Financial

Question 1

What would be the effects of an increase in risk perceptions by banks?

Answer 1

1) Mark up rises
2) Lending rate rises
3) Move up along IS curve - recession
4) bank treats as a negative demand shock
5) forecasts fall in inflation below target
6) find desired point on MR curve constrained by new PC, calculate policy rate required to achieve
7) lower interest rates

Question 2

What is narrow money?

Answer 2

central bank money or high—powered money

notes
and coins and the reserve balances of banks held at the central bank

Question 3

What is broad money?

Answer 3

central bank money plus commercial bank money

Question 4

What affects demand for money?

Answer 4

Higher income = more demand (more transaction)

Higher interest rate = less money (bonds earn more and become more attractive)

Inflation = less money

structural changes in financial sector

Question 5

What affects demand for money?

Answer 5

Higher income = more demand (more transaction)

Higher interest rate = less money (bonds earn more and become more attractive)

Inflation = less money

structural changes in financial sector and payment technology

Lower confidence = higher demand

Question 6

What does the demand function for money look like?

Answer 6

there is no well-defined and stable downward sloping money demand function

Question 7

Do changes in phi (structural factors, technolog etc) affect the CB’s ability to achieve its objectives

Answer 7

No

By keeping the policy rate unchanged, any shift in the money demand function affects the money supply but does not feed back to influence real economic activity

Question 8

Why is the lending rate close to the policy rate?

Answer 8

Opportunity for arbitrage between short term interbank lending rates ($ market rates) and the rate paid on reserves

Question 9

What are some factors that affect the mark up

Answer 9

1) risk perceptions
2) risk tolerance
3) ability to bear risk (depends on equity, capital cushions
4) competitiveness of banking sector

Question 10

What is credit risk?

Answer 10

Cresdit risk relates to the fact that there si no guarantee that loans will be repaid or the principle will be paid back in full when repayment is due

securitised loans still carry credit risk as houses that are foreclosed sell at a loss

Question 11

What is an example of moral hazard? How does it contribute to credit rationing

Answer 11

Following the signing of the contract, banks do not observe how much effort the agent exerts. IF a project fails it can be unclear whether this was due to bad luck or a lack of effort.

This affects the bank’s willingness to lend and contributes to credit rationing as the more wealth the agent invests, the better aligned their incentives are so those with little wealth may be unable to get loans

Question 12

What is an example of asymmetric information and how does this contribute to credit rationing

Answer 12

Agent knows more about their financial situation than the banks

Charging higher interest rate to those with safe but low returning projects may not gain credit (adverse selection) so banks instead respond by rationing credit

Question 13

What are the 3 main functions of a bank in a fractional reserve system?

Answer 13

1) maturity transformation
2) aggregation
3) risk pooling

Question 14

What is liquidity risk?

Answer 14

risk that a bank in a fractional reserve system has inadequate reserves to
meet the demand by depositors to withdraw money from their accounts.

Question 15

How can liquidity risk be dampened?

Answer 15

back-stop provision of central bank money through the Lender of Last Resort facility so no ‘first in queue’ incentive and deposit guarantees

Question 16

What is the risk with LoLR and deposit guarantee schemes

Answer 16

need to balance protecting public from spillovers of banking crisis and avoiding moral hazard which makes the banks to behave less prudently

Question 17

When is a bank bankrupt?

Answer 17

Value of assets < liabilities

Question 18

What happens in the banking sector when there is an investment boom?

Answer 18

1) banks make new loans to households and firms and therefore need to replenish reserves a the CB
2) higher incomes generated by boom leads to higher household deposits and m more bonds
3) because some $ goes to bonds, increase in deposits doesn’t cover new lending so banks borrow from money market
4) CB raises policy rate to bring inflation to target
5) raises bank funding costs so banks pass on increase so interest sensitive spending declines

Question 19

what happens to returns on bonds when the interest rate rises?

Answer 19

price of bonds fall so capital loss

Question 20

What is the downswing of the house price cycle?

Answer 20

house prices decline
lower value of collateral
household borrowing falls
purchases fall

Question 21

What is the downswing of the bank cycle?

Answer 21

asset prices decline
weaker balance sheets
bank borrowing falls
purchases of securitised assets fall

banks insolvent when assets < liabilities

Question 22

Why is there special treatment for the banking sector?

Answer 22

economy depends on the provision of banking services, spillovers of a single bank to system as a whole due to complexity and interconnections of the sector

Question 23

What is mark to market?

Answer 23

Asset value in the bank’s balance sheet reflect market prices

Question 24

What are the 4 main types of crises?

Answer 24

1) inflation
2) currency
3) sovereign
4) banking

Question 25

What is a banking crisis?

Answer 25

crises that Iead to the closure, merging or takeover by the public sector of one or more financial institutions

Associated with the bursting of asset price and credit bubbles and the collapse of highly-indebted borrowers

Question 26

What are 3 characteristics of banking crises?

Answer 26

1) deep and prolonged asset price collapses
2) large and persistent adverse effects on the real economy (output and employment)
3) ballooning government debt

Question 27

Describe the financial cycle?

Answer 27

Upswing characterised by rapid growth in house prices, banks extending more credit and a positive feedback process which amplifies rising prices and debt

upswing ends with collapse in prices and a banking crisis

downswing characterised by deleveraging as indebted agents seek to reduce debt and repair balance sheets, banks less willing to make loans. public debt rises

Question 28

Is teh housing sector pro or counter cyclical

Answer 28

pro cyclical

Question 29

In PDE diagrams, what do stable, unstable and multiple equilibria look like

Answer 29

x axis - time
y axis time + 1

linear, start above then below 45

unstable: start below, end up above, steep

multiple: s
first left part and last right part quite flat cross 3 places

Question 30

Why does demand for housing rise when prices do?

Answer 30

If the conviction takes hold that the price will increase further, then this leads the demand curve to shift up in the supply and
demand diagram. People expect to make a capital gain from holding them so demand rises

Question 31

How do price expectations affect the PDE curve?

Answer 31

As more and more people come to believe the price will fall, the PDE curve shifts down.

Tipping point is reached when it is tangent to the 45 degree line as in the following period, the middle equilibrium
has disappeared and the economy is pulled toward the low price equilibrium.

Question 32

What is the financial accelorator?

Answer 32

Some households are credit constrained

rising prices means higher collateral so more people can get loans

higher debt and consumption, including on houses which increases prices

Question 33

What is a plain vanilla crisis?

Answer 33

1) property bubble bursts
2) houses repossessed and sold at loss
3) net worth of banks fall
4) banks become insolvent

plain vanilla crisis does not rely on the more sophisticated behaviour of banks involving novel financial instruments or the investment and shadow banking activities

Question 34

How are housing prices reflected in 3 equation model?

Answer 34

more houses increases demand - rightward shift of IS

link to the central bank is only via the effect of the increased loans on aggregate demand and the forecast effect on CPI inflation

response of the central bank to the associated forecast rise in inflation will not necessarily prevent the continuation of the upswing

Question 35

What is the risk preference of savers and banks?

Answer 35

savers are risk averse and investment banks are risk neutral.

Question 36

What is the process for investment bank crises?

Answer 36

1) upswing begins with the widespread belief that risk has fallen significantly.
As demand for the financial asset goes up, the price rises. Investment banks will want
to hold more of the risky asset as long as the expected return is positive. Hence the financial assets are transferred from savers to investment banks.

2) second ’upswing period as the price of the financial asset leads to a capital gain This increases the equity of IBS because they use the mark-to-market valuation of their assets. This means that the investment banks have more equity available
to cover the worst case risk; so savers are now prepared to lend more

3) unexpected reversal of the previous optimistic beliefs about risk and consequent fall in asset prices leads to major capital IB becomes insolvent

Question 37

What is the formula for the number of assets a bank will buy?

Answer 37

e / z - (1 + r - P)

= equity / risk - (1 + rate of return - price)

Question 38

What is a balance sheet recession?

Answer 38

that follow the bursting of large, credit-fuelled, asset price bubbles

Households and firms deleverage and so increase their savings. This reduces
aggregate demand slowing the recovery

Question 39

What are 4 reasons for the GFC?

Answer 39

1) incentives encouraged banks to adopt stategies that added to aggregate risk
2) regulators allowed banks to use own risk calculating models
3) deposit insurance schemes, credit rating agencies and benign macroeconomic environment encouraged view that risk was low
4) rise in subprime lending and private edbt

Question 40

What were the implications of the GFC in terms of the 3 equation framework?

Answer 40

increased spread between money market and policy rate

increased markup (undermine transmission process)

Reached effective lower bound

Question 41

What were the policy responses in GFC?

Answer 41

1) liquidity problem: cb made reserves available
2) solvency problem: gov ownership stakes, nationalisation, toxic asset purchases
3) cuts to interest rates
4) quantitative easing
5) fiscal stimulus

Question 42

What is QE?

Answer 42

involves the central bank creating
creation of new central bank money to buy financial assets

Aims to support asset prices and bring down long-term interest rates (downward pivot of yield curve where nominal interest rate v time to maturity.