Intermediaries Midterm 1 Review

Question 1

What is finance?

Answer 1

1. As a verb: To provide or obtain funding.
2. As an area: Refers to institutions engaged in financial intermediation.
3. As a field of study: Examines how capital resources are allocated under scarcity.

Question 2

What is the primary market?

Answer 2

The market where new securities are issued and sold for the first time. Companies raise capital by selling directly to investors. Example: IPO.

Question 3

What is the secondary market?

Answer 3

The market where previously issued securities are bought and sold among investors. Companies do not receive funds from these transactions. Example: NYSE.

Question 4

What are financial intermediaries?

Answer 4

Institutions that facilitate fund flow between lender-savers and borrower-spenders. Examples: Banks, pension funds, mutual funds.

Question 5

What are the functions of financial markets?

Answer 5

1. Efficient Capital Allocation: Transfers funds to productive opportunities.
2. Consumer Well-being: Provides liquidity to time purchases.

Question 6

What is present value (PV)?

Answer 6

The value today of a sum of money to be received in the future, discounted by interest rates. Formula: PV = FV / (1+r)^n.

Question 7

What is the inverse relationship between bond prices and interest rates?

Answer 7

Higher rates make fixed payments less attractive, lowering bond prices. Longer duration = Higher sensitivity to rate changes.

Question 8

What is the Fisher Effect?

Answer 8

Nominal interest rates rise with expected inflation to preserve real returns. Higher inflation expectations reduce bond demand and increase bond supply.

Question 9

What is the risk structure of interest rates?

Answer 9

Explains differences in interest rates for bonds with the same maturity but varying credit risk, liquidity, and tax treatment.

Question 10

What is the term structure of interest rates?

Answer 10

Examines how interest rates vary by bond maturity while holding credit quality constant. Represented by the yield curve.

Question 11

What is a Normal yield curve?

Answer 11

Upward-sloping, indicates growth.

Question 12

What are the 3 key monetary policy tools?

Answer 12

1. Open Market Operations:
2. Discount Window Lending/Discount Rates
3. Reserve Requirements

Question 13

What is the Federal Funds Rate?

Answer 13

The interest rate at which banks lend reserves to each other overnight. It is influenced by the Fed to control economic activity.

Question 14

What is quantitative easing (QE)?

Answer 14

A nonconventional tool where the Fed buys longer-term securities to lower long-term interest rates and increase liquidity during crises.

Question 15

What is the dual mandate of the Federal Reserve?

Answer 15

1. Maximum employment: Sustainable labor growth.
2. Price stability: Keeping inflation low and predictable.

Question 16

What is the monetary base?

Answer 16

The sum of currency in circulation and reserves held by banks at the Federal Reserve.

Question 17

How does the Federal Reserve create money?

Answer 17

1. Open Market Operations
2. Discount Window Lending

Question 18

What are the components of bank reserves?

Answer 18

1. Deposits at the Federal Reserve.
2. Vault cash held by banks.

Question 19

What is the equilibrium in the market for reserves?

Answer 19

The point where the quantity of reserves demanded by banks equals the quantity supplied, determining the Federal Funds Rate.

Question 20

How do open market purchases affect the market for reserves?

Answer 20

Increase reserves, lower the Federal Funds Rate, and expand the monetary base.

Question 21

What is the discount rate?

Answer 21

The interest rate at which banks borrow directly from the Federal Reserve through the discount window.

Question 22

What is the purpose of reserve requirements?

Answer 22

To ensure that banks hold enough liquid assets to meet withdrawal demands and maintain financial stability.

Question 23

What is the difference between required reserves and excess reserves?

Answer 23

• Required Reserves: The minimum reserves mandated by the Fed.
• Excess Reserves: Reserves held above the required minimum.

Question 24

What is the Zero Lower Bound (ZLB)?

Answer 24

A situation where short-term nominal interest rates are at or near zero, limiting the effectiveness of conventional monetary policy.

Question 25

What is forward guidance?

Answer 25

A communication tool where central banks signal future policy intentions to influence market expectations.

Question 26

What are the types of forward guidance?

Answer 26

1. **Time-Based:** Commitments for a specific period. 2. **State-Based:** Policy linked to specific economic conditions like inflation or unemployment rates.

Question 27

What is the time-inconsistency problem in monetary policy?

Answer 27

The temptation to pursue short-term expansionary policies, which may harm long-term economic stability.

Question 28

What are credit-driven bubbles?

Answer 28

Asset price bubbles fueled by easy credit terms, leading to systemic risks when they burst.

Question 29

What are optimism-driven bubbles?

Answer 29

Bubbles based on overly optimistic expectations about asset prices, with less systemic impact compared to credit-driven bubbles.

Question 30

What is macroprudential regulation?

Answer 30

Policies aimed at curbing systemic risks in the financial system, such as capital requirements and risk management monitoring.

Question 31

What is the dual mandate's challenge?

Answer 31

Balancing maximum employment and price stability, as measures to control inflation (e.g., higher interest rates) can reduce employment in the short term.

Question 32

What is the Federal Open Market Committee (FOMC)?

Answer 32

A branch of the Federal Reserve responsible for open market operations and setting monetary policy.

Question 33

What is the Greenspan Doctrine?

Answer 33

A belief that central banks should not intervene in asset-price bubbles due to the difficulty of identification and potential unintended consequences.

Question 34

What are the main types of Federal Reserve lending facilities?

Answer 34

1. **Primary Credit Facility:** For healthy banks. 2. **Secondary Credit Facility:** For troubled banks. 3. **Seasonal Credit Facility:** For banks with seasonal patterns.

Question 35

What is quantitative easing's (QE) purpose?

Answer 35

To lower long-term interest rates and increase liquidity during periods when short-term rates are near zero.

Question 36

What is the Fisher Effect’s impact on bonds?

Answer 36

Higher inflation expectations increase nominal rates, reducing the price of fixed-income securities.

Question 37

How do reserve requirements impact lending?

Answer 37

- **Higher Requirements:** Reduce banks’ ability to lend, slowing economic activity. - **Lower Requirements:** Increase lending, stimulating growth.

Question 38

What is moral hazard in monetary policy?

Answer 38

When banks take on more risk, knowing the Fed will act as a lender of last resort during crises.

Question 39

How does the Fed influence the Federal Funds Rate?

Answer 39

Through open market operations that adjust the supply of reserves, affecting the equilibrium rate.

Question 40

What is a Flat Yield Curve?

Answer 40

Indicates uncertainty or transition.

Question 41

What is an Inverted Yield Curve?

Answer 41

Downward-sloping, predicts a recession.

Question 42

What are Open Market Operations?

Answer 42

Buying and selling government securities. Buying government securities to increase reserves.

Question 43

What is Discount Window Lending?

Answer 43

Allows banks to borrow directly from the Fed; Lending directly to banks to increase their reserves.

Question 44

What are Reserve Requirements?

Answer 44

Minimum reserves to hold.

Question 45

What is the discount rate?

Answer 45

Interest rate for borrowing from the Fed

Question 46

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