Chapter 6 Flashcards
(12 cards)
What does the interest rate really tell us?
How many dollars we shall have to pay in the future in exchange for having one more dollar today.
What is real interest rate based on?
Expected inflation.
What does the zero lower bound imply for the real interest rate?
That the real interest rate cannot be lower than the negative of inflation.
Why do bank holders require a risk premium?
Because some firms that issue bonds present little or more risk of not being able to repay the “borrower”. Risk premium is the compensation for this.
What determines risk premium?
The probability of default itself.
- The higher the probability, the higher the interest rate investors will ask for.
Describe risk aversion
The degree of risk aversion of the bond holders.
- Even if the expected return on a risky bond was the same as on a riskless bond, the risk itself will make them reluctant to hold the risky bond. How much more will depend on their degree of risk aversion.
- If they become more risk averse, the risk premium will go up, even if the probability of default has not changed.-
What are financial intermediaries?
Financial institutions that receive funds from some investors and then led these funds to others.
Develop expertise about specific borrowers and can tailor lending to their specific needs.
What is leverage ratio?
(of a bank) It’s the ratio of its assets to capital
- A higher leverage ratio implies a higher expected profit rate, but also a higher risk of bankruptcy.
What is policy rate?
Both bank deposits and government bonds are riskfree assets in our model, and we simply assume they yield the same return i, which is what we called the policy rate.
What is borrowing rate?
Consumers and firms don’t care about the nominal rate when they decide how much to borrow or lend; they care about the real rate adjusted for risk, r + x. We will call this rate the borrowing rate.
What is quantitative easing?
Conventional expansionary monetary policy: central banks purchase short term government bonds (T-bills) or intervene on the interbank market by buying or selling assets from/to banks in hope that these low interest rates will pass on the interest rate of other (riskier) financial assets.
Quantitative easing (QE): central banks purchase other types of financial assets (10 or 20-year government bonds, mortgages, corporate bonds…) to decrease the interest rate on these financial assets.
What is forward guidance?
Conventional expansionary monetary policy: central banks set the current policy rate, but do not specify for how long this rate is going to be in place. (They would usually make it dependent on the further economic development of their country.)
Forward guidance: the central bank additionally provides information about its future monetary policy intentions. In this way, it signals to commercial banks what interest rates they should expect in the future.
