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

Question 1

Asset and Financial Asset

Answer 1

Asset- generates a stream , of benefits for its owner, Examples encountered: a factory, a piece of software, a house

Financial asset- generates a stream, of benefits from somebody’s debt

Question 2

Financial asset/liability- example before

Answer 2

Bank: assets, liabilities and net worth
Customer: assets, liabilities and net worth

Question 3

Financial asset/liability - example, after

Answer 3

Bank: loan + assets, money deposited + liabilities and net worth

Customer: Money deposited + assets, loans + liabilities and net worth

Question 4

Money as a financial asset

Answer 4

Money emerges as both an asset and liability
- most liquid financial asset (easiest to exchange for goods and services)

Monetary system and monetary policy exist and operate within a financial market.

*making a financial asset is impossible without creating a financial liability

Question 5

Lending as a way of money creation

Answer 5

• approving the loan itself created purchasing power without involving any ‘physical’ money (currency

Question 6

Monetary system - players

Answer 6

Central bank (CB, monetary authority) - an authority tasked with the conduct of monetary policy
- Bank of England in the UK, European Central Bank in EU, Federal Reserve System in the US, the source of CBs power (monopoly control over ‘high-power/base money’)

• Monetary financial institutions (MFIs): credit unions, commercial banks, funds
  -Consumers (households and firms)

Question 7

Monetary system - aggregate balance sheets

Answer 7

Central Bank: Non-money assets, currency + reserves (BASE MONEY)

Banks: non-money + currency + reserves + loans, non-money + deposits

H/hs and Firms: Currency + Deposits (BROAD MONEY), Non-money liabilities and net worth.

+ : they are part of the same column, different categories
And: implies they are in the same group/column

Question 8

Base Money

Answer 8

• money issued by the CB, formed by currency and reserves
• created directly and solely by the CB, and so it plays a crucial role in the conduct of monetary policies
• Reserves are interest-bearing deposits for banks to settle transactions (not hoard cash)
• Just like with other deposits, they are created by lending (from the CB to banks) or by depositing funds (from banks to the CB)

Question 9

What makes the CB so central?

Answer 9

• the CB is the sole supplier of reserves and currency
• the power of base money lies in the willingness to accept and use it
• apart from this, money is not backed by any commodity

Question 10

Commercial banks

Answer 10

• in monetary systems, money is NOT created through multiplying ‘CB money’ in rounds of lending and borrowing
• base money expands into broad money directly through lending and creation of deposits by commercial banks

Question 11

Money creation by commercial banks

Answer 11

Some countries impose a floor on the reserve ratio (the ratio of reserves to deposits)

Economic limits:
- forces of competition (competing for borrowers drives rates down)
- risk management (offering more loans will start attracting more risky customers)

Question 12

Monetary policy - ingredients

Answer 12

1. Ultimate aim - macroeconomic stability (through controlling inflation )
2. Instrument - interest rate
3. Transmission mechanism - in a moment

Question 13

Instrument - interest rate

Answer 13

BoE (Bank of England) base rate - the interest rate for BoE reserves
- its the cost of borrowing from and lending to the BoE
- it sets the terms of accessing the BoEs finds

• Common generic names for analogues of the BoE rate are the base rate, the CB’s interest rate, the key rate, the policy rate

Question 14

Policy transmission mechanism

Answer 14

• suppose interest rate drops for i1 to i2, only banks have access to to reserves, transmission proceeds through the banking system

Question 15

Adjustment of lending rates: What if, say, Bank 1 tries to go below i2 and charges i low?

Answer 15

Bank 2 can profitably become Bank 1s borrower by taking all Bank 1a funds available and lending them to the CB

Bank 1s funds would end up converted into Bank 2s reserves with Bank 2 earning the difference (spread) between the rates i2-i low

The situation of making profit by just buying for less and selling it for me is called arbitrage, and its prevents too low rates from appearing in the market

Question 16

Adjustment of lending rates - the gist and the bottom line

Answer 16

Storing funds with the BoE is less profitable, and banks seek to lend more
Banks compete with each other, and this brings rates down
Rates cannot fall below the BoE rate owing to arbitrage

BoE rate = i2 ->=<- bank 1 rate <- bank 2 rate
Arbitrage ——> <——- Competition
——-0——————————————————-i—->

Question 17

Adjustment of saving rates

Answer 17

1. BoE drops the rate to i2
2. Now any amount of money can be borrowed by banks form it at i=i2
3. Banks no longer accept deposits at i1, as they have the cheaper option
4. Depositors either can get nothing at i1 or something at i2, and so they acquiesce

*By contract with lending rates, adjustment here occurs thanks to the CBs monopoly power

Question 18

Policy transmission recieved

Answer 18

Households and firms end up facing a lower rate i2<i1
This is where the IS curve kicks in - lover cost of borrowing which stimulates investment, thus increasing expenditure
In reality adjustment takes some time - rate changes do not reach households and firms instantly

This delay is called transmission lag (which happens around a year)

Question 19

Summarize monetary system

Answer 19

Deposits are created in the process of lending for investment, so there is more broad money. If there are too many for banks’ comfort, they can demand more reserves from the CB, thus expanding base money

In sum, the interest rate is decided upon first, and then adjustment in the demand for money trails behind

Question 20

Transmission of monetary policy - taking stock

Answer 20

1. CB sets the interest rate
2. Commercial banks adjust to the rate
3. The rate reaches real economy though the baking system and impacts on it through the IS relationship
4. Changes in output/spending affect the amount of money

• Crucially, the CB controls the rate, but it needs banks as a conduit for the rate to reach households and firms

Question 21

IS + Monetary policy = IS-LM

Answer 21

• So CB can control i - and project it into the real economy
• regardless of output , a given level of i can be maintained in the economy through monetary policy

Question 22

Baseline IS-LM

Answer 22

IS-LM connects together monetary policy decisions (described by the LM (MP) line) with responses of real economy (described by the IS line)

The model offers three policy tools for countering shocks: the interest rate, government spending and taxation

The policy tools do not have to compete against each other

Question 23

Open Market Operations (OMOs)

Answer 23

1. Suppose the CB buys short-term government debt from the economy
2. Bonds are taken from an economy in exchange for extra base money
3. More money => portfolio rebalancing (other financial assets are demanded)
4. With extra demand for debt, interest rates drop, and borrowers can attract funds at a lower rate
5. Extra base money is turned into extra broad money (money multiplier)

• for OMOs to be reliable, the money multiple has to remain stable

Question 24

Price changes

Answer 24

• interest rate i is nominal - it shows the return from saving and the cost of borrowing money, not goods
• it is present in the IS equation, which describes spending and production in real terms
  -real interest rate shows the return from saving and the cost of borrowing goods

Question 25

Fischer equation

Answer 25

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

Question 26

Attempt at a negative rate: Banks & Customer

Answer 26

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

Question 27

Zero lower bound (ZLB) & possible solutions

Answer 27

• 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)

Question 28

Quantitative easing: the gist

Answer 28

• 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

Question 29

Why QE instead of OMOs?

Answer 29

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

Question 30

Taking Stock

Answer 30

■ 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

Question 31

Key notions: Financial Instruments

Answer 31

■ 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

Question 32

Key notions: Money, monetary system

Answer 32

■ 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

Question 33

Key notions: Conventional & Unconditional monetary policies

Answer 33

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;

Question 34

Key notions: Directions of monetary policy

Answer 34

■ 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;

Question 35

Risk Premiums

Answer 35

■ 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;

Question 36

Debt refinancing

Answer 36

■ 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);

Question 37

Banks: CDOs

Answer 37

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;

Question 38

Leverage

Answer 38

■ 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

Question 39

Shadow banking

Answer 39

■ 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;

Question 40

Housing market

Answer 40

■ 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

Question 41

Financial system

Answer 41

■ 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

Question 42

Turning point

Answer 42

■ 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;

Question 43

Risk: Conclusion

Answer 43

■ 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