. S ponsorship
2. C olatteral 3. C ompensating Balances |
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Why is the MP Curve Piecewise, that is, it takes certain different values depending on the situation?
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The MP Curve is piecewise because of the ZLB for nominal interest rates.
If the nominal rate is positive the curve is a standard "Taylor Rule" If the nominal rate is negative the curve is according to the Fisher Equation |
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Show the first two steps of a positive supply shock. (Sigma goes up)
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There are two shifts in Aggregate Supply (AS) left to AS1 and then AS2. This results in 2 increases in pi (interest rate) and two decreases in Y tilda (output)
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What's securitization?
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This is where you make illiquid financial assets into marketable, sellable securities. i.e.: Mortgages, Credit Cards, Car Loans
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What were adjustable-rate mortgages and financial derivatives created to reduce?
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To reduce risk of changes in interest rates.
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A bank has ASSETS of Reserves $15 and Loans $455 and Liabilities of Deposits $430 and Bank Capital $40 what is the RoE, RoA, and EM? Net profits are $10
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RoE is Profits / Capital or 10 / 40 = 25%
(For investors) RoA is Profit / Assets or 10 / 470 = 2.13% (Measures efficiency) EM is Assets / Capital or 470 / 40 = 11. 75 |
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Why do increases in the real interest rate lead to decreases in net exports, and vice versa?
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An increase in real interest rate of the US relative to Foreign rate makes our securities more valuable. This creates a demand for American securities, and increases demand for American currency.
This causes the EXCHANGE RATE to increase, making our exports more expensive to foreigners and foreign imports less expensive for domestic consumers. This leads to a decline in NET EXPORTS. |
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What happens to the AD curve and why?
Increase in Financial Friction |
An increase in financial frictions will cause the output gap to fall for every level of inflation, driving the AD curve to the left.
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What happens to the AD curve and why?
Positive shock to autonomous consumption |
This causes the aCT term to increase, so the AD curve will shift to the right. This causes the output gap to increase for every level of inflation, driving the AD curve to the right.
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What happens to the AD curve and why?
The Fed lowers inflation rate target |
Lowering interest rate or pi, would cause the output gap to fall for every level of inflation, driving the AD curve to the left.
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What does it mean if inflation gap is negative?
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This is the difference between actual inflation and target inflation set by Fed. So a negative inflation gap means that inflation is BELOW the Fed's target inflation.
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What happens to the AD curve?
The Federal Reserve increases its reaction to changes in the inflation rate. |
The parameter sigma increases. Increasing sigma will NOT shift the curve. Instead, the "Normal Zone" of the AD curve will become flatter.
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There was so much increase in financial frictions during the 2008 crisis and Fed couldn't decrease the interest rates but still had to try. How, and was it successful?
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We were at ZLB so we couldn't use conventional monetary policy anymore. We had to use:
1. Term Auction Facilities 2. "Commitment to Future Action" So basically they were trying to increase expected inflation to lower inflation rate and shift "kink" in AD curve down. This was in hope to keep the AD curve in the normal zone, to allow economy to function naturally. Since we haven't had a bad deflationary spiral means it must be working somewhat, but we won't know for sure for at least 5+ years. |
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What happens when we have a positive shock to government spending?
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DEMAND SHOCKS ARE TEMPORARY. 4 Step process back to equilibrium.
1. Demand curve shifts RIGHT 2. Supply curve shifts LEFT 3. Demand curve shifts back to its original spot 4. Supply curve shifts back to original (equilibrium) |
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Positive Supply Shock
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A positive supply shock will cause the supply curve to shift to the right. Then it will begin shifting back to the left, how it's supposed to.
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Show an economy in the ZLB situation and its dynamics. How would it progress from here? What problems does this pose to central banks, and what can government do?
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Here we can have a deflationary spiral with the AS curve shifting more and more to the left. Central bankers can't use conventional policy when this happens.
The government can greatly increase spending hoping to shock aGT and shift AD curve to the right enough to get out of the ZLB situation. |
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What is SYSTEMIC RISK?
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Risk associated with the basic structure of the system.
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What is INSOLVENCY?
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Having liabilities in excess of assets, meaning that the bank has a negative net worth/bank capital.
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What have overnight loan markets made holding fewer excess reserves more likely?
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This allows a bank to adjust more quickly to a change in reserves. If this happens a bank can take out an overnight loan at Fed Funds rate to get needed reserves while they liquidate other assets.
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A bank has ASSETS of $75 Reserves and $525 Loans and LIABILITIES of $500 Deposits and $100 Capital
What does bank need to do if it has deposit outflows of $50 and it needs 10% required reserves? |
They'll have $25 in Reserves but NEED $45.
To get reserves where they need they can: 1. Take out an overnight loan from another bank 2. Sell Loans 3. Securitize Loans 4. Increase Deposits. These last 3 aren't as easy to do quickly |
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What is liquidity risk?
What are the three mechanisms that mitigate against this risk and how they do it. |
The bank takes liquid LIABILITIES with deposits and turn them into illiquid loans and and securities.
They may need cash in short term to meet liabilities. 1. Lender of Last Resort 2. Reserve Requirements 3. Deposit Insurance These give the bank a fallback if they can't meet their liquidity requirements. |
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What two things do we look at in analyzing credit risk?
What three financial instruments can affect the riskiness of a loan? |
Probability of default, and the expected losses if default occurs.
1. Collateral 2. Compensating Balances 3. Endorsement |
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A bank has ASSETS of $75 Reserves and $525 Loans and LIABILITIES of $500 Deposits and $100 Capital
Bank has a net profit of $6, calculate RoA, RoE, and EM. |
RoE is Profits / Capital or 6 / 100 = 6%
RoA is Profit / Assets or 6 / 600 = 1% EM is Assets / Capital or 600 / 100 = 6 RoE = RoA × EM |
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What are two market failures in banking system and why is there justification to regulate against these?
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Banking system can be inherently fragile because they 1) provide liquidity insurance to households and 2) screen and monitor borrowers who can't get financing. It is this inherent quality that makes it fragile.
You need to protect confidence because there can be a contagion effect, failures can be very costly to banks creditors. Regulate because 1) banks creditors aren't professionals (households) we can't monitor them well and 2) Principal/Agent problem where investors/managers/ or other conflicts of interest where goals don't necessarily align with each other. So the interests of depositors must be protected. |
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Taylor Rule
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Gives central bankers necessary interest rate target.
iT = f' (piT) Taylor Principle - f'(piT) > 0 |
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Fisher Equation
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rT = iT - piET
Fisher at ZLB Rate rT= -piET |
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Bank Capital
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The bank’s net worth or owner’s equity.
Acts as a cushion against a drop in the value of its assets. Can prevent bank failure. |
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Liquidity Management
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Having enough liquid assets to meet the bank’s obligations to depositors
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Loans
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Primary source of bank profits
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Deposits at other banks
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A bank might have some at another bank because of 1) check collection 2) foreign services 3) purchasing securities.
Also known as correspondent banking |
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Loan Sales
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Also called a secondary loan participation, it involves a contract that sells all or part of the cash stream from a specific loan. (MBS's)
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Interest Rate Risk
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Is a big concern for banks.
Can purchase futures that are inversely related to market rates, but this can lead to speculation, which is risky itself. |
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Barings Banks 1995
(Off Balance Sheet Activities) |
100 year old bank has someone making speculative trades, he had hidden $250 million in losses, but an earthquake drove it up to $1.3 billion, caused failure.
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Justifying Regulation
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1) Banks are Fragile
i. Give liquidity insurance to households ii. Screen and monitor borrowers who can't otherwise get financing 2) Protection of confidence There are market failures and bank runs, regulation helps this. |
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Dodd Frank
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Most comprehensive financial regulation since Great Depression
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Volker Rule (Dodd Frank)
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Banks are limited in the extent of the proprietary trading
- Trading with their own money - Allowed to own only a small percentage of hedge and private equity funds. |
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Derivatives
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Financial instruments (or contracts) whose value is based on one or more underlying assets.
- Forwards - Futures - Options |
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Shadow Banking v. Traditional Banking
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Has replaced much of traditional, lending via the security markets.
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Financial Instruments to Protect Against Interest Rate Risk
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1. Derivatives
2. Adjustable Rate Mortgages |
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Futures Contracts
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The seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed-on price. Helps "HEDGE" against interest rate risk
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Commercial Paper
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Short-term debt security issued by large banks and corporations. Money Market Funds that need high liquidity invest a lot in this.
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Keynes' Consumption Function
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What you have left after taxes takes away from income
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Fixed Investment
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This is planned spending by firms on equipment and structures and planned spending on new residential housing.
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Inventory Investment
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This is spending by firms on additional holdings of raw materials, parts, and finished goods, calculated as the change in holdings of these items in a given time period. It is a FLOW statistic.
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The output gap
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Subtract potential output from output at time "t". The output gap is a negative function of the real interest rate.
The difference between aggregate output and potential output. |
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If Taxes and Frictions go up
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Shift IS curve left
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If Consumption, Investment, Govt' spending, Net Exports go up
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Then IS curve shifts left
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Real Interest Rate
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Nominal Rate - Inflation Rate
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Monetary Policy Curve
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Shows the relationship between the real interest the central bank sets and the inflation rate.
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MP Curve and ZLB
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1) The real interest rates are a positive
function of the inflation rate. 2 At the ZLB, the real interest rate is equal to the negative inflation rate |
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AD Curve
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Downward Sloping at high enough interest rates, but upward sloping at lower interest rates (ZLB).
It is a combo of IS and MP curves. |
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AS Curve Dynamics
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The AS Curve must intersect the LRAS Curve at last period’s inflation rate. This makes a supply curve that moves on its own, until its back to LRAS equilibrium.
THE AS CURVE IS THE ADJUSTMENT CURVE*** DEMAND SHOCKS WILL BE TEMPORARY, DRIVEN BY POLICY, BUT AS CURVE DEPENDS ON EXPECTED INFLATION SO IT CAN BE DYNAMIC. |
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Okun's Law
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Relationship between unemployment gap and the output gap.
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Friedman Phelps Philips Curve
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Workers and firms care about real wages, not nominal.
Would reach "natural rate of unemployment" if wages and prices were flexible. |
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Monetary Policy, what does the Fed care more about.
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A higher sigma says it's more concerned with inflation rate.
A lower sigma shows it's more concerned with output gap. |
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VERY AGGRESSIVE Monetary Policy
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LARGE Sigma
Horizontal AD curve Volatile Output Gap Supply Shock Recovery Shorter |
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PASSIVE Monetary Policy
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Sigma approaching ZERO
Vertical AD curve Less Volatile Output Gap Supply Shock Recovery Longer |
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At the ZLB, nominal interest rate = 0
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So no More Taylor Rule,
It's FISHER TIME idiot! AD Curve now has a positive slope So at this point, the Fed's bag of tricks has run out. They can only really influence expected inflation |
