Week 3: The Short Run [Monetary policy, IS-LM, Extensions] Flashcards

Question

Fischer equation

Answer 1

Expected prices are given using the Fischer equation: 1+r = (Pt/P^e t+1) (1+i) Simplified r= i - pi^e Pi^e is expected inflation

Answer 2

Banks - the intended outcome is that a lower rate will prompt banks to store less with the CB, lend more, and thus expand supply and increase spending - Banks cannot be prompted to lend more as instead of offering loans at a negative rate they can instead just convert their reserves into currency Customers - Banks will be willing to accept deposits at a negative rate equal to the CBs rate (and no rate above) - However, individuals will not make such saving deposits as they too are better off holding on to currency *A negative saving rate does not materialize either

Answer 3

- any negative rate by the CB will not reach the economy - the inability of the interest rate to reach negative values is ZLB - While nominal rates cannot go much below zero, the real one surely can: r = i − πe - Fiscal politics are still effective - another option is the so-called quantitative easing (QE, asset purchases)

Answer 4

- QE involved the CB’s squiring assorted non-money financial assets - this way it absorbs non-money from the economy in exchange for money - more money means more purchasing power and spending more More demand for debt -> lower interest rates and costs of financing (portfolio rebalancing) QE aims at direct broad money creation

Answer 5

Key reason - OMOs deal with debt that is a close substitute for borrowing through reserves - interest rates for that debt closely follow the policy rate - ZLB is reached by both

Answer 6

■ The interest rate is the conventional macroeconomic policy tool; ■ By reducing the rate, the CB can boost investment in the economy to stimulate it in the short run; ■ Conversely, a higher rate inhibits investment and reduces output in the short run; ■ As a policy tool, the interest rate has its limits (zero lower bound); ■ This is where alternative unconventional policies like QE come into pla

Answer 7

■ Financial asset – an asset whose value derives from the contractual right of one party to receive an economic benefit or benefits from another party. Examples: currency (cash), deposits, bonds, stocks; ■ Interest rate – the key characteristic of a financial asset which describes the return on lending (or that on borrowing) through using that asset; ■ Money – a financial asset which acts as a medium of exchange (can be used in purchasing and selling goods and services), store of value (can be expected to retain its value over time well enough) and a unit of value measurement (the unit in which prices of goods and services are denominated); ■ Liquidity – the ability of an asset to be converted into goods and services without a loss in its value. Money is the most liquid asset, as the conversion in that case is instant and loss

Answer 8

■ Central bank (CB, monetary authority) – an authority tasked with the conduct of monetary policies. It is the monopolist producer of base money in an economy; ■ Base money – money created by the central bank. It comprises currency (physical money) and reserves used in settling transactions between commercial banks; ■ Reserves – a type of base money, which comprises interest bearing deposits available at the CB for commercial banks. Reserves are created in the process of commercial banks’ borrowing from or lending to the CB; ■ Broad money – money available to the public (households and firms) for use in their transactions. It comprises currency held by the public and d

Answer 9

Conditional: ■ Policy rate (base rate, key rate) – the interest rate at which funds can be borrowed from and lent to the CB (sometimes there are two separate rates: the discount rate for borrowing and the deposit rate for lending). It is the key instrument of the conventional monetary policy; ■ Open market operations (OMOs) – a conventional monetary policy, whereby money supply is adjusted by the CB through buying or selling short-term government bonds; ■ Conventional monetary policy – a monetary policy which seeks to change the level of economic activity by altering the policy rate (or using OMOs); Unconditional: ■ Zero lower bound – the lack of nominal interest rates’ ability to reach negative values. It constrains the scope for applying conventional monetary policies during severe economic downturns; ■ Quantitative easing (QE, asset purchase) – an unconventional monetary policy aimed at creating money in the economy through purchasing various financial assets directly from economic agents;

Answer 10

■ Monetary easing – an expansionary conventional monetary policy which involves lowering the interest rate; ■ Monetary tightening – a contractionary conventional monetary policy which involves increasing the interest rate;

Answer 11

■ Suppose when lending, we do not know for sure whether we will be paid back; ■ Specifically, our borrower can go bankrupt with probability p; ■ Let x be the risk premium: the borrower can receive a loan at the rate of not i, but i+x; ■ We assume everyone to have the same probability of being insolvent: banks, individuals, firms; ■ Thus so long as the borrower/lender is not the CB, the rate is i + x for everyone;

Answer 12

■ With a higher equity share, a new loan could be acquired on better terms to cover and repay the previous one; ■ If the original loan had introductory (teaser) rates, a new one could be taken to avoid paying higher rates later on; ■ An increase in equity could alternatively be turned into extra money through refinancing (thus turning a dwelling into a cash cow);

Answer 13

A common term for assets created from bunched mortgages is collateralised debt obligations (CDOs); CDOs’ riskiness is linked with different loss layers (tranch ■ CDOs were therefore financial assets created against households’ mortgage liabilities and, as assets, they could be sold; ■ By selling CDOs, a mortgagee can pass the risk to the CDO buyer; ■ But the number of CDOs is limited by the number of mortgages; ■ Thus selling more CDOs requires extending more mortgages, but there are only so many potential clients fitting lending standards; ■ A way to increase the mortgage base for more CDOs was by relaxing the lending standards and reducing the share of safe mortgages;

Answer 14

■ As with the house example above, net capital (equity) is the part of a bank’s value which is free of debt, and is due to its owners; ■ Leverage (leverage ratio) is the ratio of assets to capital Assets / Net capital ■ Leverage is a measure of how much of a bank’s assets originates from its debt; ■ Leverage is a source of multiplier effect for a bank’s profit

Answer 15

■ A shadow bank – looks like bank, acts like a bank not supervised like a bank (maturity transformation with little control); ■ Classic problem – maturity mismatch: lenders would like to invest for less time, while borrowers for more; ■ Shadow banking ⇒ no deposit protection, vulnerability to bank runs;

Answer 16

■ Low interest rates promoted more mortgaging and rising house prices; ■ House price growth brought about even more mortgaging; ■ House price growth allowed riskier mortgagors to meet their obligations through refinancing

Answer 17

■ Mortgages were repackaged and sold as CDOs, and the expansion of CDO supply was achieved through lowering lending standards; ■ Major investment banks ended up holding substantial volumes of CDOs; ■ Their exposure to risk was magnified further through leveraging; ■ Securitisation proceeded through the shadow banking system lacking supervision and protection

Answer 18

■ With increasing rates’ reaching mortgage markets, demand for housing was outstripped by supply, and so real house prices began to fall; ■ Lowering prices made refinancing infeasible, thus trapping sub-prime borrowers with their current mortgages, where non-teaser rates were due to kick in; ■ Ultimately that lead to defaults, foreclosures, and an even higher supply of housing, thus creating a vicious circle ■ As mortgage failure numbers were growing, there was a realisation that CDOs were far less reliable assets than it had been believed, and so their prices started to drop; ■ The resulting devaluation of banks’ assets was magnified further through the leverage; ■ Among major investment banks, Lehman Brothers went into bankruptcy, and Merrill Lynch and Bear Sterns were sold on the verge of failure;

Answer 19

■ Low interest rates and growing housing markets created a perfect storm in the US financial system; ■ Leverage magnified banks’ losses from mortgage-backed securities; ■ Shadow banking increased the vulnerability of the financial system; ■ The collapse of the US financial system prompted a rapid contraction of the US economy; ■ Through trade and financial linkages, the crisis reached other economies Policies ■ Conventional monetary policies were used widely to counter the crisis; ■ Owing to the ZLB, they proved to be insufficient and had to be augmented by either fiscal policies or quantitative easing