Instructor Solution Manual for Economics of Money, Banking, and Financial Markets, 13th Edition by F

Instructor’s Resource Manual for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets Thirteenth Edition

Frederic S. Mishkin

PART ONE How to Use the Instructor’s Manual and Other Textbook Ancillaries Organization of the Instructor’s Manual To help instructors cope with the increased demands for good teaching in recent years, The Economics of Money, Banking, and Financial Markets, Thirteenth Edition, includes the most comprehensive package of supplementary materials of any money, banking, and financial markets textbook. As part of these supplemental materials, I have designed the Instructor’s Manual to help save you time in preparing class materials, such as class outlines, solutions to homework problems, lecture notes, and overhead transparencies.

This Instructor’s Manual is divided into four parts. Part One discusses how to use the Instructor’s Manual and the other textbook ancillaries to make your teaching of the money and banking course both more effective and less time-consuming. Part Two contains an overview of all the textbook chapters along with teaching tips that I have found effective. Part Three contains the answers to the end-of-chapter problems for use by the instructor to prepare solution sets for the problems he or she assigns to the students as problem sets. Part Four contains chapter outlines, which can be used either to make slides for use in class or to make handouts for the students.

To obtain any of the available ancillaries, adopters of the text just need to get in touch with their Pearson sales representative, or alternatively they can visit the Instructor’s Resource Center at www.pearsonhighered.com.

Alternative Course Outlines There are many different ways to teach a course on money, banking, and financial markets.

For this reason, the material in The Economics of Money, Banking, and Financial Markets, Thirteenth Edition, has been arranged with flexibility in mind, so that many teaching styles can be accommodated. The following sections suggest sample outlines for four main approaches to teaching money, banking, and financial markets, showing how the text can be adapted to each approach, as well as to quarter and semester teaching schedules. Note, however, that many variations on these outlines are possible.

 Outline for General Money and Banking Course Core Chapters Chapter No. 1 2 3 4 5 9 10 11 12 13 15 16 22 23

Chapter Title Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

Understanding Interest Rates The Behavior of Interest Rates Banking and the Management of Financial Institutions Economic Analysis of Financial Regulation Banking Industry: Structure and Competition Financial Crises Central Banks and the Federal Reserve System Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics Aggregate Demand and Supply Analysis Monetary Policy Theory

For a one-semester course, cover any five of the following optional chapters: Chapter No. 6 7 Market 8 14 17

Chapter Title The Risk and Term Structure of Interest Rates The Stock Market, the Theory of Rational Expectations, and the Efficient Hypothesis An Economic Analysis of Financial Structure The Money Supply Process The Foreign Exchange Market

18 19 20 21 24 25

The International Financial System Quantity Theory, Inflation, and the Demand for Money The IS Curve The Monetary Policy and Aggregate Demand Curves The Role of Expectations in Monetary Policy Transmission Mechanisms of Monetary Policy

A one-quarter course would probably only include one or two of the optional chapters unless some of the chapters on central banking and the conduct of monetary policy (Chapters 13, 15, and 16) were deleted.

 Outline for General Money and Banking Course with an International Emphasis Core Chapters Chapter No. 1 2 3 4 5 9 10 11 12 13.

15 16 17 18 22 23

Chapter Title Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

Understanding Interest Rates The Behavior of Interest Rates Banking and the Management of Financial Institutions Economic Analysis of Financial Regulation Banking Industry: Structure and Competition Financial Crises Central Banks and the Federal Reserve System Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics The Foreign Exchange Market The International Financial System Aggregate Demand and Supply Analysis Monetary Policy Theory

For a one-semester course, cover any three of the following optional chapters: Chapter No. 6 7 Market 8 14 19 20 21 24

Chapter Title The Risk and Term Structure of Interest Rates The Stock Market, the Theory of Rational Expectations, and the Efficient Hypothesis An Economic Analysis of Financial Structure The Money Supply Process Quantity Theory, Inflation, and the Demand for Money The IS Curve The Monetary Policy and Aggregate Demand Curves The Role of Expectations in Monetary Policy

25

Transmission Mechanisms of Monetary Policy

A one-quarter course would probably not include any other chapters unless some of the chapters on central banking and the conduct of monetary policy (Chapters 13, 15, and 16) were deleted.

 Outline for Financial Markets and Institutions Course Core Chapters Chapter No. 1 2 3 4 5 6 7 Market 8 9 10 11 12

Chapter Title Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

Understanding Interest Rates The Behavior of Interest Rates The Risk and Term Structure of Interest Rates The Stock Market, the Theory of Rational Expectations, and the Efficient Hypothesis An Economic Analysis of Financial Structure Banking and the Management of Financial Institutions Economic Analysis of Financial Regulation Banking Industry: Structure and Competition Financial Crises

For a one-semester course, cover any seven of the following optional chapters: Chapter No. 13 14 15 16 17 18 19 20 21 22 23 24 25

Chapter Title Central Banks and the Federal Reserve System The Money Supply Process Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics The Foreign Exchange Market The International Financial System Quantity Theory, Inflation, and the Demand for Money The IS Curve The Monetary Policy and Aggregate Demand Curves Aggregate Demand and Supply Analysis Monetary Policy Theory The Role of Expectations in Monetary Policy Transmission Mechanisms of Monetary Policy

A one-quarter course would probably only include one or two of the optional chapters.

 Outline for Monetary Theory and Policy Course Core Chapters Chapter No. 1 2 3 4 5 13 14 15 16 19 20 21 22.

23 24

Chapter Title Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

Understanding Interest Rates The Behavior of Interest Rates Central Banks and the Federal Reserve System The Money Supply Process Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics Quantity Theory, Inflation, and the Demand for Money The IS Curve The Monetary Policy and Aggregate Demand Curves Aggregate Demand and Supply Analysis Monetary Policy Theory The Role of Expectations in Monetary Policy

For a one-semester course, cover any four of the following optional chapters: Chapter No. 6 7 Market 8 9 10 11 12 17 18 25

Chapter Title The Risk and Term Structure of Interest Rates The Stock Market, the Theory of Rational Expectations, and the Efficient Hypothesis An Economic Analysis of Financial Structure Financial Crises Banking and the Management of Financial Institutions Economic Analysis of Financial Regulation Banking Industry: Structure and Competition The Foreign Exchange Market The International Financial System Transmission Mechanisms of Monetary Policy

A one-quarter course would probably only include one or two of the optional chapters.

Overviews of the Textbook Chapters and Teaching Tips I have been teaching money and banking now for over 40 years. The overviews and teaching tips in Part Two of the Instructor’s Manual are intended to share with you some of my experiences in the classroom with teaching the material in the textbook. The overview and teaching tips for each chapter provide a brief description of the contents of the chapter, discuss the novel features of the chapter, indicate what central points need to be transmitted to the student, suggest teaching tips that I have found useful in class, and provide guidance as to what material can easily be skipped in each chapter.

Answers to End-of-Chapter Problems Part Three of the Instructor’s Manual contains the answers to end-of-chapter problems.

Some of these questions require students to look up current data, and in these cases no answers are given; however, for the rest of the questions, the answers are quite complete.

Many instructors will use the end-of-chapter questions for homework assignments, as I do. I have found it useful to hand out answers to the questions provided in Part Three to the students as solutions sets after they have completed their assignments; they find them to be an invaluable study aid. Making up these solution sets for reproduction should be quite easy, either by cutting and pasting from Part Three or downloading the files from the Instructor’s Resource Center at www.pearsonhighered.com.

PowerPoint Presentation Also offered in the instructor’s supplement package is a PowerPoint Presentation that contains lecture notes and all the textbook’s figures and tables. These slides are comprehensive and outline all the major points covered in the text. The lecture notes have been class-tested successfully—they are the ones that I use in class—and they should help other instructors prepare their lectures as they have helped me.

Please note that unless you have access to PowerPoint version 4.0 or higher you will only be able to project the provided images using the viewer that is included; editing or adding material will not be possible unless you have the software program.

To obtain the PowerPoint files, adopters of the text just need to get in touch with their Pearson sales representative, or visit the Instructor’s Resource Center at www.pearsonhighered.com to download the available electronic files.

Test Bank The Test Bank contains over 2,600 multiple-choice questions that are appropriate for use as quiz or test questions. It is provided as a set of Word files in Macintosh and Windows versions, as well as a set of .BOK TestGen files. It can be downloaded from the Instructor’s Resource Center at www.pearsonhighered.com. These forms provide alternative methods for the instructor to make up exams.

The Pearson TestGen program offered is a computerized test generator that lets you construct tests by choosing questions from the Test Bank that was prepared specifically for this textbook and your course.

The test construction process involves the use of a simple TestGen screen that you fill in on the computer to choose questions for your test. If desired, test questions can be viewed on the screen, and test questions can be edited, saved, or printed. In addition, you can add questions, which may include graphics.

Program features:       

The Test Bank can include four types of questions: multiple choice, true/false, short answer, and essay.

A supplementary page attached to each Test Bank question can contain its topic, objective, skill, difficulty, and other user-added information.

Test questions can be chosen in a variety of ways including manual selection, random selection, choose while viewing, and choose by searching.

Questions chosen for a test can be viewed and edited without affecting the original versions of the questions in the item bank.

Test size is limited only by the memory size of the computer and the length of the questions you choose.

Test questions can be printed in the exact order you specify or grouped and sorted automatically by the program.

Printer files can be created or modified to take advantage of the capabilities of your printer.

Course Management with MyLab Economics MyLab Economics delivers rich online content and innovative learning tools to your classroom. Instructors who use MyLab Economics gain access to powerful communication and assessment tools, and their students receive access to the additional learning resources described below.

Students and MyLab Economics MyLab Economics delivers the content and tools your students need to succeed online.

Students whose instructors use MyLabEconomics gain access to a variety of study and practice tools that put them in control of their own learning:        

 

All end-of-chapter questions and applied problems from the text are available in MyLab Economics.

Applications from the text are provided, along with assignable questions.

Mini-Lecture Videos provide a step-by-step analysis of all the data and analytic figures included in the text. The videos can be used in class or viewed by students on their own time.

A Personal Study Plan is created for each individual student based on his or her performance on assigned and sample exercises.

Instant tutorial feedback is provided for problems and graphing responses to questions.

Interactive learning aids, such as Help Me Solve This (a step-by-step tutorial), are designed to help the student exactly when he or she needs support.

News articles are available for classroom and assignment use. Up-to-date news articles and complementary discussion questions are posted weekly to bring today’s news into the classroom and course.

Real-Time Data Analysis Problems allow instructors to assign problems that use up-to-the-minute data. Each RTDA exercise loads the appropriate and most current data from FRED, a comprehensive and up-to-date data set maintained by the Federal Reserve Bank of St. Louis. Exercises are graded based on the particular data used, and feedback is provided.

An Enhanced Pearson eText is available within the online course materials and offline via iPad and Android apps. The enhanced Pearson eText enables instructors and students to highlight, bookmark, and take notes.

Auto-graded problems and graphs are available for assignments.

Instructors and MyLab Economics With MyLab Economics instructors can customize existing content and add their own.

They can manage, create, and assign tests to students, choosing from the exercises in the Study Plan as well as from our Test Banks. MyLab Economicsalso includes advanced tracking features that record students’ usage and performance and a Gradebook feature to see students’ test results. Please contact your Pearson sales representative to see how MyLab Economics can work for your course.

PART TWO Overviews of the Textbook Chapters and Teaching Tips

Chapter 1 Why Study Money, Banking, and Financial Markets?

Before embarking on a study of money, banking, and financial markets, the student must be convinced that this subject is worth studying. Chapter 1 pursues this goal in two ways.

First, it shows the student that money and banking is an exciting field because it focuses on economic phenomena that affect everyday life. Second, using eight figures, this chapter encourages the student to look at data that bear on the central issues in this field.

An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters, and to indicate how the book will be taught.

In teaching this chapter, the most important goal should be to get the student excited about the material. I have found that talking about the data presented in the figures helps achieve this goal. Furthermore, it shows the student that the subject matter of money and banking has real-world implications that the student should care about.

The appendix to this chapter reviews concepts regarding the definitions of aggregate output, income, and the price level that the student already has seen in an economic principles course. Since these concepts are extremely important, it might be worthwhile to have your students read this appendix outside of class to jog their memories.

Chapter 2 An Overview of the Financial System Chapter 2 is an introductory chapter that contains the background information on the structure and operation of financial markets that is needed in later chapters of the book.

This chapter allows the instructor to branch out to various choices of later chapters, thus allowing different degrees of coverage of financial markets and institutions.

The most important point to transmit to the student is that financial markets and financial intermediaries are crucial to a well-functioning economy because they channel funds from those who do not have a productive use for them to those who do. Professors who emphasize financial markets and institutions in their course will want to teach this chapter in detail, and those who focus on international issues will want to spend some time on the section ―Internationalization of Financial Markets.‖ However, those who slant their course to monetary theory and policy may want to give this chapter a more cursory treatment. No matter how much class time is devoted to this chapter, I have found that it is a good reference chapter for students. You might want to tell them that if in later chapters they do not recall what some financial instrument is or who regulates whom, they can refer back to this chapter, especially to summary tables, such as Tables 3 and 5.

The chapter introduces Global boxes, which are sprinkled throughout the text, to get students to recognize the growing importance of the global economy. The Global box in this chapter gets students to think about how the financial system in the United States is both similar to and different from financial systems in other countries.

Chapter 3 What Is Money?

Before becoming immersed in the study of money and banking, the student must understand how money is defined and measured. The first half of Chapter 3 discusses the definition of money: how the economist’s definition differs from that of common speech, the functions of money, and a historical view of how what serves as money has changed over time. The second half of the chapter describes the tricky issues involved in applying the definition of money in order to measure it.

Once the student understands what money is, the most important point to get across to him or her is that economists are not exactly sure how to measure money. This presents to policymakers a serious problem: Although they might want to control the money supply to affect the economy, they are not sure which measure of money is the right one to control. In many situations, knowing which measure of money is the right one is not crucial because different measures (such as Ml and M2) move together. But, as Figure 1 illustrates, this is sometimes not the case, presenting the policymaker with a dilemma.

This chapter introduces FYI boxes, which highlight dramatic historical episodes, interesting ideas, and intriguing facts to keep students excited about the material.

Chapter 4 The Meaning of Interest Rates In my years of teaching money and banking, I have found that students have trouble with what I consider to be easy material because they do not understand what an interest rate is: that it is negatively associated with the price of a bond, that it differs from the return on a bond, and that there is an important distinction between real and nominal interest rates.

This chapter spends more time on these issues than does any other competing textbook.

Furthermore, it contains many numerical applications to drive home the concepts. My experience has been that giving this material so much attention is well rewarded. After putting more emphasis on this material in my money and banking courses, I witnessed a dramatic improvement in students’ understanding of bank asset and liability management, portfolio choice, models of the demand for money, and other topics in monetary theory. I have also found that students very much enjoy this chapter because it is so useful to them in their careers.

An appendix to the chapter, which can be found in MyLab Economics, provides more detail on how interest rate risk can be measured with the concept of McCauley’s duration.

This is a basic financial tool that is used by practitioners and so will be of great interest to students who plan careers in the financial industry.

Chapter 5 The Behavior of Interest Rates As is clear in the Preface to the textbook, I believe that money and banking is taught effectively by emphasizing a few economic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 5 introduces one of these basic economic principles: the theory of portfolio choice. This theory indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of money and banking and makes it much easier for the student to understand how interest rates are determined, how banks manage their assets and liabilities, why financial innovation takes place, how prices are determined in the stock market and the foreign exchange market, and how various theories explain the demand for money.

One teaching device that I have found helps students develop their intuition is the use of summary tables such as Table 1 in class. I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout my course and in this book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly.

Chapter 5 goes on to lay out two partial equilibrium approaches to the determination of interest rates: supply and demand in the bond market and the liquidity preference framework (supply and demand in the money market). As is made clear in this chapter, these approaches are not inconsistent with each other but are two different and useful ways of looking at the same thing. (A third approach to the determination of interest rates used by some practitioners in financial markets is the so-called loanable funds framework. An appendix to the chapter found in MyLab Economics shows how the supply and demand analysis of the bond market developed in this chapter relates to the loanable funds framework.)

An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus, there are two reasons for using a stock approach rather than a flow approach: (1) it is easier and (2) it is more consistent with modern treatment of asset markets by economists.

Another important feature of this chapter is that it lays out supply and demand analysis of the bond and money markets at a similar level to that found in principles of economics textbooks. The ceteris paribus derivation of supply and demand curves with numerical examples are presented, the concept of equilibrium is carefully developed, the factors that shift the supply and demand curves are outlined, and the distinction between movements along a demand or supply curve and shifts in the curve are clearly drawn. My feeling is that the step-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of money, banking, and financial markets. I have found that even those students who have had excellent training in their principles course find that this chapter provides a valuable review of supply and demand analysis.

This chapter is also designed to show the student how useful economic analysis can be. In teaching my class, we discuss a recent news reports on the bond market and then use it to conduct a case discussion using the supply and demand analysis of the bond market developed in the chapter. My students very much like the resulting case discussions and have told me that they are better than case discussions in other classes because the material is so current. The application at the end of the chapter encourages students to use all they have learned in this chapter to analyze an important issue to policymakers—the relationship between money and interest rates.

Some practitioners use an alternative approach to interest rate determination, the loanable funds framework. A third appendix in MyLab Economics discusses this framework and shows how it is similar to the analysis of supply and demand analysis for the bond markets in the text.

Chapter 6 The Risk and Term Structure of Interest Rates Chapter 6 applies the tools the students learned in Chapter 5 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on monetary theory and policy in their courses might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the student’s understanding of later chapters.

A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the applications on interpreting yield curves in the 1980–2020 period and on the impact of the global financial crisis on the Baa-Treasury spread demonstrates.

Chapter 7 The Stock Market, the Theory of Rational Expectations, and Efficient Market Hypothesis Because the stock market is of such great interest to students, this chapter discusses theories of how stocks are priced and how information is incorporated into stock prices. Laying out the simple models of the one-period valuation model, the generalized dividend valuation model, and the Gordon growth model gives students the tools to understand how stock prices are determined. Two applications show students how relevant these models are by applying them to see how monetary policy influences stock prices.

An important development in monetary theory that has far-reaching implications for the way we evaluate economic policy is the theory of rational expectations. Chapter 7 explains this theory and its application to financial markets, which is referred to as the efficient market hypothesis. Although the theory of rational expectations can be laid out in mathematical terms, I have found that it is best to give the students an example such as Joe Commuter’s expectations to give them an intuitive sense of what ―rational expectations‖ means. When provided with a graphic example like that used in the text, students have no trouble understanding the theory of rational expectations, which is really just good common sense.

The implications of rational expectations theory become much clearer when this theory is used to understand behavior in the financial markets as in the efficient market hypothesis.

Research has been dredging up fascinating anomalies that cast doubt on these theories.

This chapter has therefore been written to give a more balanced view of these theories: It reflects this latest research, including a discussion of the new field of behavioral finance, which applies concepts from other social sciences such as anthropology, sociology, and particularly psychology, to understand the often anomalous behavior of security prices.

Students particularly enjoy the application of rational expectations (efficient market hypothesis) theory to provide a practical guide to investing in the stock market. This application captures the attention of even the most disinterested student because all of us are interested in how to get rich (or, at least, in how to keep from getting poor). This application also gives students practice using the reasoning that they learned earlier in the chapter. In addition, the theory is confronted with evidence that shows the student important implications for the real world.

Chapter 8 An Economic Analysis of Financial Structure The development of the literature in economics on asymmetric information and financial structure in recent years now enables financial institutions to be taught with basic economic principles rather than placing emphasis on a set of facts that students may find boring and so will forget after the final exam. This chapter provides an outline of this literature to the student and provides him or her with an economic understanding of why our financial system is structured the way it is. In addition, it emphasizes the ideas of adverse selection and moral hazard, which are basic economic concepts that are useful in understanding principles of bank credit risk management in Chapter 9, principles of bank regulation in Chapter 10, the economics of financial regulation in Chapter 11, and financial crises in Chapter 12.

The chapter begins with a discussion of eight basic facts about financial structure.

Students find some of these facts to be quite surprising—the relative unimportance of the stock market as a source of financing investment activities, for example—which piques their interest and stimulates them to want to understand the economics behind our financial structure. The next two sections then explain these facts by providing an understanding of how transaction costs and asymmetric information affect financial structure. My experience with teaching this material is that it is very intuitive and therefore easy for students to learn. Furthermore, students find the material inherently exciting because it explains phenomena that they know are important in the real world. I have also found that it helps students to learn facts about the financial system because they now have a framework to make sense out of all these facts.

Two applications give students practice with using the concepts in the earlier asymmetric information analysis. They examine the role of financial development on economic growth and whether China is a counterexample to the importance of financial development. Students find these applications to be very stimulating because there is something inherently exciting about economic growth. These applications can be skipped without loss of continuity, especially for courses focusing on financial institutions.

The chapter has been designed to keep the textbook very flexible. The concepts of adverse selection and moral hazard were explained in Chapter 2 and are explained again in Chapter 9, so that Chapter 8 does not have to be covered in order to teach this or later chapters. Furthermore, the applications at the end of the chapter do not need to be covered in order to teach other chapters in the book.

Chapter 9 Banking and the Management of Financial Institutions Although this chapter performs the conventional function of outlining what banks (depository institutions) do and what their balance sheets look like, it also emphasizes the economic way of thinking about how banks manage their assets and liabilities to make a profit. Three tools are used throughout this chapter and the rest of the book—the asymmetric information concepts of adverse selection and moral hazard, introduced in Chapter 2, the theory of portfolio choice developed in Chapter 5, and T-accounts, introduced in this chapter. In teaching this material, it is worth emphasizing to the student that mastery of these tools will pay high dividends in helping them to learn (and perform well on exams) in this course.

The economics of bank management is important, not only because it will help students comprehend the operation of banks, the most important of our financial intermediaries, but also because bank management affects the money supply, as shown in Chapter14.

The first three sections of the chapter—―The Bank Balance Sheet,‖ ―Basic Banking,‖ and ―General Principles of Bank Management‖—place particular emphasis on the question of why banks hold excess reserves, since banks’ decisions about the amount of excess reserves they hold play an important role in the money supply process.

The subsection, ―Capital Adequacy Management,‖ and the final three sections in the chapter, ―Managing Credit Risk,‖ ―Managing Interest-Rate Risk,‖ and ―Off-BalanceSheet Activities,‖ discuss issues that have become increasingly important in recent years.

Many instructors may therefore want to include this material in their courses, yet none of this material is essential to understanding later chapters, so it can be skipped without any loss of continuity. The application on how a capital crunch caused a credit crunch during the global financial crisis particularly piques the interest of students because it shows how changes in banks’ behaviors can have major effects on the economy.

Chapter 9 has two appendices in MyLab Economics. The first outlines duration gap analysis and the second discuses how to measure bank performance. For instructors who are teaching students who might want to go into the financial industry, these appendices can give these students extra tools that they can use in their future jobs.

Chapter 10 Economic Analysis of Financial Regulation Chapter 10 stresses the economic way of thinking by conducting an economic analysis using the adverse selection and moral hazard concepts to show why our regulatory system takes the form it does and how it can lead to banking crises.

An appendix in MyLab Economics goes into more detail on banking crises in other countries. This material will be useful to instructors who want to give their course a more international focus.

Note that Chapter 8 does not need to be covered in order to teach this chapter. However, if Chapter 8 is covered in class, Chapter 10 is a nice application of the analysis in that chapter. Indeed, the instructor might want to stress in class the counterparts in private financial markets to the methods financial regulators use to cope with adverse selection and moral hazard.

Chapter 11 Banking Industry: Structure and Competition Chapter 11 supplements Chapter 2 by going into much greater detail about the structure of the banking system. This chapter differs from conventional chapters on the banking industry in other money and banking textbooks by stressing a more dynamic, analytical framework than in other books. In particular, it provides an analytic framework for understanding the process of financial innovation in which financial institutions respond to changes in the financial environment by searching for innovations that are likely to be profitable. This framework is then used to show how financial innovation and changes in the ability to process information have led to a decline in the traditional banking business and to fundamental changes in the structure of the banking industry.

Chapter 12 Financial Crises Financial crises are inherently interesting because they are so dramatic. This has become even more the case with the recent global financial crisis that has had such devastating consequences for not only the U.S. economy, but for Europe as well. Indeed, teaching this material on the financial crises has engaged students’ interest more than anything else I have taught in my entire career of over 40 years of teaching.

This chapter makes use of an asymmetric information analysis (agency theory) to explain the dynamics and adverse impact of financial crises. Teaching Chapter 8 in full is not necessary to cover Chapter 12 as long as the instructor goes over the concepts of asymmetric information, adverse selection, and moral hazard. Although Chapter 12 defines these concepts, many instructors will prefer to cover these concepts in more detail using the material in the first part of Chapter 8.

After defining the basic asymmetric information concepts, the chapter outlines the dynamics of financial crises in advanced economics by separating crises into three phases: the initial phase in which financial innovation or liberalization occurs, but is deeply flawed, so it leads to a credit boom and bust, the second phase of a banking crisis, and the third phase, which only occurs in the worst financial crises, of debt-deflation, in which a decline in the price level causes a further deterioration in household and businesses balance sheets. Figure 1 is particularly useful to get students to see the sequence of events and dynamics of financial crises, and going through all the stages in the figure helps students get the big picture of what is happening during financial crises.

This chapter then applies the analysis to real-world events. Students will be most interested in using the analysis to discuss the application on recent financial crisis in 2007–2009, which was the worst financial crisis to hit the world since the Great Depression. Nonetheless, the application on the Great Depression is worth covering because it contains so many lessons for today. An additional application discusses why the coronavirus pandemic could have led to a financial crisis, but didn’t.

For those instructors who would like to internationalize their course, a chapter available in MyLab Economics extends the analysis to emerging market economies, economies in an early stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world.

The chapter ends with a discussion of where financial regulation might be heading in the aftermath of the global financial crisis. Instead of lecturing on this issue, I have the students themselves speculate on what measures may be needed to prevent a crisis like this from happening again. This gets them to apply the concepts in the chapter and makes for a very spirited discussion.

Chapter 13 Central Banks and the Federal Reserve System Chapters 13–16 explore in detail how monetary policy is conducted. Although most professors covering monetary theory will want to include much of this material in their courses, later chapters on monetary theory do not directly depend on Chapters 13–16, so they can be skipped without loss of continuity. Other professors covering monetary theory may prefer to teach this material after they have taught the chapters on monetary theory.

The chapter starts by discussing how the central bank in the United States—the Federal Reserve System— operates. The basic point that should be driven home in class is that although the Federal Reserve System has a complicated bureaucratic structure, in practice it functions like a single central bank, headquartered in Washington, D.C. Students should enjoy the discussion of how foreign central banks are structured, and how foreign central banks are similar to or differ from the central bank in the United States.

To help the instructor spice up the discussion of the Federal Reserve, I try to provide an inside view of the Fed by including material on such topics as: the political genius of the way the Federal Reserve was set up to preserve its independence; the special role of the Federal Reserve Bank of New York and the research staff in the Federal Reserve System; how a typical FOMC meeting is conducted; the evolution of the Fed’s communication strategy; how Ben Bernanke, Janet Yellen, and Jerome Powell’s style differs from that of the former Chairman of the Fed, Alan Greenspan; how the foreign exchange and open market desks at the Federal Reserve Bank of New York operate; and the increasing attacks by U.S. presidents on the independence of the Fed. To feature this new material I have included some of it in a set of special interest boxes, titled ―Inside the Fed,‖ which provide insights on how the Federal Reserve System operates although they are based on information that is entirely in the public domain.

Students seem to particularly enjoy the next section in the chapter, which discusses the theory of bureaucratic behavior and the related issue of whether or not central banks should be independent. Thus, I recommend focusing on these topics, rather than the detail of the Fed’s and other central banks’ structures, which can be tedious.

In addition to the institutional detail on the Fed that is usually found in money and banking textbooks, Chapter 13 also tries to provide the student with a feel for what motivates central bankers. Furthermore, discussing the theory of bureaucratic behavior shows students that the economic way of thinking is useful in understanding a wider range of problems than they might otherwise have thought.

Until recently, the Federal Reserve had no significant rivals in the central banking world.

This changed in January 1999 with the startup of the European Central Bank (ECB), which now conducts monetary policy for countries that are members of the European Monetary Union, which in total has a population that exceeds that of the United States and a GDP comparable to that of the United States. Because of growing interest by students in the workings of the European Central Bank, the chapter has an extensive discussion of the structure and independence of the European Central Bank. To motivate the students, I focus on how the ECB is similar to the Federal Reserve, and how it differs. The chapter also contains brief descriptions of the structure and independence of three other important central banks of interest to students: the Bank of Canada, the Bank of England, and the Bank of Japan.

Chapter 14 The Money Supply Process This chapter provides an analysis of how the money supply is determined. One point that needs to be emphasized at the outset is that the money supply is not determined solely at the whim of the central bank; rather, there are two other players in the money supply process who also play an important role: banks and depositors. Chapter 14 first extensively discusses the simple model of multiple deposit creation, even though it is unrealistic and does not feature all of the players, because it illustrates the basic principles used later in the chapter. The critique of the simple model of multiple deposit creation then leads to a discussion of the money multiplier and a more complete treatment of the money supply process.

I have found that going over the summary Table 1 with students in class is an excellent device to help them review the money supply model; it gives them an overall and complete picture of how the money supply is determined.

Chapter 14 ends with an application on quantitative easing and the money supply in recent years. There has been tremendous confusion about this topic in the media because many pundits claimed that because quantitative easing has led to an explosion of highpowered money, it will be highly inflationary. However, as the application shows, a change in the Fed’s rules so that it could pay interest on reserves means that a massive expansion of the Fed’s balance sheet is likely to result in only a moderate increase in the money supply, and this is exactly what happened during the global financial crisis and the coronavirus pandemic. This application should convince students that the analysis they have learned is not mere theory, but a useful means of explaining topics that are hotly debated in the media.

This chapter has three appendices in MyLab Economics: The first provides more detail on the Fed’s balance sheet and the factors that affect the monetary base; the second derives the M2 money multiplier and explains the intuition behind it; the third provides an economic analysis of what determines the currency ratio; and the fourth looks at how bank panics during the 1930s affected the money supply. Some instructors may want to cover this material in class because it shows how money supply analysis can be extended to monetary aggregates other than M1 and provides more detail on how the money supply is determined. In addition, it provides students with additional practice in using the concepts they have learned in the chapter.

For instructors who would prefer to deemphasize discussion of the money supply process in their course, this chapter can easily be skipped. I have also found that I can skip this chapter as well.

Chapter 15 Tools of Monetary Policy Chapter 15 examines in detail the tools at the Fed’s (and the European Central Bank’s) disposal for conducting monetary policy. To fully understand how these tools are used in the conduct of monetary policy, this chapter shows how they affect the federal funds rate directly. Students are introduced to the nitty gritty of how the Fed wields these tools and are exposed to current debates on whether Fed policymaking could be made more effective by altering their use of these tools.

To keep the material in this chapter from being too descriptive, I have started the chapter with an analytic analysis of how Federal Reserve actions influence the federal funds rate.

This analysis reflects the changes in the way the market for reserves works because the Fed now pays interest on reserves.

One topic that frequently does not get enough attention in money and banking courses is the lender-of-last-resort function of discounting. I feel this function should be stressed in class because students find it inherently interesting in the wake of the recent massive operations by the Fed during the global financial crisis. Also students will be particularly interested in the section on the nonconventional monetary policy tools used to combat the financial crisis and the Great Recession. Students particularly like to hear about realworld examples of monetary policy actions to avoid banking and financial panics. It is particularly worth discussing in class the examples in the Inside the Fed box on the Federal Reserve’s lender-of-last-resort facilities during the global financial crisis and the coronavirus pandemic.

Chapter 16 The Conduct of Monetary Policy: Strategy and Tactics Chapter 16 outlines the goals, strategies, and tactics of central bank policymaking. It starts by laying out modern theories of central banking: It first discusses the price stability goal and the role of a nominal anchor in solving the time-inconsistency problem, and then discusses the other goals of monetary policy and why price stability is now viewed as the primary goal of monetary policy.

The time-inconsistency problem is one of the most important ideas in monetary theory in the last 30 years. I illustrate the time-inconsistency problem in class by using the example of how many people cannot stick to a diet even though they know this is the right thing for them to do in the long run. Many other examples can bring this idea home to the student. Another good example is the fact that it is optimal not to give in to children when they are behaving badly, but parents still have a tendency to renege on this optimal plan.

A third example is that governments usually provide funds to rebuild in coastal areas after a hurricane, even though it is not optimal to build in areas that are likely to be ravaged by hurricanes. You might ask the students to think of other examples in order to hammer home this important idea.

The chapter then goes on to discuss the monetary policy strategy of inflation targeting, which involves announcement of an inflation target objective, with a commitment by the central bank to achieve it. I was a strong proponent of this policy framework when I was a governor of the Federal Reserve from 2006 to 2008, and the Fed finally adopted an inflation target in 2012, modifying if further in 2019 to focus on an average inflation target. The chapter then discusses how the Fed’s monetary policy strategy evolved to inflation targeting from an earlier monetary policy strategy, what I refer to as the ―Just Do It‖ approach, in which the Fed displayed a strong commitment to control inflation, but did not have an explicit inflation target. There is an additional monetary policy strategy that central banks used in the past, but not currently—monetary targeting. For those instructors who would like to cover this material, I have provided an appendix to Chapter 16 found in MyLab Economics that covers monetary targeting. I have found that discussing the pros and cons of different monetary policy strategies piques students’ interest. One teaching technique is to have students debate which strategy is best.

The chapter concludes the discussion of monetary policy strategy first, with a section on lessons from the global financial crisis. Then it discusses a particularly hot topic in central banking circles after the crisis, the debate on how central banks should respond to asset-price bubbles. Asset-price bubbles are particularly interesting to students because they involve huge booms in asset prices and then crashes, which are very dramatic. The issue of what should be done about asset-price bubbles is very controversial, and so one way of teaching this material is to stage a debate in class with two opposing views: that central banks should not respond at all, which is the position associated with Alan Greenspan, or alternatively, that monetary policy should try to preemptively prick bubbles.

The chapter then moves on to discuss monetary policy tactics: in particular, what policy instrument should be chosen to conduct monetary policy. Figures 3 and 4 illustrate why targeting on a monetary aggregate like nonborrowed reserves implies a loss of control of interest rates like the federal funds rate, while targeting on the federal funds rate implies a loss of control of monetary aggregates. This analysis can also be done in terms of the supply and demand for money framework. Indeed, covering this topic is an excellent way of providing students with another application to give them practice with the supply and demand analysis for the market for reserves or the market for money.

The second tactical issue is how to set a target for the federal funds rate with the so-called Taylor rule. Discussion of the Taylor rule helps students understand that the Fed focuses not only on inflation but also on fluctuations around potential output. The role of the output gap in setting monetary policy follows from Phillips curve theory and the validity of the NAIRU concept. The Phillips curve and NAIRU are very controversial of late, and a discussion of the controversy can engage students in understanding how difficult it is for the Federal Reserve to decide on the appropriate stance of monetary policy.

The chapter has a second appendix in MyLab Economics that provides a historical discussion of how the Fed has conducted monetary policy over the last 90 years. It presents students with many real-world examples that make the study of monetary policy more concrete. It also provides students with a review of the money supply process and how the Fed’s policy tools work, thus giving them another pass at this material, which should solidify their understanding of it. Finally, it will give students some perspective on where monetary policy may be heading in the future.

Chapter 17 The Foreign Exchange Market Chapter 17 explains behavior in the foreign exchange market by using a modern assetmarket approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in the literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in money and banking textbooks.

As the second application in the chapter indicates, the asset-market approach, in contrast to earlier approaches emphasizing import and export demand, can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates. This phenomenon is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile.

The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates.

The key idea that must be transmitted to the student is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets.

To help students achieve an intuitive grasp of how the relative expected return on domestic assets, and hence the demand curve shifts, tell them to put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets. When a factor changes, have them ask themselves whether at the same exchange rate they would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right. This kind of thinking will help them manipulate the demand curve so they can predict which way the exchange rate changes. Several summary tables in the chapter should help students master the material, and I have found that using them in class helps greatly in clarifying the discussion.

The four applications in the chapter on the Economist’s Big Mac Index and PPP, on the response of exchange rates to changes in interest rates, the effect of global financial crisis on the dollar, and the impact of Britain’s exit (Brexit) and the subsequent collapse of the pound, can all be used in class to show students that the material they have learned has practical uses.

In teaching my class, I again describe a recent news report on the foreign exchange markets and then conduct a case discussion using the analysis developed in the chapter.

The case discussion is always very lively and the students love it.

Some instructors like to teach the foreign exchange market at the same time they discuss the bond market and stock market which is what I do. They can do this by teaching this chapter immediately after Chapter 7 if they so choose.

Chapter 18 The International Financial System Chapter 18 shows why international financial transactions have important implications for the conduct of monetary policy. The beginning of the chapter explains how foreign exchange market intervention affects the exchange rate, a country’s international reserves, and the money supply. It then discusses the balance of payments, but this sometimes dry topic can be spiced up for students by a discussion of the box on why large current account deficits worry economists.

The chapter then goes on to discuss the evolution of the international financial system and how fixed exchange rate systems work. Two applications in this section make the material come alive for students. The first examines the September 1992 foreign exchange crisis and recent foreign exchange crises in emerging market countries. This application captures the imagination of students because huge profits were made during this crisis and because government intervention in the markets was massive. The second examines how China has accumulated over $4 trillion of international reserves, a subject of great interest to students. These applications also give students further practice with the model of the foreign exchange market developed in Chapter 17.

The currency and financial crises in recent years have caused policymakers throughout the world to focus on how the architecture of the international financial system might be reformed in order to limit the threat of financial crises. Concerns about international financial architecture have led to a lively debate, to say the least, about the role of the International Monetary Fund and capital controls. I use the discussion in the text on these subjects to stimulate a lively debate among the students, which gets them to realize that what happens outside the United States is still of tremendous importance to us. The next section on international considerations and monetary policy explains how international financial transactions and movements in the exchange rate can affect monetary policy, and this material is closely related to the discussion in Chapter 16 about the conduct of monetary policy.

The final section on exchange rate targeting can be staged as a debate in class of the pros and cons of fixed versus flexible exchange rate regimes and can be linked to the discussion of international financial architecture. Debates can also be staged on the desirability of exchange rate targeting versus other monetary policy strategies such as inflation targeting.

Chapter 19 Quantity Theory, Inflation, and the Demand for Money Chapter 19 discusses two of the basic building blocks of monetary theory, the quantity theory of money and the demand for money, examining how these theories can explain inflation in the long run. This material is more appropriate for a course that emphasizes monetary theory, and many professors will prefer not to cover it. Later chapters do not depend on this material, so dropping it from your course will not hinder students’ ability to understand later chapters.

The chapter starts with the quantity theory of money. The key equation to get students to understand is the equation of exchange in Equation 2, which is then transformed into the quantity theory Equation 4. The quantity theory embedded in Equation 6 is then tested in the application, ―Testing the Quantity Theory of Money,‖ which shows that the theory helps explain long-run inflation.

Using the quantity theory, the next section of the chapter discusses how budget deficits can lead to inflation. Students find this discussion particularly interesting because of the current debates in Congress on reigning in budget deficits. The key to getting students to understand why budget deficits matter to inflation is to emphasize the government budget constraint in Equation 7. The application on the Zimbabwean hyperinflation is fun to discuss in class, not only because it illustrates how budget deficits lead to high inflation but also because Robert Mugabe is famous for destroying his country and hyperinflation is one manifestation of his disastrous policies.

This chapter then describes the two basic approaches to theories of the demand for money: Keynesian theories and portfolio-choice theories. This seems to be the natural way to organize this material. It is important to emphasize in class that a central question in monetary theory is whether the demand for money is affected by changes in interest rates, because this issue is crucial to how we view money’s effect on aggregate economic activity. This is why the discussion in this chapter always focuses on the role of interest rates in the demand for money.

The chapter ends with a discussion of the current state of empirical evidence on the demand for money, and it focuses on two basic questions that are central in monetary theory: (1) How sensitive is the demand for money to changes in interest rates? and (2) Is the demand for money function stable over time? The discussion here is nontechnical but should give the student a feel for how empirical research in economics is done.

Chapter 20 The IS Curve This chapter introduces the basic concept of aggregate demand and develops one of the key building blocks of the AD/AS model, the IS curve. The framework here is pretty conventional, first outlining the components of planned expenditure—consumption expenditure, planned investment spending, government purchases, and net exports. Then the chapter goes into detail about goods market equilibrium, when planned equals actual expenditure, and shows how this equilibrium generates the IS curve, the relationship between the real interest rate and equilibrium output. Spending a fair amount of time in class on the concept of goods market equilibrium, and why the economy will gravitate to this equilibrium, is worthwhile because this concept is so important to short-run macroeconomic analysis.

One element of the framework here that is not conventional is that I build directly into the IS curve the impact of financial frictions on aggregate demand. After the global financial crisis, it is now imperative to discuss the interaction of finance and the macroeconomy and this is done at the outset in this textbook’s discussion of monetary theory.

The chapter then goes on to provide a deeper understanding of the IS curve by explaining the intuition behind it, using a numerical example to explain it with mathematics Then the chapter takes the student through all the factors that shift the IS curve and explains the intuition for how each factor shifts the IS curve. The application of the Vietnam War buildup from 1964 to 1969 and its effect on the economy shows that the IS curve analysis is a useful one for explaining interesting historical episodes (and the Vietnam War period is one close to my heart because it had such a big impact on my generation). Discussion of the application on the fiscal stimulus package of 2009 also shows students that the analysis in this chapter is useful for understanding more recent events.

One teaching device that I have found helps students develop their intuition is the use of Summary Table 1 in class. You can use the blackboard to write a list of changes in variables that shift the IS curve and ask students to fill in the table by saying which way the IS curve shifts in response to each change and explaining what the reasoning is. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout this part of the book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly.

Chapter 21 The Monetary Policy and Aggregate Demand Curves Chapter 21 develops two other building blocks of the AD/AS framework, the monetary policy curve and the aggregate demand curve. It explains why monetary policymakers raise interest rates when inflation rises so that there is a positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve. It also explains that shifts in monetary policy involve autonomous easing or tightening of monetary policy, which involve changes in the real interest rate for a given level of inflation. Students often struggle with the difference between movements along the MP curve and shifts in the MP curve. Two applications help clarify this for students: ‟Movement Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 and 2015–2019,‖ and ―Autonomous Monetary Easing During the Global Financial and Coronavirus Crises.‖ These two applications provide useful illustration to cover in class to hammer home the distinction between movements along and shifts in the MP curve.

The chapter then goes on to use the MP curve with the IS curve from Chapter 20 to derive the aggregate demand (AD) curve, a key element in the AD/AS framework. The AD curve has the usual downward slope, but in contrast to the more traditional AD curve in other textbooks, it displays a negative relationship between inflation (instead of the price level) and aggregate demand. The AD curve is derived both graphically and with a numerical example to hone students’ intuition, and students are shown that the factors that shift the IS curve are the same ones that shift the AD curve in exactly the same direction.

Chapter 22 Aggregate Demand and Supply Analysis The basic tool used to analyze the role of money in the economy in this book is a dynamic aggregate demand and supply analysis. The aggregate demand/aggregate supply model in this book differs from that in many other textbooks because it is inherently dynamic and emphasizes the interaction of inflation and economic activity. In contrast to older AD/AS frameworks that have the price level on the vertical axis, the dynamic AD/AS approach in this textbook has inflation on the vertical axis.

There are several advantages to the approach used here. First, students have to learn only one model to understand fluctuations in output and inflation, the AD/AS model here, while older approaches require two models, the ISLM model and then a separate AD/AS model. Learning just one model is almost always easier than learning two. Second, the dynamic AD/AS model used here directly allows analysis of the interaction of inflation and economic activity, a key feature of modern macroeconomic analysis. Third, because the model directly builds in expectations as a central element, it can far more directly deal with current policy discussions about the importance of credibility to the success of macro policies and the benefits of adopting a strong nominal anchor like an inflation target in conducting monetary policy.

The chapter starts with a discussion of business cycles and inflation movements, which is what aggregate demand and supply analysis seeks to explain. The chapter then starts to build the AD/AS model by first providing a recap of the aggregate demand curve. There are two reasons for doing so. First, it drives home the intuition behind the aggregate demand curve, and recaps like this are a good way of getting students to really understand the material. Second, many instructors who are pressed for time might not want to go into so much detail about the derivation of the aggregate demand curve and so would prefer to skip Chapters 20 and 21. The recap in Chapter 22 allows instructors to skip Chapters 20 and 21 and still get across the major ideas in monetary theory. In teaching this material, it is again useful in class to make use of the teaching device of the Summary Table 1, which summarizes what factors cause the aggregate demand and supply curves to shift. Listing changes in the variables that shift the AD curve and then asking students to fill in the tables by saying which way the curve will shift and the reasons behind the shift will give them the practice they need to master the aggregate demand curve.

The chapter then develops the remaining building block of the AD/AS framework, the aggregate supply curve. This chapter develops the aggregate supply intuitively, stressing that the long-run aggregate supply curve is a vertical line determined by the amount of capital in the economy, the amount of labor supplied at full (the natural rate level of) employment, and the available technology. It develops the short-run aggregate supply curve using the intuition that there are three factors that drive inflation: (1) expectations of inflation, (2) output gap, and (3) price (supply) shocks. The Summary Table 2 can be used to hone students’ intuition by listing changes in the variables that shift the short-run AS curve and then asking students to fill in the tables by saying which way the curve will shift and the reasons behind the shift. This intuitive approach to understanding the aggregate supply curve works extremely well with students, but some instructors will want to delve deeper into the theory behind the short-run aggregate supply curve and show that it is developed from a Phillips curve analysis and Okun’s law. The appendix at the end of the chapter allows them to do this. The next step is to describe the equilibrium in AD/AS analysis, while getting across the key point that there are two equilibria. The short-run equilibrium occurs at the intersection of the AD curve with the short-run AS curve, while the long-run equilibrium occurs at the intersection of the AD curve and the long-run aggregate supply curve. The chapter then shows them how the economy has a self-correcting mechanism because over time, a sequence of short-run equilibria lead the economy to go to the longrun equilibrium at which output returns to potential and the economy is at full employment.

Starting with Figure 11, the AD/AS diagram is converted to one with an aggregate output index (where it has a value of 100 when aggregate output equals potential output) on the horizontal axis rather than aggregate output. This is the AD/AS diagram that is used throughout the rest of the text. It has the important advantage that the output gap, which is what tells us how well the economy is doing in the short run, is immediately obtained from the equilibrium value of the aggregate output index, and so enables the instructor to talk about actual business cycle output gaps, rather than hypothetical numbers, making AD/AS analysis more real world.

The rest of the chapter shows how inflation and equilibrium output changes as a result of either aggregate demand shocks or aggregate supply (inflation) shocks. To drive home the analysis and also show students how useful the AD/AS model is, the chapter goes through a large number of applications, which describe business cycle episodes with actual numbers. The first ―The Volcker Disinflation, 1980–1986‖ demonstrates how the economy responded to demand shocks. The next, ―Negative Supply Shocks, 1973–1975‖ and 1978–1980,‖ demonstrate how the economy responded to supply shocks. The chapter ends with two applications, ―AD/AS analysis of the Great Recession of 2007–2009‖ and ―An AD/AS Analysis of the Covid-19 Recession,‖ which describe what happened during the two most recent recessions. They show how the economy can be devastated by the double whammy of adverse supply and demand shocks. All of these applications are selfcontained, so an instructor can pick and choose the ones he or she would like to teach in class. However, I think there is nothing more fun than to explain important historical episodes, which all of the applications do, and show how powerful economic models can be used to explain real-world phenomena.

In order to bring international factors into the aggregate demand and supply analysis of the chapter, net exports are included in the definition of aggregate demand. This enables the instructor to discuss how international trade flows can affect aggregate output and inflation. If the instructor wants to stick with a closed-economy framework, he or she can easily ignore the material in the chapter that deals with international trade by just leaving net exports out of his or her discussion. None of the basic analysis in this or later chapters will be affected by this choice. However, if the instructor wants to fully internationalize the course, he or she might want to teach Chapters 17 and 18, which provide a more complete description of how monetary policy affects foreign exchange rates, before teaching this chapter.

For those instructors who want to spend more time on monetary theory and delve deeper into the dynamic AD/AS model, the chapter has one appendix in the text and two others available in MyLab Economics. For instructors who like to discuss the Phillips curve, the appendix in the text describes the relationship between the Phillips curve and the shortrun aggregate supply curve. The first appendix in MyLab Economics, ―The Effects of Macroeconomic Shocks on Asset Prices,‖ is worth teaching to students who are interested in pursuing careers in finance. It shows how the AD/AS model can explain how macroeconomic events that students are seeing reported in the media every day affect both stock prices and interest rates. The second appendix in MyLab Economics provides an algebraic example of aggregate demand and supply analysis. This appendix allows the instructor to bring in more mathematics to the treatment of monetary theory for students who are more mathematically inclined.

Chapter 23 Monetary Policy Theory Chapter 23 brings a new set of actors into the AD/AS framework—policymakers—and develops the theory behind monetary policy making, examining how monetary policymakers react to shocks to the economy in order to stabilize both inflation and economic activity. One unique feature of the dynamic AD/AS framework in this book is that it can address policy questions that other frameworks cannot, such as ―When does stabilizing inflation, stabilize output (i.e., when does the divine coincidence occur)?‖ The chapter starts by seeing how policymakers respond to shocks to aggregate demand or aggregate supply to achieve these objectives. The analysis in the chapter makes clear that stabilizing inflation stabilizes economic activity, so there is no policy tradeoff, except when there are shocks to aggregate demand or permanent shocks to aggregate supply. On the other hand, temporary shocks to aggregate supply do involve a policy tradeoff because in this case stabilizing inflation does not stabilize economic activity.

Another big issue in macroeconomics is whether policymakers should be activist—that is, respond aggressively to fluctuations in economic activity—or alternatively, not respond and be nonactivist. One way of bringing home to the students the importance of this issue is to discuss in class the box on the activist/nonactivist debate over the Obama fiscal stimulus package.

The chapter also discusses what causes inflation and one of the most famous adages in macroeconomics, coined by Milton Friedman: ―Inflation is always and everywhere a monetary phenomenon.‖ It then delves more deeply into why inflationary monetary policy occurs. The AD/AS model shows that overly expansionary monetary policy that leads to high inflation can occur when the policymakers try to achieve high employment targets. The application on the Great Inflation shows students that this is not just a theoretical possibility, but actually occurred from the late 1960s to the early 1980s.

The chapter ends with a discussion of monetary policy at the effective lower bound, which is of great interest currently because the Federal Reserve cannot lower the federal funds rate much below zero and so has to resort to nonconventional monetary policy. The dynamic aggregate demand and supply framework in this text is especially suited to explaining the impact of the zero lower bound and how nonconventional monetary policy works in this situation. The first step is to show students how the zero lower bound results in a backward bending aggregate demand curve, which means that the selfcorrecting mechanism is no longer operational. Applying this analysis then allows the instructor to show how nonconventional monetary policy and quantitative easing works.

To show students how relevant this analysis is it can be used to show how the historic shift in Japanese monetary policy in 2013, which has been dubbed Abenomics, might help get the Japanese economy out of the funk it has been in for the last 15 years.

Chapter 24 The Role of Expectations in Monetary Policy Over the last 30 years, the role of the public and the market’s expectations has moved to the front and center of the thinking about how the macro economy works. Chapter 24 discusses the most widely used theory to describe the formation of household and business expectations—rational expectations—and develops it from microeconomic principles. Using the AD/AS model developed earlier in the book, it then explores how this theory has shaped current policy-making and debates.

The chapter starts by using the concept of rational expectations introduced in Chapter 7 to discuss one of the most important ideas in macroeconomics in the last 30 years, the Lucas critique, which says that macro-econometric relationships based on past data will change when the way policy is done is changed, so that policy evaluation with these models can be very misleading. The intuition behind the Lucas critique is illustrated in an application with a simple example using the consumption function. There are numerous other examples an instructor might want to discuss in class.

The chapter next turns to a set of policy issues. The first is the debate over whether policymakers should follow rules or instead conduct policy with complete discretion, in which policy is conducted on a day-to-day basis. The argument for rules is based on the time-inconsistency problem, another one of the most important ideas in macroeconomics over the last 30 years. The problem with discretion is that policymakers can’t commit to good long-run strategies. Instead they have incentives to renege on the good strategy and therefore pursue policy that leads to poor outcomes. I like to illustrate this concept in class by presenting everyday examples. One is how we eat. We don’t want to eat unhealthy food, but when we see that juicy hamburger, we just can’t resist it. Another example is the inability to stay on a diet, as discussed in the text. I also like discussing the problem of child rearing and the temptation to give in to bad behavior. This example also illustrates why having a rule helps solve the time-inconsistency problem. Rules, however, ―are made to be broken,‖ as the adage says. The application ―The Political Business Cycle and Richard Nixon‖ provides a graphic historical example of the timeinconsistency problem at work, while the second Policy and Practice box, ―The Demise of Monetary Targeting in Switzerland,‖ illustrates how following rules can lead to policy mistakes. A solution to the problems with both rules and complete discretion is provided by the concept of ―constrained discretion,‖ a term that Ben Bernanke and I coined in a paper published in 1997. Constrained discretion imposes rule-like behavior on policymakers by imposing a discipline on them, but one that allows for some flexibility.

This is exactly the approach in the policy framework of inflation targeting, which was discussed in Chapter 16.

The next policy issue the chapter discusses is the role of credibility and a nominal anchor.

Here, the rational expectations conclusion that expectations about policy affect inflation expectations is embedded in the AD/AS model, which is then used to show that having a credible commitment to a nominal anchor produces better outcomes on both inflation and output when there are either demand or supply shocks. To demonstrate to students that the analysis is relevant to real-world outcomes, it is worth discussing in class the application ―A Tale of Three Oil Shocks‖ to show that a surge in oil prices has adverse affects on the economy when the commitment to a nominal anchor is weak, as occurred in the two oil price shocks in the 1970s. On the other hand, when the Federal Reserve commitment to the nominal anchor of controlling inflation was strong, then an oil price shock like that in 2007 did not have as adverse consequences (although the financial crisis did).

Students also enjoy historical examples showing how credibility is critical to the success of anti-inflation policies. The box on ending the Bolivian hyperinflation drives home the importance of credibility because it is so dramatic. The application that discusses credibility and the Reagan budget deficits asks the student to use the analysis he or she has learned in this chapter to see if Reagan’s budget deficits might have made antiinflation policy in that period less successful. The application not only gives students additional practice in using the material they have learned but also shows them that this material is important in current policy debates.

The final section of the chapter discusses different approaches to establishing a credible nominal anchor. Besides the approaches of inflation targeting, outlined in Chapter 16, and exchange rate targeting, discussed in Chapter 18, this chapter discusses a variant of the inflation targeting approach, nominal GDP targeting, which has received a lot of attention lately. It also discusses an additional approach, the appointment of inflation hawks (dubbed ―conservative‖ by Ken Rogoff) to head central banks. The Inside the Fed box, ―The Appointment of Paul Volcker,‖ shows students that this strategy has indeed been used in the past when Paul Volcker was appointed as Fed Chairman in 1979.

Chapter 25 Transmission Mechanisms of Monetary Policy Chapter 25 discusses the transmission mechanisms of monetary policy so that students can understand how monetary policy affects the economy. The two applications on monetary transmission mechanisms during the Great Recession and the lessons this research provide to monetary policymaking for Japan also stimulate student interest.

An appendix in MyLab Economics discusses the empirical evidence on whether or not money is important to aggregate economic activity and provides the student with an understanding of the transmission mechanisms of monetary policy. I teach this material because it gives students a feel for how tricky it is to interpret empirical evidence in economics and other social sciences. The appendix starts off by dichotomizing evidence into two types: reduced-form versus structural-model evidence. I have found that the best way to teach the difference between these two types of evidence and the advantages and disadvantages of each type is to give several analogies. The link between coffee drinking and heart disease mentioned in the chapter is one useful analogy; others include the link between cholesterol and heart disease or jogging and long life. Explaining why correlation does not imply causation is also helped by stories such as the boxes on the Russian folktale or how to lose an election in Box 2. Students find these stories to be fun, and they really drive the point home.

Once students understand the advantages and disadvantages of reduced-form versus structural-model evidence, encourage them to discuss the problems with the Keynesian and monetarist evidence described in the appendix in order to give them practice in using this knowledge. An important point to stress is that evidence is much easier to interpret if we have controlled experiments in which an event is exogenous; we can then look for what happens afterward.

The ability to conduct controlled experiments in the hard sciences is one reason why empirical evidence in these sciences is so much more persuasive than in economics. This discussion also suggests why economists frequently look for exogenous events in evaluating empirical evidence: It makes the evidence stronger and easier to interpret, as is the case for monetarist historical evidence.

Web Chapter 1 Financial Crises in Emerging Market Economies This MyLab chapter is for instructors who want to have a more international orientation of their courses. It extends the analysis in Chapter 12 on financial crises to economies that are just entering the world marketplace. The analysis is parallel to that in Chapter 12, with Figure 1, which is similar to Figure 1 in Chapter 12, outlining the dynamics of financial crises in emerging market economies. Then the chapter takes students through two detailed applications, South Korea in 1997–1998 and Argentina in 2001–2002, to illustrate how useful the analysis in the chapter is.

I have found that my students particularly enjoy the discussion of the crazy government policies that promote financial crises in emerging market countries, and I spend a lot of time on this in the case on South Korea because of the perverse policies to help out the chaebols, who had an enormous influence on South Korean politics. Similarly, I spend a lot of time in the case on Argentina discussing how severe fiscal imbalances led to policies that encouraged banks to take on government debt, which eventually was to be their downfall.

Once the case discussions are finished, students can use the material at the end of the chapter to debate differing policies to prevent future emerging market financial crises.

They also enjoy the global box on the Icelandic financial crisis, because it illustrates how advanced economies can find themselves in similar circumstances to emerging market economies and be subjected to the enormous costs of financial crises.

Web Chapter 2 Nonbank Finance This MyLab chapter supplements Chapter 2 by going into greater detail about the structure and regulation of nonbank financial institutions. To again stress the economic way of thinking, the chapter has a section that applies the concepts of moral hazard and adverse selection to explain many principles of insurance management. These concepts are also utilized in a section on government financial intermediation to look at the potential crisis that is brewing because of government loan guarantees. In addition, this chapter differs from more conventional chapters in other textbooks by stressing a more dynamic, analytical framework that explains why many nonbank financial institutions have been growing so rapidly in recent years.

Student interest can also be stimulated by class discussion of special interest boxes on whether social security should be privatized, the AIG blowup, and the bailout of Fannie Mae and Freddie Mac during the global financial crisis.

Web Chapter 3 Financial Derivatives The treatment of financial derivatives markets (forwards, futures, options, and swaps) in this book differs markedly from that in other money and banking textbooks. Financial derivatives are approached from the perspective of managers of financial institutions, and this is why this material is placed in the financial institutions part of the book. Rather than go into a lot of facts about these different markets, this chapter focuses on how the markets work and how they can be used to hedge the risk faced by financial institutions. This approach makes more sense to students who now clearly see why studying these markets and their operation is relevant.

One problem that I have encountered in teaching students about financial derivatives is that many do not find the financial derivative contracts to be particularly intuitive. In order to get them to understand how these contracts work, I find it helps to first discuss what hedging is and drive home the principal that hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or vice versa. Then I find it important to walk them through a numerical example in class that shows them what the profits are for these contracts given different outcomes. In addition, to hammer home how these contracts work, this chapter contains several applications that provide specific examples of how hedges are conducted with financial futures, forward contracts, options, and swaps. I know of no other money and banking textbook that takes as applied an approach to teaching students about financial futures and forward contracts as I do in this book. My experience is that only with applications of the type found in this chapter can students have any real understanding of what financial derivatives are all about.

Other money and banking textbooks tend to give only a cursory treatment of what profits arise for a holder of an option contract given different market outcomes. They may have a figure illustrating the profits, but do not give a detailed explanation of how profits are generated. I think that this is a terrible mistake because students often do not find financial derivatives contracts to be particularly intuitive, and this is particularly true for the options contract. This chapter takes a different approach by containing an extensive explanation and discussion of Figure 1, which outlines the profits and losses that occur on financial options and futures contracts depending on what happens to the price of bonds.

To get the students to understand these contracts and what their differences are, the instructor needs to carefully walk the students through the numerical example of Figure 1. My experience in class suggests that unless this is done, many students will just not understand what these financial derivatives, and particularly options, are all about.

Web Chapter 4 Conflicts of Interest in the Financial Industry Recent corporate and accounting scandals have attracted tremendous public attention and are of particular interest to students because resulting bankruptcies have cost employees of these firms their jobs and their pensions, and because the scandals may have hampered the efficient functioning of the financial system.

In addition, the growing concerns about the proliferation and effects of conflicts of interest have resulted in the decision of many business schools to add business ethics courses to their curriculums. This chapter allows the instructor to discuss ethical issues, but with the analysis grounded on the asymmetric information concepts featured so prominently in this book.

When I teach this material, I start by emphasizing that conflicts of interest occur when people who are supposed to act in the interests of the investing public by providing them with reliable information instead have incentives (conflicting interests) to deceive the public to benefit themselves and their corporate clients.

I then encourage the students to discuss which conflicts of interest arise in different sectors of the financial services industry. Then I emphasize how central information issues are in understanding why conflicts of interest occur and what remedies make sense to deal with them. The key point that comes out of this analysis is that conflicts of interest are only damaging if they reduce information flows in financial markets. This information-based framework for evaluating conflicts of interest raises two key points: (1) The fact that a conflict of interest exists does not necessarily have adverse consequences and (2) even if incentives to exploit conflicts of interest remain strong, eliminating the economies of scope that create the conflicts of interest may be harmful because it might reduce the flow of reliable information.

The chapter ends by describing five approaches to remedying conflicts of interest: (1) leave it to the market, (2) regulate for transparency, (3) supervisory oversight, (4) separation of functions, and (5) socialization of information production. Teaching the case at the end of the chapter that applies the analysis to Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill of 2010 hammers home the basic concepts of the chapter and shows the students that the asymmetric information approach developed in this chapter can help them understand how conflicts of interest should be dealt with.

PART THREE

Answers to End-of-Chapter Questions and Problems

Chapter 1 ANSWERS TO QUESTIONS 1. What is the typical relationship among interest rates on three-month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?

The interest rate on three-month Treasury bills fluctuates more than the other interest rates and is lower on average. The interest rate on Baa corporate bonds is higher on average than the other interest rates.

2. What effect might a fall in stock prices have on business investment?

The lower price for a firm’s shares means that it can raise a smaller amount of funds, so investment in facilities and equipment will fall.

3. Explain the main difference between a bond and a common stock.

A bond is a debt instrument, which entitles the owner to receive periodic amounts of money (predetermined by the characteristics of the bond) until its maturity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state that stockholders are residual claimants (i.e., the corporation has to pay all bondholders before paying stockholders).

4. Explain the link between well-performing financial markets and economic growth.

Name one channel through which financial markets might affect economic growth and poverty.

Well-performing financial markets tend to allocate funds to its more efficient use, thereby allowing the best investment opportunities to be undertaken. The improvement in the allocation of funds results in a more efficient economy, which stimulates economic growth (and thereby poverty reduction).

5. What was the main cause of the recession that began in 2007?

The U.S. economy was hit by the worst financial crisis since the Great Depression.

Defaults in subprime residential mortgages led to major losses in financial institutions, producing not only numerous bank failures but also the demise of two of the largest investment banks in the United States. These factors led to the ―Great Recession‖ that began late in 2007.

6. Can you think of a reason why people in general do not lend money to one another to buy a house or a car? How would your answer explain the existence of banks?

In general, people do not lend large amounts of money to one another because of several information problems. In particular, people do not know about the capacity of other people of repaying their debts, or the effort they will provide to repay their debts.

Financial intermediaries, in particular commercial banks, tend to solve these problems by acquiring information about potential borrowers and writing and enforcing contracts that encourage lenders to repay their debt and/or maintain the value of the collateral.

7. What are the other important financial intermediaries in the economy, besides banks?

Savings and loan associations, mutual savings banks, credit unions, insurance

companies, mutual funds, pension funds, and finance companies.

8. Can you date the latest financial crisis in the United States or in Europe? Are there reasons to think that these crises might have been related? Why? The latest financial crisis in the United States and Europe occurred in 2007–2009. At the beginning, it hit mostly the U.S. financial system, but it then quickly moved to Europe, since financial markets are highly interconnected. One specific way in which these markets were related is that some financial intermediaries in Europe held securities backed by mortgages originated in the United States, and when these securities lost their a considerable part of their value, the balance sheet of European financial intermediaries was adversely affected.

9. Has the inflation rate in the United States increased or decreased in the past few years? What about interest rates?

Since 2015, inflation has been around 2%, with some brief dips in 2015 and 2020. In 2015, the interest rate on three-month Treasury bills was near zero, and it then rose to just over 2% in 2019, only to fall back near to zero in 2020.10. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to a. real output? b. the inflation rate? c. interest rates?

The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest rates would all fall.

11. When interest rates decrease, how might businesses and consumers change their economic behavior?

Businesses would increase investment spending because the cost of financing this spending is now lower, and consumers would be more likely to purchase a house or a car because the cost of financing their purchase is lower.

12. Is everybody worse off when interest rates rise?

No. It is true that people who borrow to purchase a house or a car are worse off because it costs them more to finance their purchase; however, savers benefit because they can earn higher interest rates on their savings.

13. Why do managers of financial institutions care so much about the activities of the Federal Reserve System?

Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.

14. How does the current size of the U.S. budget deficit compare to the historical budget deficit or surplus for the time period since 1950?

The deficit as a percentage of GDP expanded dramatically in 2007 but improved starting in 2010; in 2009, the deficit to GDP ratio was 9.8%, and in 2016 was 3.2%,.

However, by 2019 it increased to 4.6%, then sharply increased further in 2020 as a result of the coronavirus pandemic, and still above the historical average of around 2% since 1950.

15. How would a fall in the value of the pound sterling affect British consumers?

It makes foreign goods more expensive, so British consumers will buy fewer foreign goods and more domestic goods.

16. How would an increase in the value of the pound sterling affect American businesses?

It makes British goods more expensive relative to American goods. Thus, American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise.

17. How can changes in foreign exchange rates affect the profitability of financial institutions?

Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets. Also changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions.

18. According to Figure 8, in which years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London?

In the mid-to-late 1970s, the late 1980s to early 1990s, and 2008 to 2015, the value of the dollar was low, making travel abroad relatively more expensive; thus, it was a good time to vacation in the United States and see the Grand Canyon. With the rise in the dollar’s value in the early 1980s, late 1990s, and after 2015, travel abroad became relatively cheaper, making it a good time to visit the Tower of London. This was also true, to a lesser extent, in the early 2000s.

19. When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American-made or foreign-made jeans? Are U.S. companies that manufacture jeans happier when the dollar is strong or when it is weak? What about an American company that is in the business of importing jeans into the United States?

When the dollar increases in value, foreign goods become less expensive relative to American goods; thus, you are more likely to buy French-made jeans than Americanmade jeans. The resulting drop in demand for American-made jeans because of the strong dollar hurts American jeans manufacturers. On the other hand, the American company that imports jeans into the United States now finds that the demand for its product has risen, so it is better off when the dollar is strong.

20. Much of the U.S. government debt is held by foreign investors as Treasury bonds and bills. How do fluctuations in the dollar exchange rate affect the value of that debt held by foreigners?

As the dollar becomes stronger (worth more) relative to a foreign currency, one dollar is equivalent to (can be exchanged for) more foreign currency. Thus, for a given face

value of bond holdings, a stronger dollar will yield more home currency to foreigners, so the asset will be worth more to foreign investors. Likewise, a weak dollar will lead to foreign bond holdings worth less to foreigners.

ANSWERS TO APPLIED PROBLEMS 21. The following table lists the foreign exchange rate between U.S. dollars and British pounds (GBP) during May 2020. Which day would have been the best for converting $200 into British pounds? Which day would have been the worst? What would be the difference in pounds?

Date

$/£

Date

$/£

05-01 05-04

1.2509 1.2430

05-18 05-19

1.2211 1.2255

05-05

1.2449

05-20

1.2257

05-06

1.2347

05-21

1.2227

05-07

1.2349

05-22

1.2178

05-08

1.2436

05-25

NA

05-11

1.2330

05-26

1.2337

05-12

1.2299

05-27

1.2231

05-13

1.2225

05-28

1.2325

05-14 05-15

1.2194 1.2129

05-29

1.2320

The best day is 5/15. At a rate of $1.2129/pound, you would have £164.89. The worst day is 5/01. At $1.2509/pound, you would have £159.88, or a difference of £5.01.

ANSWERS TO DATA ANALYSIS PROBLEMS 1.

Go to the St. Louis Federal Reserve FRED database and find data on the threemonth Treasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate (CPN3M), the 30-year Treasury bond rate (GS30), the 30-year fixed rate mortgage average (MORTGAGE30US), and the NBER recession indicators (USREC). For the mortgage rate indicator, set the frequency setting to ‟monthly.‖ a. In general, how do these interest rates behave during expansionary periods?

Generally speaking, the interest rates fall during recessions and rise during expansionary periods. b. In general, how do the three-month interest rates compare to the 30-year rates?

How do the Treasury rates compare to the respective commercial paper and mortgage rates?

In nearly all instances, the 30-year rates are significantly higher than the threemonth rates. Likewise, in most cases, the 30-year mortgage rate is higher than the 30-year Treasury rate, and the three-month commercial paper rate is higher than the three-month Treasury rate. c. For the most recent available month of data, take the average of each of the three-month rates and compare it to the average of the three-month rates from

January 2000. How do the averages compare? d. For the most recent available month of data, take the average of each of the 30year rates and compare it to the average of the 30-year rates from January 2000.

How do the averages compare?

June 2020

January 2000

Three-month rate avg.

0.17

5.53

30-year rate avg.

2.33

7.42

See the table above. For both rate averages, they have decreased significantly since January 2000.

2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 money supply (M1SL) and the 10-year Treasury bond rate (GS10). Add the two series into a single graph by using the ―Add Data Series‖ feature. Transform the M1 money supply variable into the M1 growth rate by adjusting the units for the M1 money supply to ―Percent Change from Year Ago.‖ a. In general, how have the growth rate of the M1 money supply and the 10-year Treasury bond rate behaved during recessions and during expansionary periods since the year 2000?

Generally, the 10-year Treasury rate fell during the recessionary periods of 2001 and 2007–2009; during expansionary periods, there was less of a pattern, but there seems to be a long-run downward trend in the interest rate. The money growth rate increased significantly during recessionary periods; however, during expansions, there is less of a pattern; following the 2001 recession, money growth gradually declined, but after the 2007–2009 recession, money growth was relatively high and variable. b. In general, is there an obvious, stable relationship between money growth and the 10-year interest rate since the year 2000?

When money growth rises, the 10-year Treasury rate appears to fall, and vice versa; however, this effect is more obvious over some periods than others.

c. Compare the money growth rate and the 10-year interest rate for the most recent month available to the rates for January 2000. How do the rates compare?

May M1 Money Growth 10-year Treasury rate

2020

January 2000

33.49

2.19

0.67

6.66

The money growth rate is significantly higher in May 2020 than it was in January 2000.

The 10-year Treasury rate is significantly lower in May 2020 than it was in January 2000.

Chapter 2 ANSWERS TO QUESTIONS 1. If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next year because it enables me to get a job as a traveling salesman, should I take out a loan from Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan sharking?

Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $5,500. Since Larry’s loansharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.)

2. Some economists suspect that one of the reasons economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly.

3. Give at least three examples of a situation in which financial markets allow consumers to better time their purchases.

Examples of how financial markets allow consumers to better time their purchases include: 

The purchase of a durable good, like a car or furniture.



Paying for tuition.



Paying the cost of repairing a flooded basement.

In all three cases, consumers were able to pay for a good or service (education or the reparation of a flooded basement) without having to wait to save enough and only then being able to afford such goods and services.

4. If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why? You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.

5. Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrument considered a Eurobond? How would your answer change if the bond were sold in New York?

If the yen-denominated bond is sold in Tokyo, then it is not considered a Eurobond. If the bond is sold in New York, then it is considered a Eurobond.

6. Describe who issues each of the following money market instruments: a. Treasury bills b. Certificates of deposit c. Commercial paper d. Repurchase agreement e. Fed funds Treasury bills are short-term debt instruments issued by the U.S. government to cover immediate spending obligations, that is, finance deficit spending. Certificates of deposit (CD) are issued by banks and sold to depositors. Corporations and large banks issue commercial paper as a method of short-term funding in debt markets. Repos are issued primarily by banks and funded by corporations and other banks through loans in which Treasury bills serve as collateral, with an explicit agreement to pay off the debt (repurchase the treasuries) in the near future. Fed funds are overnight loans from one bank to another.

7. What is the difference between a mortgage and a mortgage-backed security?

Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans. Mortgagebacked securities are bond-like debt instruments that are backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holders of the security. In other words, when an individual takes out a mortgage, that loan is bundled with other individual mortgages to create a composite debt instrument, which is then sold to investors.

8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a railroad system. Why did this make both countries better off?

The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads.

9. A significant number of European banks held large amounts of assets as mortgagebacked securities derived from the U.S. housing market, which crashed after 2006.

How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

The international trade of mortgage-backed securities is generally beneficial in that the European banks that held the mortgages could earn a return on those holdings, while providing needed capital to U.S. financial markets to support borrowing for new home construction and other productive uses. In this sense, both European banks and U.S. borrowers should have benefitted. However, with the sharp decline in the U.S. housing market, default rates on mortgages rose sharply, and the value of the mortgage-backed securities held by European banks fell sharply. Even though the financial crisis began primarily in the United States as a housing downturn, it significantly affected European markets; Europe would have been much less affected without such internationalization of financial markets.

10. How does risk-sharing benefit both financial intermediaries and private investors?

Financial intermediaries benefit by carrying risk at relatively low transaction costs.

Since higher risk assets on average earn a higher return, financial intermediaries can earn a profit on a diversified portfolio of risky assets. Individual investors benefit by earning returns on a pooled collection of assets issued by financial intermediaries at lower risk. The financial intermediary lowers risk to individual investors through the pooling of assets.

11. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk-taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.

12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection?

The issuance of subprime mortgages represents lenders loaning money to the pool of potential homeowners who are the highest credit risk and have the lowest net wealth and other financial resources. In other words, this group of borrowers most in need of mortgage credit was also the highest risk to lenders, a perfect example of adverse selection.

13. Why do loan sharks worry less about moral hazard in connection with their borrowers than some other lenders do?

Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize their paying off the loan. Hence, borrowers from a loan shark are less likely to increase moral hazard.

14. If you are an employer, what kinds of moral hazard problems might you worry about with regard to your employees?

They might not work hard enough while you are not looking or may steal or commit fraud.

15. If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard problem still exist?

Yes, because even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so the problem of moral hazard still exists.

16. ―In a world without information costs and transaction costs, financial intermediaries would not exist.‖ Is this statement true, false, or uncertain? Explain your answer.

True. If there are no informational or transactions costs, people could make loans to each other at no cost and would thus have no need for financial intermediaries.

17. Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate, rather than lend her the funds yourself?

Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor.

18. How do conflicts of interest make the asymmetric information problem worse?

Potentially competing interests may lead an individual or firm to conceal information or disseminate misleading information. A substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient. That is, false information as a result of a conflict of interest can lead to a more inefficient allocation of capital than just asymmetric information alone.

19. How can the provision of several types of financial services by one firm be both beneficial and problematic?

Financial firms that provide multiple types of financial services can be more efficient through economies of scope that is, by lowering the cost of information production.

However, this can be problematic since it can also lead to conflicts of interest, in which the financial firm provides false or misleading information to protect its own interests. This can lead to a worsening of the asymmetric information problem, making financial markets less efficient.

20. If you were going to get a loan to purchase a new car, which financial intermediary would you use: a credit union, a pension fund, or an investment bank?

You would likely use a credit union if you were a member, since their primary business is consumer loans. In some cases, it is possible to borrow directly from pension funds, but it can come with high borrowing costs and tax implications.

Investment banks do not provide loans to the general public.

21. Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing market?

Most life insurance companies hold large amounts of corporate bonds and mortgage assets; thus, poor corporate profits or a downturn in the housing market can significantly adversely impact the value of asset holdings of insurance companies.

22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit on insured losses to bank depositors from $100,000 per account to $250,000 per account. How would this help stabilize the financial system?

During the financial panic, regulators were concerned that depositors worried their banks would fail, and that depositors (especially with accounts over $100,000) would

pull money from banks, leaving cash-starved banks with even less cash to satisfy customer demands and day-to-day operations. This could create a contagious bank panic in which otherwise healthy banks would fail. Raising the insurance limit would reassure depositors that their money was safe in banks and prevent a bank panic, helping to stabilize the financial system.

23. Financial regulation is similar, but not exactly the same, in industrialized countries.

Discuss why it might be desirable—or undesirable—to have the same financial regulation across industrialized countries.

This is a topic for which there is no clear answer. On one side, it would be beneficial to have financial regulations that are identical in all countries to avoid financial markets participants to migrate their business to countries with fewer regulations. On the other side, all countries are different and designing a common set of financial regulations seems to be a rather difficult task. Most countries would want to maintain at least part of their regulations, so consensus is difficult to reach.

ANSWERS TO APPLIED PROBLEMS 24. Suppose you have just inherited $10,000 and are considering the following options for investing the money to maximize your return: Option 1: Put the money in an interest-bearing checking account that earns 2%. The FDIC insures the account against bank failure.

Option 2: Invest the money in a corporate bond with a stated return of 5%, although there is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friend’s roommates, Mike, at an agreedupon interest rate of 8%, even though you believe there is a 7% chance that Mike will leave town without repaying you.

Option 4: Hold the money in cash and earn zero return. a. If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event.) b. Suppose Option 3 and Option 4 are your only choices. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, would you pay the $100?

What does this say about the value of better information regarding risk? a. With Option 1, since deposits are insured it can be assumed a riskless investment. Thus, the expected total payoff would be $10,000 × 1.02 = $10,200.

With Option 2, a bond return of 5% implies a potential payoff of $10,000 × 1.05 = $10,500, and there is a 90% chance that this outcome will occur, thus the expected payoff is $10,500 × 0.9 = $9,450. Under Option 3, the expected payoff is $10,000 × 1.08 × 0.93 = $10,044. Option 4 is riskless, so the expected total

payoff is $10,000. Given these choices and the assumption that you don’t care about risk, Option 1 is the best investment. b. Option 3 implies the very real possibility of either receiving nothing (if he actually leaves town), or $10,800 (if he indeed pays as promised). If you don’t pay Mike, you have an expected return of $10,044 as shown above. If you paid your friend the $100 and learned that Mike would leave without paying, then obviously you wouldn’t loan Mike the money, and you would be left with $9,900. However, if you paid the friend $100 and learned that Mike would pay, you would have $10,700 (= $10,000 × 1.08 − $100). After paying your friend Mike, but before knowing the true outcome, your expected return would be $10,644 ($9,900 × 0.07 + $10,700 × 0.93). Under Option 3, paying your friend the $100 is definitely worth it because it increases your expected return and in addition dramatically reduces the downside risk that you make a bad loan, and increases the certainty of the payoff amount. That is, with asymmetric information (not paying your roommate), you have a range of payoffs of $0 to $10,800 versus $9,900 to $10,700 without asymmetric information. Thus, paying a small amount to improve risk assessment under Option 3 can be very beneficial, a task for which financial intermediaries are well suited. Option 4, is riskless, so the expected total payoff is $10,000. If you are more risk averse, Option 4 is likely the better option. However, if you are more risk neutral then paying your roommate the $100 to have a minimum $9,900 payment and possibly as much as $10,700 is the better scenario.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on federal debt held by the Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international and foreign investors (FDHBFIN). Using these series, calculate the total amount held and the percentage held in each of the three categories for the most recent quarter available. Repeat for the first quarter of 2000, and compare the results.

See the table below. Since the year 2000, the Fed has increased its share of federal debt held, and foreign investors have significantly increased their share of debt held. This reflects a significant decline in the share of federal debt held by private investors.

2020:Q1

Fed Private Investors Foreign Investors Total

2000:Q1

Held ($bil.)

% Share

Held ($bil.)

% Share

3559.6

14.4

501.7

10.5

14407.2

58.1

3182.8

66.7

6810.1

27.5

1085.0

22.7

24776.9

4769.5

2. Go to the St. Louis Federal Reserve FRED database and find data on the total assets of all commercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds (MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjusting the Frequency setting to ―Quarterly.‖ Calculate the percent increase in growth of assets for each series, from January 2000 to the most recent quarter available. Which of the two financial intermediaries has experienced the most growth?

See the table below. Commercial bank assets have increased by 223% from 2000:Q1 to 2020:Q1, while money market mutual fund assets have increased also, but by less than commercial banks during that time, at 155.8%.

2020:Q1 Commercial Banks Money Market Mutual Funds

$18249.5 Bil. $4338.0 Bil.

2000:Q1 $5645.1 Bil. $1696.1 Bil.

Chapter 3 ANSWERS TO QUESTIONS 1. Why is simply counting currency an inadequate measure of money?

Since a lot of other assets have liquidity properties that are similar to currency but can be used as money to purchase goods and services, not counting them would understate an economy’s access to liquidity for transactions purposes. For this reason, counting assets such as checking deposits or savings accounts more accurately reflects the stock of assets that can be considered money.

2. In prison, cigarettes are sometimes used among inmates as a form of payment. How is it possible for cigarettes to solve the ―double coincidence of wants‖ problem, even if a prisoner does not smoke?

Even if he or she were a nonsmoker, since the prisoner knows that others in the prison will accept cigarettes as a form of payment, they themselves would be willing to accept cigarettes as a form of payment. So, rather than prisoners having to barter and trade favors, cigarettes satisfy the double coincidence of wants in that both parties to a trade stand ready to use them to ―purchase‖ goods or services.

3. Three goods are produced in an economy by three individuals: Good

Producer

Apples

Orchard Owner

Bananas

Banana Grower

Chocolate

Chocolatier

If the orchard owner likes only bananas, the banana grower likes only chocolate, and the chocolatier likes only apples, will any trade between these three persons take place in a barter economy? How will introducing money into the economy benefit these three producers?

Because the orchard owner likes only bananas but the banana grower doesn’t like apples, the banana grower will not want apples in exchange for his bananas, and they will not trade. Similarly, the chocolatier will not be willing to trade with the banana grower because she does not like bananas. The orchard owner will not trade with the chocolatier because he doesn’t like chocolate. Hence, in a barter economy, trade among these three people may well not take place, because in no case is there a double coincidence of wants. However, if money is introduced into the economy, the orchard owner can sell his apples to the chocolatier and then use the money to buy bananas from the banana grower. Similarly, the banana grower can use the money he receives from the orchard owner to buy chocolate from the chocolatier, and the chocolatier can use the money to buy apples from the orchard owner. The result is that the need for a double coincidence of wants is eliminated, and everyone is better off because all three producers are now able to eat what they like best.

4. Why did cavemen and women not need money?

Cavemen and women did not need money. In their primitive economy, they did not specialize in producing one type of good and they had little need to trade with other cavemen and women.

5. Most of the time it is quite difficult to separate the three functions of money. Money performs its three functions at all times, but sometimes we can stress one in particular. For each of the following situations, identify which function of money is emphasized. a. Brooke accepts money in exchange for performing her daily tasks at her office, since she knows she can use that money to buy goods and services.

This situation illustrates the medium-of-exchange function of money. We often do not think why we accept money in exchange for hours spent working, as we are so accustomed to using money. The medium-of-exchange function of money refers to its ability to facilitate trades (hours worked for money and then money for groceries) in a society. b. Tim wants to calculate the relative value of oranges and apples, and therefore checks the price per pound of each of these goods as quoted in currency units.

In this case, we observe money performing its unit-of-account function. If modern societies did not use money as a unit of account, then the price of apples would have to be quoted in terms of all the other items in the market. This quickly becomes an impossible task. Suppose that a pound of apples sells for 0.80 pounds of oranges, half a gallon of milk, one-third of a pound of meat, 2 razor blades, 1.5 pound of potatoes, etc. c. Maria is currently pregnant. She expects her expenditures to increase in the future and decides to increase the balance in her savings account.

Maria is contemplating the store-of-value function of money. As a medium of exchange and unit of account, measures of money known as M1 or M2 have no important rivals. With respect to the store-of-value function, however, there are many assets that can preserve value better than a checking account. Maria’s choice to preserve the purchasing power of her income by increasing her savings account balance is fine for a small period of time. For a period of 20 years, however, you might choose to buy a U.S. Treasury bond that matures in 20 years (as many grandparents have done as a way to pay for their grandchildren’s educations).

6. In Brazil, a country that underwent a rapid inflation before 1994, many transactions were conducted in dollars rather than in reals, the domestic currency. Why? Because of the rapid inflation in Brazil, the domestic currency, the real, was a poor store of value. Thus, many people preferred to hold dollars, which were a better store of value, and used them in their daily shopping.

7. Was money a better store of value in the United States in the 1950s than in the 1970s? Why or why not? In which period would you have been more willing to hold money?

Because money was losing value at a slower rate (the inflation rate was lower) in the

1950s than in the 1970s, it was a better store of value then, and you would have been willing to hold more of it.

8. Why have some economists described money during a hyperinflation as a ―hot potato‖ that is quickly passed from one person to another?

Money loses its value at an extremely rapid rate in hyperinflation, so you want to hold it for as short a time as possible. Thus money is like a hot potato that is quickly passed from one person to another.

9. Why were people in the United States in the nineteenth century sometimes willing to be paid by check rather than with gold, even though they knew there was a possibility that the check might bounce?

Because a check was so much easier to transport than gold, people would frequently rather be paid by check even if there was a possibility that the check might bounce. In other words, the lower transactions costs involved in handling checks made people more willing to accept them.

10. In ancient Greece, why was gold a more likely candidate for use as money than wine?

Wine is more difficult to transport than gold and is also more perishable. Gold is thus a better store of value than wine and also leads to lower transactions cost. It is therefore a better candidate for use as money.

11. If you use an online payment system such as PayPal to purchase goods or services on the Internet, does this affect the M1 money supply, the M2 money supply, both, or neither? Explain.

Neither. Although PayPal and many other e-money systems work as other forms of money do to facilitate purchases of goods and services, it does not count in the M1 or M2 money supplies. Because PayPal and similar payment systems are generally credit-based, this requires payment at a future date for funds used today; those future payments must be made using existing money that is already in the system, such as currency or funds in a bank deposit account. In other words, the M1 and M2 money supplies would theoretically remain the same, but money would move from your checking account to a third party, once the credit transaction is settled.

12. Rank the following assets from most liquid to least liquid: a. Checking account deposits b. Houses c. Currency d. Automobiles e. Savings deposits f. Common stock The ranking from most liquid to least liquid is (c), (a), (e), (f), (d), and (b).

13. Which of the Federal Reserve’s measures of the monetary aggregates—M1 or M2—is composed of the most liquid assets? Which is the larger measure?

M1 contains the most liquid assets. M2 is the largest measure.

14. It is not unusual to find a business that displays a sign saying ―no personal checks, please.‖ On the basis of this observation, comment on the relative degree of liquidity of a checking account versus currency.

The degree of liquidity of an asset is measured by considering how much time and effort (i.e., transaction costs) are needed to convert that asset into currency. Currency is by definition the most liquid type of money. Different types of money have different degrees of liquidity. A check, which represents a balance on a checking account, is a quite liquid type of money. After all, all that is needed to pay for a good or service using a check is the two minutes it takes to include the date and amount and sign the check. However, the above example shows that some merchants refuse to accept checks as a means of payment. (They cannot refuse to accept dollars, as dollars are legal tender in the United States.) This can result in significant transaction costs in trying to find a bank or an ATM. It is even possible that the transaction never takes place. This example illustrates the point that even inside the same monetary aggregate, different types of money do not have the same degree of liquidity.

15. For each of the following assets, indicate which of the monetary aggregates (M1 and M2) includes them: a. Currency b. Money market mutual funds c. Small-denomination time deposits d. Checkable deposits a. M1 and M2 b. M2 c. M2 d. M1 and M2 16. Assume that you are interested in earning some return on the idle balances you usually keep in your checking account and decide to buy some money market mutual funds shares by writing a check. Comment on the effect of your action (with everything else the same) on M1 and M2.

Your actions will reduce your checking account balance and increase your holdings of money market mutual fund shares. Considering this transaction only, M1 will decrease as one of its components decreased. M2 will remain constant, as M2 is composed of all items that add up to M1 plus some other types of money that are not so liquid to be considered part of M1. One of these categories is money market mutual fund shares. The decrease in your checking account balance is offset by the increase in money market mutual fund shares, and therefore M2 remains constant.

17. In April 2009, the growth rate of M1 fell to 6.1%, while the growth rate of M2 rose to 10.3%. In September 2013, the year-over-year growth rate of the M1 money supply

was 6.5%, while the growth rate of the M2 money supply was about 8.3%. How should Federal Reserve policymakers interpret these changes in the growth rates of M1 and M2?

During the period in question, the M1 growth rate fell by 0.4%, while the M2 growth rate increased by 2.0%. Because these growth rates moved in opposite directions, it is difficult to judge the appropriateness of monetary policy by just looking at the money supply measures alone. One measure indicates that monetary policy is more expansionary, while the other indicates the opposite.

18. Suppose a researcher discovers that a measure of the total amount of debt in the U.S. economy over the past 20 years was a better predictor of inflation and the business cycle than M1 or M2. Does this discovery mean that we should define money as equal to the total amount of debt in the economy?

Not necessarily. Although the total amount of debt has predicted inflation and the business cycle better than M1 or M2, it may not be a better predictor in the future.

Without some theoretical reason for believing that the total amount of debt will continue to predict well in the future, we may not want to define money as the total amount of debt.

ANSWERS TO APPLIED PROBLEMS Q.19

The table below shows hypothetical values, in billions of dollars, of different forms of money. a. Use the table to calculate the M1 and M2 money supplies for each year, as well as the growth rates of the M1 and M2 money supplies from the previous year. b. Why are the growth rates of M1 and M2 so different? Explain.

A. B. C.

Currency Money market mutual fund shares Saving account deposits

2021 900 680

2022 920 681

2023 925 679

2024 931 688

5,780

5,968

6,105

1,245

1,274

1,329

972

980

993

861

1,123

1,566

2,374

2,436

2,502

5,500 D. E. F. G

Money market deposit accounts Demand and checkable deposits Small-denomination time deposits 3-month Treasury bills

1,214 1,000 830 1,986

19. The M1 money supply is the sum of rows A and E for each year. The M2 money supply is the sum of all components A–F for each year. Note that three-month

Treasury bills are not considered part of the M1 or M2 money supply, even though they are fairly liquid assets. The table below shows the M1 and M2 money supplies, along with the growth rates from the previous year. Note that while the M1 money supply is relatively flat (and slightly negative for 2022), the M2 money supply grows at a much higher, positive rate. This is because the components of M2 are rising much more rapidly compared to the components of M1 (which are also included in M2). In particular, small-denomination time deposits increase 30% from 2022 to 2023, and 39% from 2023 to 2024, driving much of the growth in M2. Moreover, the narrower components that make up just the M1 money supply represent less than 20% (1904/10128) of the broader M2 indicators. Thus, movements in the money market, savings account, and time deposit measures will have a much bigger impact on M2 growth than the narrower M1 components will.

2021 A. B. C. D. E. F. G.

2022

2023

2024

920

925

931

681

679

688

5,780

5,968

6,105

1,245

1,274

1,329

972

980

993

861

1,123

1,566

2,374

2,436

2,502

1,892 10,45 9

1,905 10,94 9

1,924 11,61 2

M1 growth rate

−0.4%

0.7%

1.0%

M2 growth rate

3.3%

4.7%

6.1%

Currency Money market mutual fund shares Saving account deposits Money market deposit accounts Demand and checkable deposits Small-denomination time deposits 3-month Treasury bills Total M1 money stock Total M2 money stock

900 680 5,500 1,214 1,000 830 1,986 1,900 10,12 4

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on currency (CURRSL), demand deposits (DEMDEPSL), and other checkable deposits (OCDSL).

Calculate the M1 money supply, and calculate the percentage change in M1 and in each of the three components of M1 from the most recent month of data available to the same time one year prior. Which component has the highest growth rate? The lowest growth rate?

See the tables below, showing calculations from May 2019 to May 2020. Over that one-year period, other checkable deposits grew the fastest at 66.3%, while currency grew the least, increasing by 10.2% over the period.

Currency Demand Deposits Other Checkable Deposits M1

May 2019 $1650.8 Bil.

May 2020 $1818.7 Bil.

$1493.8 Bil.

$2166.7 Bil.

$647.9 Bil. $3792.5 Bil.

$1077.3 Bil. $5062.7 Bil.

May 2019 to May 2020 Currency Demand Deposits Other Checkable Deposits

10.2%

M1

33.5%

45.0%

66.3%

2. Go to the St. Louis Federal Reserve FRED database and find data on smalldenomination time deposits (STDSL), savings deposits and money market deposit accounts (SAVINGSL), and retail money market funds (RMFSL). Calculate the percentage change of each of these three components of M2 (not included in M1) from the most recent month of data available to the same time one year prior. Which component has the highest growth rate? The lowest growth rate? Repeat the calculations using the data from January 2000 to the most recent month of data available, and compare your results. Use your answers from question 1 to determine which grew faster: the non-M1 components of M2 or the M1 money supply.

See the tables below, showing calculations from the May 2020 benchmark period. Over the one-year period from May 2019 to May 2020, retail money market mutual funds grew the fastest at 34.6%, while small-time deposits grew the least, decreasing by 8.9% over the period. For the period January 2000 to May 2020 savings deposits grew a substantial amount, at 545.3% over the period, while small-time deposits decreased significantly, by 43.4%.

Overall, the M1 money supply grew more over the one-year period (33.5% versus 19.5%) and the longer period (351.1% versus 267.4%) than the non-M1 components that make up M2; however, the non-M1 components of M2 are much larger in size than the M1 components, so will have a larger influence overall on the M2 money supply.

Small Time Deposits

May 2020

May 2019

January 2000

$545.7 Bil.

$598.9 Bil.

$963.4 Bil.

Savings/MMDA

$11239.4 Bil.

$9373.2 Bil.

$1741.6 Bil.

Retail MMMF

$1196.3 Bil.

$888.7 Bil.

$828.6 Bil.

Non-M1 M2

$12981.4 Bil.

$10860.8 Bil.

$3533.6 Bil.

M1

$5062.6 Bil.

$3245.8 Bil.

$1122.2 Bil.

May 2019 to May 2020

January 2000 to May 2020

Small Time Deposits

8.9%

43.4%

Savings/MMDA

19.9%

545.3%

Retail MMMF

34.6%

44.4%

Non-M1 M2

19.5%

267.4%

33.5%

351.1%

M1 Chapter 4 ANSWERS TO QUESTIONS

1. Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%?

It would be worth 1/(1 + 0.20) = $0.83 when the interest rate is 20%, rather than 1/(1 + 0.10) = $0.91 when the interest rate is 10%. Thus, a dollar tomorrow is worth less with a higher interest rate today.

2. Explain which information you would need to take into consideration when deciding to receive $5,000 today or $5,500 one year from today.

When comparing amounts of money that are disbursed at different dates, one has to take into consideration the concept of present value of money. To calculate the present value of the $5,500 promised one year from today one needs to know the annual interest rate. In this case, for an interest rate larger than 10%, one would prefer to accept the $5,000 today (since one can deposit that amount and receive more than $5,500 one year from today).

3. To help pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don’t have to start making these payments until you graduate from college two years from now. Why is the yield to maturity necessarily less than 12%? (This is the yield to maturity on a normal $1,000 fixed-payment loan on which you pay $126 per year for 25 years.)

If the interest rate were 12%, the present discounted value of the payments on the government loan are necessarily less than the $1,000 loan amount because they do not start for two years. Thus the yield to maturity must be lower than 12% in order for the present discounted value of these payments to add up to $1,000.

4. Do bondholders fare better when the yield to maturity increases or when it

decreases? Why? When the yield to maturity increases, this represents a decrease in the price of the bond. If the bondholder were to sell the bond at a lower price, the capital gains would be smaller (capital losses larger) and therefore the bondholder would be worse off.

5. Suppose today you buy a coupon bond that you plan to sell one year later. Which part of the rate of return formulation incorporates future changes into the bond?

Note: Check Equations 7 and 8 in this chapter.

The rate of capital gain is the part of the rate of return formula that incorporates future changes in the price of the bond. The other part of the formula, the current yield, is composed of the coupon payment (completely determined by the bond’s face value and coupon rate) and the price you paid for the bond today. The rate of capital gain incorporates the future price of the bond and is therefore the part of the formula that reflects the consequences of future price changes.

6. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3% (= 5–2%) to 1% (= 10–9%). The real cost of financing the house is thus lower, even though nominal mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)

7. When is the current yield a good approximation of the yield to maturity?

The current yield will be a good approximation to the yield to maturity whenever the bond price is very close to par or when the maturity of the bond is over about 10 years. This is because cash flows farther in the future have such small present discounted values that the value of a long-term coupon bond is close to a perpetuity with the same coupon rate.

8. Why would a government choose to issue a perpetuity, which requires payments forever, instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?

The near-term costs to maintaining a given size loan are much smaller for a perpetuity than for a similar fixed-payment loan, discount, or coupon bond. For instance, assuming a 5% interest rate over 10 years, on a $1,000 loan, a perpetuity costs $50 a year (or $500 in payments over 10 years). For a fixed-payment loan, this would be $129.50 per year (or $1,295 in payments over the same 10-year period). For a discount loan, this loan would require a lump-sum payment of $1628.89 in 10 years.

For a coupon bond, assuming the same $50 coupon payment as the perpetuity implies a $1,000 face value. Thus, for the coupon bond, the total payments at the end of 10 years will be $1,500.

9. Under what conditions will a discount bond have a negative nominal interest rate? Is it possible for a coupon bond or a perpetuity to have a negative nominal interest rate?

Whenever the current price P is greater than face value F of a discount bond, the yield to maturity will be negative. It is possible for a coupon bond to have a negative

nominal interest rate, as long as the coupon payment and face value are low relative to the current price. As an example, with a one-year coupon bond, the yield to maturity is given as i = (C + F – P)/P; in this case whenever C + F < P, i will be negative. It is impossible for a perpetuity to have a negative nominal interest rate, since this would require either the coupon payment or the price to be negative.

10. True or False: With a discount bond, the return on the bond is equal to the rate of capital gain.

True. The return on a bond is the current yield iC plus the rate of capital gain, g. A discount bond, by definition, has no coupon payments, thus the current yield is always zero (the coupon payment of zero divided by current price) for a discount bond.

11. If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest rate risk?

You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return. Longer-term bonds are more susceptible to higher price fluctuations than shorter-term bonds, and hence have greater interest rate risk.

12. Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have commented that real interest rates were actually much higher in the mid-1980s than in the late 1970s. Does this make sense? Do you think that these economists are right?

The economists are right. They reason that nominal interest rates were below expected rates of inflation in the late 1970s, making real interest rates negative. The expected inflation rate, however, fell much faster than nominal interest rates in the mid-1980s, so nominal interest rates were above the expected inflation rate and real rates became positive.

13. Retired persons often have much of their wealth placed in savings accounts and other interest-bearing investments, and complain whenever interest rates are low. Do they have a valid complaint?

While it would appear to them that their wealth is declining as nominal interest rates fall, as long as expected inflation falls at the same rate as nominal interest rates, their real return on savings accounts will be unaffected. However, in practice, expected inflation as reflected by the cost of living for seniors and retired persons often is much higher than standard measures of inflation, thus low nominal rates can adversely affect the wealth of senior citizens and retired persons.

ANSWERS TO APPLIED PROBLEMS 14. If the interest rate is 10%, what is the present value of a security that pays you $1,100 next year, $1,210 the year after, and $1,331 the year after that? $1,100/(1 + 0.10) + $1,210/(1 + 0.10)2 + $1,331/(1 + 0.10)3 = $3,000.

15. Calculate the present value of a $1,000 discount bond with five years to maturity if the yield to maturity is 6%

PV = FV/(1 + i)n, where FV = 1,000, i = 0.06, n = 5. Thus, PV = 747.26.

16. A lottery claims its grand prize is $10 million, payable over 5 years at $2,000,000 per year. If the first payment is made immediately, what is this grand prize really worth?

Use an interest rate of 6%.

In present value terms, the lottery prize is worth $2,000,000 + $2,000,000/(1.06) + $2,000,000/(1.06)2 + $2,000,000/(1.06)3 + $2,000,000/(1.06)4, or $8,930,211.

17. Suppose that a commercial bank wants to buy Treasury bills. These instruments pay $5,000 in one year and are currently selling for $5,012. What is the yield to maturity of these bonds? Is this a typical situation? Why? The yield to maturity of these bonds solves the following equation: 5,000/(1+i) = 5,012. After some algebra, the yield to maturity happens to be around – 0.24%. This is not a typical situation. In normal times, banks will not choose to pay more than the face value of a discount bond, since that implies negative yields to maturity.

This example illustrates situations as the ones described in the Global Box in this chapter.

18. What is the yield to maturity on a simple loan for $1 million that requires a repayment of $2 million in five years’ time?

14.9%, derived as follows: The present value of the $2 million payment five years from now is $2/(1 + i)5 million, which equals the $1 million loan. Thus 1 = 2/(1 + i)5.

Solving for i, (1 + i)5 = 2, so that i  5 2  1  0.149  14.9%.

19. Which $1,000 bond has the higher yield to maturity, a 20-year bond selling for $800 with a current yield of 15% or a one-year bond selling for $800 with a current yield of 5%?

If the one-year bond did not have a coupon payment, its yield to maturity would be ($1,000 – $800)/ $800 = $200/$800 = 0.25, or 25%. Because it does have a coupon payment, its yield to maturity must be greater than 25%. However, because the current yield is a good approximation of the yield to maturity for a 20-year bond, we know that the yield to maturity on this bond is approximately 15%. Therefore, the one-year bond has a higher yield to maturity.

20. Consider a bond with a 4% annual coupon and a face value of $1,000. Complete the following table. What relationships do you observe between years to maturity, yield to maturity, and the current price?

Years to Maturity

Yield to Maturity

2

2%

2

4%

3

4%

5

2%

5

6%

Current Price

Years to Maturity

Yield to Maturity

Current Price

2

2%

1038.83

2

4%

1000.00

3

4%

1000.00

5

2%

1094.27

5

6%

915.75

21. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently selling for $1,044.89 and has two years to maturity. What is the bond’s yield to maturity?

When yield to maturity is above the coupon rate, the bond’s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate.

For a given maturity, the bond’s current price falls as yield to maturity rises. For a given yield to maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond’s current price equals its face value regardless of years to maturity.

22. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%? If the yield to maturity doubles, what will happen to the perpetuity’s price? $1044.89 = $100/(1 + i) + $100/(1 + i)2 + $1,000/(1 + i)2. Solving for i gives a yield to maturity of 0.075, or 7.5%.

23. Property taxes in a particular district are 4% of the purchase price of a home every year. If you just purchased a $250,000 home, what is the present value of all the future property tax payments? Assume that the house remains worth $250,000 forever, property tax rates never change, and a 6% interest rate is used for discounting.

The price would be $50/0.025 = $2,000. If the yield to maturity doubles to 5%, the price would fall to half its previous value, to $1,000 = $50/0.05.

24. A $1000-face-value bond has a 10% coupon rate, its current price is $960, and its price is expected to increase to $980 next year. Calculate the current yield, the expected rate of capital gain, and the expected rate of return.

The taxes on the $250,000 home are $250,000  0.04 = $10,000 per year. The PV of all future payments = $10,000/0.06 = $166,666.67 (a perpetuity).

25. Suppose that you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 3%. Assuming that the annualized expected rate of inflation over the life of the bond is 1%, determine the nominal interest rate that the bank will charge you. What happens if, over the life of the loan, actual inflation is 0.5%?

The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if actual inflation turns out to be lower than expected, then you will be worse off than originally planned, since the real cost of borrowing (measured by the real interest

rate) turned out to be 4–0.5% = 3.5%.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the interest rate on a four-year auto loan (TERMCBAUTO48NS). Assume that you borrow $20,000 to purchase a new automobile and that you finance it with a four-year loan at the most recent interest rate given in the database. If you make one payment per year for four years, what will the yearly payment be? What is the total amount that will be paid out on the $20,000 loan?

For May 2020, the rate on a four-year auto loan is 5.13%. Thus, the yearly payment can be found by solving: $20,000 = FP ×[1/1.0513 + 1/(1.0513)2 + 1/(1.0513)3 + 1/(1.513)4]. Solving yields FP = $20,000/3.535, or a $5657.28 payment per year.

Spread over four years, this is $22,629.12 total in payments for the $20,000 loan.

2. The U.S. Treasury issues some bonds as Treasury Inflation Indexed Securities, or TIIS, which are bonds adjusted for inflation; hence the yields can be roughly interpreted as real interest rates. Go to the St. Louis Federal Reserve FRED database and find data on the following TIIS bonds and their nominal counterparts. Then answer the questions below. 

5-year U.S. Treasury (DGS5) and 5-year TIIS (DFII5)



7-year U.S. Treasury (DGS7) and 7-year TIIS (DFII7)



10-year U.S. treasury (DGS10) and 10-year TIIS (DFII10)



20-year U.S. Treasury (DGS20) and 20-year TIIS (DFII20)



30-year U.S. Treasury (DGS30) and 30-year TIIS (DFII30) a. Following the Great Recession of 2008–2009, the 5-, 7-, 10-, and even the 20year TIIS yields became negative for a period of time. How is this possible?

Market participants expected the inflation rate on average to be higher than the nominal interest rate over that same period; thus, the real interest rate, as represented by the difference between the Treasury and TIIS yields, was negative. b. Using the most recent data available, calculate the difference between the yields for each of the pairs of bonds (DGS5 – DFII5, etc.) listed above. What does this difference represent?

The difference between the pairs represents expected inflation over the relevant bond horizon. Calculations for July 9, 2020, are shown below.

July 9, 2020 Nominal

TIIS

Difference (Inflation Expectations)

5 Year

0.28

–0.94

1.22

7 Year

0.46

–0.87

1.33

10 Year

0.62

–0.77

1.39

20 Year

1.09

–0.48

1.57

30 Year

1.32

–0.24

1.56

c. Based on your answer to part (b), are there significant variations among the differences in the bond-pair yields? Interpret the magnitude of the variation in differences among the pairs.

The difference, which roughly represents inflation expectations, is fairly constant over the various horizons, but grows slightly as you move farther out.

In this case, market participants expect average inflation to be somewhat lower in the near term, but average near 1.5% at 10, 20, and 30 years out.

Chapter 5 ANSWERS TO QUESTIONS 1. Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: a. Your wealth falls.

Less, because your wealth has declined b. You expect the stock to appreciate in value.

More, because its relative expected return has risen c. The bond market becomes more liquid.

Less, because it has become less liquid relative to bonds d. You expect gold to appreciate in value.

Less, because its expected return has fallen relative to gold e. Prices in the bond market become more volatile.

More, because it has become less risky relative to bonds 2. Explain why you would be more or less willing to buy a house under the following circumstances: a. You just inherited $100,000.

More, because your wealth has increased b. Real estate commissions fall from 6% of the sales price to 5% of the sales price.

More, because the house has become more liquid c. You expect Microsoft stock to double in value next year.

Less, because its expected return has fallen relative to Microsoft stock d. Prices in the stock market become more volatile.

More, because it has become less risky relative to stocks e. You expect housing prices to fall.

Less, because its expected return has fallen 3. Explain why you would be more or less willing to buy gold under the following circumstances: a. Gold again becomes acceptable as a medium of exchange.

More, because it has become more liquid b. Prices in the gold market become more volatile.

Less, because it has become more risky c. You expect inflation to rise, and gold prices tend to move with the aggregate price level.

More, because its expected return has risen

d. You expect interest rates to rise.

More, because its expected return has risen relative to the expected return on long-term bonds, which has declined 4. Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances: a. Trading in these bonds increases, making them easier to sell.

More, because the bonds have become more liquid b. You expect a bear market in stocks (stock prices are expected to decline).

More, because their expected return has risen relative to stocks c. Brokerage commissions on stocks fall.

Less, because they have become less liquid relative to stocks d. You expect interest rates to rise.

Less, because their expected return has fallen e. Brokerage commissions on bonds fall.

More, because they have become more liquid 5. What will happen to the demand for Rembrandt paintings if the stock market undergoes a boom? Why? The rise in the value of stocks would increase people’s wealth and therefore the demand for Rembrandts would rise.

6. Raphael observes that at the current level of interest rates there is an excess supply of bonds and therefore he anticipates an increase in the price of bonds. Is Raphael correct?

Raphael is incorrect. If at the current level of interest rates there is an excess supply of bonds, the supply and demand analysis tells us that interest rates will increase, creating a movement along both the demand curve (in the southeast direction) and the supply curve (in the southwest direction) in order to reach the equilibrium interest rate (and price). The bond’s price will therefore fall and the interest rate will rise to the equilibrium level.

7. Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and 1% standard deviation of its expected return. Can you tell if Maria is more or less risk-averse than Jennifer?

Maria is choosing a bond with higher standard deviation, but also with higher expected return than Jennifer. In order to decide whether Maria or Jennifer is more risk averse, one will need to compare two bonds with the same expected return and different standard deviations of their expected returns. Since a high expected return is a desirable characteristic of a bond and a high volatility of its expected return (high standard deviation) is a

nondesirable characteristic, it is not uncommon that highly volatile bonds exhibit higher expected returns, as the bond preferred by Maria.

8. What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?

If the government imposes a limit on the amount of daily transactions in the bond market, then bonds will become less liquid with respect to alternative assets. Such a regulation will mean that it will now be more difficult to find buyers and sellers in the bond market, thereby affecting the liquidity of bonds and the demand curve (which will shift to the left), increasing the interest rate and lowering bond’s prices (for a given supply curve).

9. How might a sudden increase in people’s expectations of future real estate prices affect interest rates?

Interest rates would rise. A sudden increase in people’s expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve Bd shifts to the left, bond prices fall, and the equilibrium interest rate rises.

10. Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?

If many big corporations decide not to issue bonds because of new financial markets regulations, this will affect the supply curve. The impact will translate into a shift to the left in the supply curve, increasing bond’s prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.

11. In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for quite some time. Does this make sense? Why or why not?

Given the answer to question 10 above, the supply effect of large deficits should lead to higher interest rates. The effects of the economic crisis lead to significantly lower wealth and income, which depressed Treasury bond demand, but also decreased corporate bond supply by even more because investment opportunities collapsed. The larger leftward shift in the bond supply curve than the rightward shift in the bond demand curve would then result in a rise in bond prices and a fall in interest rates. In addition, due to the severity of the global crisis, U.S. Treasury debt became a safe haven investment, reducing relative risk and increasing liquidity for U.S. Treasury debt. This significantly raised U.S. Treasury bond demand, leading to higher bond prices and significantly lower yields. In other words, the decrease in investment opportunities and risk factors significantly offset the wealth effect on demand and the deficit effect on supply.

12. Will there be an effect on interest rates if brokerage commissions on stocks fall?

Explain your answer.

Yes, interest rates will rise. The lower commission on stocks makes them more liquid relative to bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium interest rate will rise.

13. The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.

If the public believes the president’s program will be successful, interest rates will fall.

The president’s announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases and the demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd cause the equilibrium interest rate to fall.

14. Suppose that people in France decide to permanently increase their savings rate.

Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?

If people in France decide to permanently increase their savings rate, then more wealth will be accumulated over the years. This increase in wealth determines that more bonds will be bought at any given interest rate (or bond’s price), creating a shift to the right in the demand curve for bonds in France. This European country can therefore expect permanent lower interest rates in the future.

15. Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future.

Predict what will happen to interest rates. Will you advise borrowing short or long term?

If the government is planning to fund a major infrastructure plan, it will need to get funds, and thereby will probably issue more bonds. Since the government is a major player in the market for bonds, this will most likely result in a shift to the right in the supply curve, lowering the price of bonds and increasing interest rates in the future. If you have the opportunity, it would be wise to lock in now a long-term loan with current low interest rates.

16. Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?

Yes, fiscal policymakers should worry about potentially inflationary conditions. If people expect higher inflation, this increases the yield on U.S. Treasury debt, meaning that the interest rates paid to debt holders increase. In other words, higher inflation leads to a higher debt service burden and increases the costs of financing deficit spending.

17. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed?

When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money.

Thus, the money demand curve Md shifts to the right, and the interest rate rises.

18. If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates? Discuss the possible resulting situations.

Slower rate of money growth will lead to a liquidity effect, which raises interest rates, while the lower price level, income, and inflation rates in the future will tend to lower interest rates. There are three possible scenarios for what will happen: (a) if the liquidity effect is larger than the other effects, then interest rates will rise; (b) if the liquidity effect is smaller than the other effects and expected inflation adjusts slowly, then interest rates will rise at first but will eventually fall below their initial level; and (c) if the liquidity effect is smaller than the expected inflation effect and there is rapid adjustment of expected inflation, then interest rates will immediately fall.

19. M1 money growth in the United States was about 15% in 2011 and 2012, and 10% in 2013. Over the same time period, the yield on three-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low, rather than increase? What does this say about the income, price-level, and expected inflation effects?

With unusually high rates of money growth, this should lead to higher expected inflation, a jump in the overall price level, and stronger economic growth. These factors should all result in interest rates rising over time, notwithstanding the liquidity effect. However, in the period from 2011 to 2013, unemployment remained high, economic growth was weak, and if anything, policymakers were worried about deflation (a decrease in the price level) rather than any inflationary effects from the money growth. In other words, the income, price-level, and expected inflation effects of the unusually high money growth conditions were very small relative to the liquidity effect. This is similar to case (a) shown in Figure 11.

ANSWERS TO APPLIED PROBLEMS 20. Suppose you visit with a financial adviser, and you are considering investing some of your wealth in one of three investment portfolios: stocks, bonds, or commodities. Your financial adviser provides you with the following table, which gives the probabilities of possible returns from each investment: Stocks

Bonds

Commodities

Probability

Return

Probability

Return

Probability

Return

0.25

12%

0.6

10%

0.2

20%

0.25

10%

0.4

7.50%

0.25

12%

0.25

8%

0.25

6%

0.25

6%

0.25

4%

0.05

0%

a. Which investment should you choose to maximize your expected return: stocks, bonds, or commodities?

The expected return on the stock portfolio is 0.25(12%) + 0.25(10%) + 0.25(8%) + 0.25(6%) = 9%. The expected return on the bond portfolio is 0.6(10%) + 0.4(7.5%) = 9%. The expected return on the commodities portfolio is 0.2(20%) + 0.25(12%) + 0.25(6%) + 0.25(4%) + 0.05(0%) = 9.5%. Since the commodities portfolio has the higher expected return, you should choose that. b. If you are risk-averse and have to choose between the stock and the bond investments, which should you choose? Why? In choosing between the stock or bond portfolio, they both have the same expected return. However, since there is less uncertainty over the outcomes in the bond portfolio than the stock portfolio, a risk-averse individual should choose the bond portfolio.

21. An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve Bs to the right. The result is that the intersection of the supply and demand curves Bs and Bd occurs at a lower price and a higher equilibrium interest rate, and the interest rate rises. With the liquidity preference framework, the decrease in the money supply shifts the money supply curve Ms to the left, and the equilibrium interest rate rises. The answer from bond supply and demand analysis is consistent with the answer from the liquidity preference framework.

22. Using both the liquidity preference framework and the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).

In the bond framework, when the economy booms, the demand for bonds increases.

The public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right (shown in graph below), but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the interest rate falls. The conclusion is that interest rates rise during booms and fall during recessions: that is, interest rates are procyclical. The same answer is found with the liquidity preference framework. When the economy booms, the demand for money increases (shown in the graph below); people need more money to carry out an increased amount of transactions and also because their wealth has risen. The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. When the economy enters a recession, the demand for money falls and the demand curve shifts to the left, lowering the equilibrium interest rate. Again, interest rates are seen to be procyclical.

23. Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?

In the bond supply and demand analysis, the increased riskiness of bonds lowers the demand for bonds. The demand curve Bd shifts to the left, and the equilibrium interest rate rises. The same answer is found in the liquidity preference framework. The increased riskiness of bonds relative to money increases the demand for money. The money demand curve Md shifts to the right, and the equilibrium interest rate rises.

24. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations: Bd: Price = − 0.6 * Quantity + 1,140 Bs: Price = Quantity + 700 a. What is the expected equilibrium price and quantity of bonds in this market?

Solving for the equilibrium gives: –0.6 Quantity + 1,140 = Quantity + 700; 1.6 Quantity = 440; or Quantity = 275.

Using the bond supply equation Price = 275 + 700 = 975 b. Given your answer to part (a), what is the expected interest rate in this market?

The expected interest rate on a one-year discount bond with face value of $1,000 and current price of $975 is given as i = (1,000 – 975)/975 = 0.0256, or 2.56%.

25. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations Bd: Price = − 0.6 * Quantity + 1,140 Bs: Price = Quantity + 700 Suppose that, as a result of monetary policy actions, the Federal Reserve sells 80 bonds that it holds. Assume that bond demand and money demand are held constant. a. How does the Federal Reserve policy affect the bond supply equation?

The monetary policy action, essentially an open market operation, increases the supply of bonds in the market by a quantity of 80, at any given price. Thus, the bond supply equation will become Quantity = Price – 700 + 80, so that Price = Quantity + 620. b. Calculate the effect of the Federal Reserve’s action on the equilibrium interest rate in this market.

As a result of the Federal Reserve action, the new equilibrium is given as: –0.6 Quantity + 1140 = Quantity + 620; 1.6 Quantity = 520; or Quantity = 325.

Using the bond supply curve, Price = 325 + 620 = 945. Thus, the expected interest rate on a one-year discount bond with face value of $1,000 and current price of $945 is given as i = (1,000 – 945)/945 = 0.0582, or 5.82%. This is an increase from 2.56% in the initial equilibrium, which was calculated in the answer to the previous question. Note that as we will see in Chapter 14, the open market sale leads to a decline in the money supply and so the liquidity preference framework would then also indicate that the interest rate would rise.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on net worth of households and nonprofits (BOGZ1FL192090005Q) and the 10-year U.S. Treasury bond (GS10). For the net worth indicator, adjust the units setting to ―Percent Change from Year Ago,‖ and for the 10-year bond, adjust the frequency setting to ―Quarterly.‖ a. What is the percent change in net worth over the most recent year of data available? All else being equal, what do you expect should happen to the price and yield on the 10-year Treasury bond? Why? In 2020:Q1, net worth decreased by 0.6% from 2019:Q1. Holding everything else constant, this would be representative of a decrease in wealth of bond investors.

Thus, bond demand should decrease, leading to a decrease in the price of bonds, and an increase in the yield on bonds. b. What is the change in yield on the 10-year Treasury bond over the last year of data available? Is this result consistent with your answer to part (a)? Briefly explain.

Over the same time period, the yield on the 10-year Treasury decreased from 2.65% to 1.38%, which is inconsistent with the answer in part (a). It is likely that there are many other factors in the bond market which affected supply and demand to increase the price and lower yields, more than offsetting the effects of higher wealth on demand.

2. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 money supply (M1SL) and the 10-year U.S. Treasury bond (GS10). For the M1 money supply indicator, adjust the units setting to ―Percent Change from Year Ago,‖ and for the 10year Treasury bond, adjust the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet. a. Create a scatter plot, with money growth on the horizontal axis and the 10-year Treasury rate on the vertical axis, from 2000:Q1 to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are several ways to do this; however, one particular chart layout has this option built in). Based on the fitted line, are the data consistent with the liquidity effect? Briefly explain.

See the scatter plot below. Yes, the liquidity effect is clearly demonstrated. As money growth increases, the interest rate on the 10-year Treasury decreases; based on the regression results, a one percentage point increase in money growth reduces the 10-year rate by 15.8 basis points.

Money Growth and Contemporaneous 10-Year Rate 2000:Q1 to 2020:Q1

y = -0.1579x + 4.4467 R² = 0.4036

7.00 6.00

Interest Rate

5.00 4.00 Series1

3.00

Linear (Series1) 2.00 1.00 0.00

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the interest rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1 with the interest rate from 2001:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected inflation effects.

See the scatter plot below. The effects of money growth one year later still seem to indicate money growth lowers the interest rate on net. However, since the regression coefficient is smaller, the net effect after one year is less than the initial (liquidity) effect. That is, if the liquidity effect lowered the 10-year yield by 15.8

basis points on average in a given quarter as in (a) above, but it was lowered by only 12.5 basis points one year later, then the feedback effects from the income, price-level, and expected inflation effect must be helping to offset some of the liquidity effect (on the order of around 3.3 basis points) after one year, on average.

Money Growth and 4 Quarter Ahead Interest Rate 2000:Q1 to 2019:Q2 6 y = -0.1252x + 4.0614 R² = 0.3098

Interest Rate

5 4 3

Series2 Linear (Series2)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1 with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

See the scatter plot below. Assuming all the effects run its course after two years, the data after two years suggest that a one percentage point increase in money growth, on average, will leave the 10-year yield lower by about 10 basis points.

Thus, putting the liquidity, income, price-level, and expected inflation effects together, on net indicates that higher money growth should leave nominal interest rates lower overall according to this data.

Money Growth and 8 Quarter Ahead Interest Rate 2000:Q1 to 2018:Q2 6

y = -0.0998x + 3.816 R² = 0.2217

Interest Rate

5 4 3

Series3 Linear (Series3)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11 of this chapter?

The data interpretation illustrates a story consistent with panel (a) in the figure, where the liquidity effect is dominant, and over time the income, pricelevel, and expected inflation effects slowly offset some of the downward effects of expansionary policy on the nominal interest rate, but leave nominal interest rates lower on net overall.

Chapter 6 ANSWERS TO QUESTIONS 1. If junk bonds are ―junk,‖ then why do investors buy them?

Junk bonds are referred to as ―junk‖ in that they are very risky investments, but provide high yields to investors who buy them at very low prices and are therefore compensated with a high risk premium.

2. Which should have the higher risk premium on its interest rates, a corporate bond with a Moody’s Baa rating or a corporate bond with a C rating? Why? The bond with a C rating should have a higher interest rate because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond.

3. Do you think that a U.S. Treasury bill will have a risk premium that is higher than, lower than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the government of Colombia?

The U.S. government issued securities are usually considered to be default free.

However, securities issued by other governments usually have a positive risk premium, depending in general on the fiscal imbalances that each country exhibits at a given point in time.

4. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?

The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher yield. After the announcement that the government would provide extraordinary assistance to support AIG and keep it from failing, demand for its corporate debt would rise, and yields would fall.

5. Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Conversely, during recessions default risk on corporate bonds increases and their risk premium increases.

The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

6. Just before the collapse of the subprime mortgage market in 2007, the most important credit-rating agencies rated mortgage-backed securities with Aaa and AAA ratings.

Explain how it was possible that a few months into 2008, the same securities had the lowest possible ratings. Should we always trust credit-rating agencies?

Historically, mortgage-backed securities were considered low-risk assets, since homeowners had the highest incentives to pay their mortgages (otherwise they might lose their home). However, after standards on lending practices decreased during the

first years of the new century, many individuals were able to buy a house, but not to make their mortgage payments. This resulted in poor quality mortgage-backed securities that should never have had such good ratings. Both Standard and Poor’s and Moody’s were investigated for assigning such good ratings and therefore misleading investors in buying these instruments. Sometimes credit-rating agencies also make mistakes in assigning risks.

7. The U.S. Treasury offers some of its debt as Treasury Inflation Indexed Securities, or TIIS (more commonly known as TIPS, an acronym for Treasury Inflation Protected Securities), in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds?

Since TIPS (TIIS) bonds are traded much more lightly than their nominal counterparts, demand for these bonds is somewhat lower than comparable U.S. treasuries; hence the higher yield (controlling for the effects of inflation) represents a liquidity premium. Note that because this liquidity effect is relatively small, inflation compensation will generally be larger than the liquidity premium, implying that nominal bond yields overall will be higher than TIPS of comparable maturity.

8. Predict what will happen to interest rates on a corporation’s bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

9. Predict what would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments. Do you think that it will then make sense for municipal bonds to be exempt from income taxes?

If the federal government decides to guarantee payments on all municipal bonds, then these bonds will effectively be default free. This characteristic will make them very desirable assets, increasing their demand and thereby lowering their interest rates. If this were to happen, then municipal bonds will be even better than U.S. government bonds, since both are default free, but municipal bonds are income tax–exempted instruments. In this case, it will not make sense for municipal bonds to be exempted from paying taxes, since this exemption is made precisely to ―help‖ local governments to gain access to funds.

10. During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. What explains this sudden increase?

The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system, and doubt about the soundness of even the most healthy banks and financial companies. As a

result, there was a sharp decrease in demand for financial commercial paper relative to the seemingly safer nonfinancial commercial paper. This resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investments.

11. If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.

12. Prior to 2008, mortgage lenders required a house inspection to assess a home’s value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre-2008 scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

Credit rating agencies had a conflict of interest that was said to contribute to the crisis in that the rating agencies had an incentive to provide overly optimistic ratings to clients whom they also advised. Similarly, the way in which lenders and the house inspection process occurred provided incentives for the house inspectors to provide overly optimistic assessments of the value of housing to ensure continued work in the future, and at the same time mortgage lenders benefitted because it continued the cycle of creating and selling mortgages as long as housing value was maintained.

13. ―According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years.‖ Is this statement true, false, or uncertain?

False. The expectations theory of the term structure implies that, with a $1 investment in one-period bonds over two years, the expected return is given as it  ite1 , which equals 2it assuming that one-period bond rates are expected to be the same across both periods. With a $1 investment in a two-period bond, the expected return is 2i2t . Thus, only if the (expected) one-period bond rate for both periods is greater than the expected two-period bond rate will one-period bonds be a better investment.

14. If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds and (b) the segmented markets theory of the term structure holds. (a) Under the expectations theory of the term structure, if 30-year bonds become less desirable, this will increase the demand for bonds of other maturities, since they are viewed as perfect substitutes. The result is a higher price and a lower yield at all other maturities, and an increase in yield at the end of the yield curve. In other words, the yield curve would steepen at the end, and flatten somewhat along the rest of the curve.

(b) Under the segmented markets theory, the assumption is that each type of bond maturity is an independent market, and therefore not linked in any particular way. Thus, changes in long rates won’t affect shorter- and medium-term bond yields. Thus, the yield curve under the segmented markets theory will result in a jump in the 30-year rate, with the remainder of the yield curve unchanged.

15. Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%, 6%, and 6%, respectively. Investor A chooses to hold only one-year bonds and Investor B is indifferent with regard to holding five- and ten-year bonds.

How can you explain the behavior of Investors A and B? Investor A, even though she receives a lower expected return, clearly prefers to hold short-term debt, perhaps because it is more liquid. Investor A’s preferences are consistent with the segmented markets theory. Investor B is apparently maximizing expected return, but since he is indifferent between the five- and ten-year bonds, Investor B doesn’t appear to favor any particular maturity, and so views the five- and ten-year bonds as essentially perfect substitutes, an assumption consistent with the expectations theory of the term structure.

16. If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

17. If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?

The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future is above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the preferred habitat theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates are expected to fall far into the future. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.

18. If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?

If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the expectations hypothesis.

19. If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

You would raise your predictions of future interest rates, because the higher longterm rates imply that the average of the expected future short-term rates is higher.

20. If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected future short rates falls so that the long rate falls.

21. Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

If the Federal Reserve purchases a significant amount of longer-term Treasury debt, this will reduce the effective supply of treasuries of those particular maturities, resulting in a higher price and lower yield. This should have the effect of lowering the ―long end‖ of the curve, decreasing medium- and longer-term yields. In other words, the yield curve will shift down, but mostly on medium- and long-term maturities.

ANSWERS TO APPLIED PROBLEMS 22. In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek debt.

As the risk of default by the Greek government increased, this reduced the demand for Greek bonds relative to U.S. treasuries. The result was lower prices and higher yields of Greek debt relative to U.S. debt, similar to the graphs in Figure 2 shown in the text.

23. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the plot the resulting yield curves for the following paths of one-year interest rates over the next five years: a. 5%, 6%, 7%, 6%, 5% b. 5%, 4%, 3%, 4%, 5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds? (a) The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for a three-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond. (b) The yield to maturity would be 5% for a one-year bond, 4.5% for a twoyear bond. 4.33% for a three-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond. The upward-sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds, because long-term bonds would then have a positive liquidity premium. The downward-sloping yield curve in (b) would be less steep and might have a slight positive upward slope if the long-term bonds have a positive liquidity premium.

24. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: a. 5%, 6%, 7%, 6%, 5% b. 5%, 4%, 3%, 4%, 5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds? (a) The yield to maturity would be 5% for a one-year bond, 5.5% for a two-year bond, 6% for a three-year bond, 6% for a four-year bond, and 5.8% for a five-year bond; (b) the yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4% for a three-year bond, 4% for a four-year bond, and 4.2% for a five-year bond. The upward- and then downward-sloping yield curve in (a) would tend to be even more upward sloping if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward- and then upward-sloping yield curve in (b) also would tend to be more upward sloping because of the positive risk premium for long-term bonds.

25. The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.

Year

One-Year Bond Rate

Multiyear Bond Rate

1

2%

2%

2

3%

3%

3

4%

5%

4

6%

6%

5

7%

8%

The liquidity premium for a given year is the current rate on a multiyear horizon bond minus the average of expected one-year interest rates over that horizon. Thus, the liquidity premiums for each year are given as: l11 = 2 – 2/1 = 0%. l21 = 3 – (3 + 2)/2 = 0.5%. l31 = 5 – (4 + 3 + 2)/3 = 2%. l41 = 6 – (6 + 4 + 3 + 2)/4 = 2.25%. l51 = 8 – (7 + 6 + 4 + 3 + 2)/5 = 3.6%.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on Moody’s Aaa corporate bond yield (AAA) and Moody’s Baa corporate bond yield (BAA).

Download the data into a spreadsheet. a. Calculate the spread (difference) between the Baa and Aaa corporate bond yields for the most recent month of data available. What does this difference represent?

The Baa yield for June 2020 was 3.64%, and the Aaa yield that month was 2.44%.

Thus, the credit spread was 1.20 percentage points, or 120 basis points. This difference represents the risk premium. b. Calculate the spread again, for the same month but one year prior, and compare the result to your answer to part (a). What do your answers say about how the risk premium has changed over the past year?

One year prior in June 2019, the Baa yield was 4.46% and the Aaa yield was 3.42%, representing a risk premium of 1.04 percentage points, or 104 basis points.

Thus, the risk premium has declined somewhat over the last year of available data. c. Identify the month of highest and lowest spreads since the beginning of the year 2000. How do these spreads compare to the most current spread data available?

Interpret the results.

Since the year 2000, the highest credit spread occurred in December 2008, at 3.38 percentage points, and the lowest occurred in January 2000 and June 2014 at 0.55 percentage points. The high credit spread isn’t surprising that it occurred in late 2008, since this was the height of the financial crisis. The current risk premium of 120 basis points is quite a bit higher than the low reported in January 2000 and again in June 2014 at 55 basis points.

2. Go to the St. Louis Federal Reserve FRED database, and find daily yield data on the following U.S. treasuries securities: one-month (DGS1MO), three-month (DGS3MO), six-month (DGS6MO), one-year (DGS1), two-year (DGS2), three-year (DGS3), fiveyear (DGS5), seven-year (DGS7), 10-year (DGS10), 20-year (DGS20), and 30-year (DGS30). Download the last full year of data available into a spreadsheet. a. Construct a yield curve by creating a line graph for the most recent day of data available, and for the same day (or as close to the same day as possible) one year prior, across all the maturities. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

The yield curve is shown below, for July 9, 2019, and July 9, 2020. In general, the more recent yield curve is shifted down significantly across all maturities by about 200 basis points on the short end of the yield curve, and about 120 basis points on the long end of the yield curve. However, the more recent yield curve appears to be somewhat steeper at the long end than the yield curve from one year prior, suggesting that increases in future short-term interest rates could be more plausible than a year earlier with a somewhat flat and inverted yield curve.

Yield Curves - Current and One Year Ago 3.00 2.50

Yield

2.00 9-Jul-19

1.50

9-Jul-20 1.00 0.50 0.00 1 MO3 MO6 MO 1 YR 2 YR 3 YR 5 YR 7 YR 10 YR20 YR30 YR

b. Determine the date of the most recent Federal Open Market Committee policy statement. Construct yield curves for both the day before the policy statement was released and the day on which the policy statement was released. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?

The most recent FOMC meeting policy statement occurred on June 10, 2020. The yield curve below shows yields for the end of trading day on that day, and the day prior. There is very little change between the two yield curves, indicating that for the most part, markets were not surprised by monetary policy actions, and that no unexpected monetary policy changes were announced or implemented. However, the long end of the yield curve declined very slightly after the policy meeting, perhaps indicating a slightly more dovish stance of monetary policy as viewed by market participants based upon information from the policy statement.

Yield Curves - Policy Announcement 1.60 1.40 1.20

Yield

1.00 9-Jun-20

0.80

10-Jun-20

0.60 0.40 0.20 0.00 1 MO3 MO6 MO 1 YR 2 YR 3 YR 5 YR 7 YR 10 YR20 YR30 YR

Chapter 7 ANSWERS TO QUESTIONS 1. What basic principle of finance can be applied to the valuation of any investment asset?

The value of any investment is found by computing the value today of all cash flows the investment will generate over its life.

2. What are the two main sources of cash flows for a stockholder? How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. Which security would you predict to be more volatile?

There are two cash flows from stock: periodic dividends and a future sales price.

Dividends are frequently changed when a firm’s earnings either rise or fall, which can make them difficult to estimate. The future sales price is also difficult to estimate, because it depends on the dividends that will be paid at some date even further in the future. Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. These payments are established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy. Stock prices tend to be more volatile, because their cash flows are more subject to change.

3. Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a market bubble? Explain using the Gordon growth model.

A stock market bubble can occur if market participants either believe that dividends will have rapid growth or if they substantially lower the required return on their equity investments, thus lowering the denominator in the Gordon model and thereby causing stock prices to climb. By raising interest rates the central bank can cause the required rate of return on equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the expected growth rate of the economy and hence of dividends, thus also keeping stock prices from climbing.

4. If monetary policy becomes more transparent about the future course of interest rates, how will stock prices be affected, if at all?

With more certainty over the course future interest rates will follow, uncertainty and risk would likely be reduced, which will lower the required return on investment ke and lead to a higher stock price. In addition, with a reduction in the uncertainty of future short-term interest rates, this would likely lower longer-term interest rates, increasing capital investment. This would likely raise long-run economic growth and dividend growth, also pushing stock prices higher.

5. Suppose that you are asked to forecast future stock prices of ABC Corporation, so you proceed to collect all available information. The day you announce your forecast, competitors of ABC Corporation announce a brand new plan to merge and reshape the structure of the industry. Would your forecast still be considered optimal?

Your forecast is still considered to be optimal, since it was made with all available information at the time. The fact that new information that would most probably impact the stock price of ABC Corporation arrived today, is simply out of the forecaster’s control. In this case, your forecast was optimal, but short-lived.

6. ―Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. When it is not snowing, his expectations of the driving time are perfectly accurate. Considering that it snows only once every ten years where Joe lives, Joe’s expectations are almost always perfectly accurate.‖ Are Joe’s expectations rational? Why or why not?

Although Joe’s expectations are typically quite accurate, they could still be improved by his taking account of a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations.

7. If suppose that you decide to play a game. You buy stock by throwing a dice a few times, using that method to select which stock to buy. After ten months you calculate the return on your investment and the return earned by someone who followed ―expert‖ advice during the same period. If both returns are similar, would this constitute evidence in favor of or against the efficient market hypothesis?

If both returns are similar, this would constitute evidence in favor of the efficient market hypothesis that states that the so-called ―expert‖ advice is not a better predictor of movements in stock prices than a random method. No one can predict a stock price movement if the market is efficient. The only thing that can create a price movement is new information, that by definition no one has.

8. ―If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market.‖ Is this statement true, false, or uncertain? Explain your answer.

True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable; however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist.

9. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has sharply increased in the past week, you should go out and buy stocks? Why or why not?

No, you shouldn’t buy stocks, because the rise in the money supply is publicly available information that will be already incorporated into stock prices. Hence, you cannot expect to earn more than the equilibrium return on stocks by acting on the money supply information.

10. If the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis predict will happen to the price of the stock when the $4 loss is announced?

The stock price will rise. Even though the company is suffering a loss, the price of the

stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.

11. If you read in the Wall Street Journal that the ―smart money‖ on Wall Street expects stock prices to fall, should you follow that lead and sell all your stocks?

No, because this is publicly available information and is already reflected in stock prices. The optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from selling your stocks.

12. If your broker has been right in her five previous buy and sell recommendations, should you continue listening to her advice?

Probably not. Although your broker has done well in the past, efficient markets theory suggests that she has probably been lucky. Unless you believe that your broker has better information than the rest of the market, efficient markets theory indicates that you cannot expect the broker to beat the market in the future.

13. Can a person with rational expectations expect the price of a share of Google to rise by 10% in the next month?

No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on Google stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person’s expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.

14. Suppose that in every last week of November stock prices go up by an average of 3%.

Would this constitute evidence in favor of or against the efficient market hypothesis?

If there is a phenomenon that takes place regularly and it is not incorporated into people’s expectations, then these expectations are not optimal (since they are not including all available information). We can conclude that people are not taking into account that stock prices go up every last week of November, because if they did, that price increase would represent a profit opportunity (i.e., someone could buy stock the first week of November and sell it in the last week) and would therefore be quickly exploited. This would therefore constitute evidence against the efficient market hypothesis.

15. ―An efficient market is one in which no one ever profits from having better information than the rest of the market participants.‖ Is this statement true, false, or uncertain? Explain your answer.

False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information.

16. If higher money growth is associated with higher future inflation, and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think will happen to long-term bond prices?

Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and as we learned in Chapter 7, long-term interest rates would fall.

The decline in long-term interest rates implies that long-term bond prices would rise.

17. ―Foreign exchange rates, like stock prices, should follow a random walk.‖ Is this statement true, false, or uncertain? Explain your answer.

True, in principle. Foreign exchange rates are a random walk over a short interval such as a week, because changes in the exchange rate are unpredictable; if a change were predictable, large unexploited profit opportunities would exists in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist and so the foreign exchange rate will approximately follow a random walk.

18. Assume that the efficient market hypothesis holds. Marcos has been recently hired by a brokerage firm and claims that he now has access to the best market information.

However, he is the ―new guy,‖ and no one at the firm tells him much about the business. Would you expect Marcos’s clients to be better or worse off than the rest of the firm’s clients?

If the efficient market hypothesis holds, then Marcos’s clients would technically not be at any disadvantage with respect to other clients of the same firm. However, information flows usually have a given hierarchy, in which some individuals get access to information before others. Even though the SEC makes a huge effort to avoid this phenomenon, it is quite difficult to completely eliminate it. Also, stockbrokers’ experience and expertise play a role in their favor.

19. Suppose that you work as a forecaster of future monthly inflation rates and that your last six forecasts have been off by minus 1%. Is it likely that your expectations are optimal?

For your expectations to be optimal, they have to include all available information up to date, including the fact that you have been off by minus 1% the last six times. This means that you have to incorporate your mistake or forecast errors in your predictions. Failure to do so indicates that your expectations are not optimal. Of course you can miss the exact observed inflation rate every time, but you cannot miss consistently (i.e., always predict less than the actual inflation rate).

20. In the late 1990s, as information technology advanced rapidly and the Internet was widely developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets began to unwind and then crashed, with many commentators identifying the previous few years as a ―stock market bubble.‖ How might it be possible for this episode to be a bubble but still adhere to the efficient market hypothesis?

It may be considered a bubble in that stock market prices rose well above true fundamental values. However, given the relatively new and rapid technology advances during the time, there was a great deal of uncertainty over what the true fundamental values of many technology-related companies were. Thus, even though it might be easy to identify the bubble after the fact, the efficient market hypothesis could still hold in that market participants were at the time acting on the best information available in valuing the stocks, considering much of the technology was

new and had seemingly unlimited growth potential.

21. Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?

Behavioral finance suggests that when stock prices rise, market participants are less likely to engage in short sales, which would otherwise capture unexploited profit opportunities and push misaligned stock prices back down to fundamental values.

This is due to the notion that people are more averse to downside risk than upside risk, and since short sellers can incur nearly unlimited losses, very little short selling occurs in practice. In addition, short selling is sometimes seen as taboo, since it is viewed as profiting off the losses of others.

ANSWERS TO APPLIED PROBLEMS 22. Compute the price of a share of stock that pays a $1 per year dividend and that you expect to be able to sell in one year for $20, assuming you require a 15% return.

$1/(1.15)+ $20/(1.15) = $18.26 23. After careful analysis, you have determined that a firm’s dividends should grow at 7%, on average, in the foreseeable future. The firm’s last dividend was $3. Compute the current price of this stock, assuming the required return is 18%.

P0  $3  (1.07)/(0.18  0.07)  $29.18 24. The current price of a stock is $65.88. If dividends are expected to be $1 per share for the next five years, and the required return is 10%, then what should the price of the stock be in 5 years when you plan to sell it? If the dividend and required return remain the same, and the stock price is expected to increase by $1 five years from now, does the current stock price also increase by $1? Why or why not?

The price five years from now should be $100. This can be found by solving for P5 below: $65.88 = $1/(1 + 0.1) + $1/(1 + 0.1)2 + $1/(1 + 0.1)3 + $1/(1 + 0.1)4 + $1/(1 + 0.1)5 + P5/ (1 + 0.1)5. No, the current stock price will not increase by the full dollar. Since the future stock price is discounted by the required return, the current stock price will only increase by $1/(1 + 0.1)5, or $0.62.

25. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding. Assuming the split conveys no new information about the company, what are the value of the company, the number of shares outstanding, and the price per share after the split? If the actual market price immediately following the split is $17.00 per share, what does this tell us about market efficiency?

Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split conveys no new information, the market value of the company does not change, remaining at $5 billion. But with the split, every share becomes three shares, so 300 million shares are outstanding. The new price/share is $5 billion/300 million, or $16.67/share. If the actual price is $17.00/share, the price appears too high. This can

be viewed in two ways. One possibility is that markets are inefficient—some type of anomaly has occurred, and it’s not clear if the market will correct itself. Another possibility is that the stock split actually conveyed information about the company.

Investors may believe (possibly incorrectly) that the price/share is expected to increase significantly, and that is why the firm implemented the stock split.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the Dow Jones Industrial Average (DJIA). Assume the DJIA is a stock that pays no dividends. Apply the one-period valuation model, using the data from one year prior up to the most current date available, to determine the required return on equity investment. In other words, assume the most recent stock price of DJIA is known one year prior. What rate of return would be required in order to ―buy‖ a share of DJIA? Suppose that a $100 dividend is paid out instead. How does this change the required rate of return?

The DJIA on July 10, 2020, was 26,075.30, and one year prior on July 10, 2019, was 26,860.20. With no dividend, and assuming the 2020 price was perfectly predicted, the required return is found by solving: 26,860.20= 0/(1 + ke) + 26,075.30/(1 + ke).

Solving for ke implies ke = –2.9% required rate of return on equity investment. If a $100 dividend were paid out, then 26,860.20= 100/(1 + ke) + 26,075.30/(1 + ke) gives ke = –2.5% required rate of return on equity investment.

2. Go to the St. Louis Federal Reserve FRED database and find data on net corporate dividend payments (B056RC1A027NBEA). Adjust the units setting to ―Percent Change from Year Ago,‖ and download the data into a spreadsheet. a. Calculate the average annual growth rate of dividends from 1960 to the most recent year of data available.

From 1960 to 2019, the average growth rate of dividend payments was 8.3%. b. Find data on the Dow Jones Industrial Average (DJIA) for the most recent day of data available. Suppose that a $100 dividend is paid out at the end of next year.

Use the Gordon growth model and your answer to part (a) to calculate the rate of return that would be required for equity investment over the next year, assuming you could buy a share of DJIA. Using the value of the DJIA on July 10, 2020, the required rate of return under the Gordon growth model can be found by solving for ke: 26,075.30= 100/(ke – 0.083), or ke = 0.087, or 8.7%.

Chapter 8 ANSWERS TO QUESTIONS 1. For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding: United States; Germany; Japan; Canada. Comment on the similarities and differences among the countries’ funding sources.

For each country, the largest (most important) is listed first, and smallest (least important) is listed second, as reported in Figure 1 in the text. United States: Nonbank loans; Stocks. Germany: Bank loans; Bonds. Japan: Bank loans; Stocks. Canada: Bank loans; Stocks. For the United States, bank loans are relatively unimportant, but for the other countries, this makes up a very large part of overall external financing.

For these countries (with the exception of the United States), stock and bond financing are relatively unimportant.

2. How can economies of scale help explain the existence of financial intermediaries?

Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large scale allows them to keep legal and computing costs per transaction low.

Economies of scale, which help financial intermediaries lower transactions costs, explain why financial intermediaries exist and are so important to the economy.

3. Explain why dating can be considered a method to solve the adverse selection problem.

When a couple dates, they are (explicitly or implicitly) extracting information about the significant other. At the same time, they are sharing information about themselves. This information flow helps both individuals to make better decisions about a probable (or not) future life together. In this way, one can think that this process is formally no different from the one in which the loan officer tries to choose the right borrower.

4. Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

Investors in financial instruments who engage in information collection face a freerider problem, which means other investors may be able to benefit from their information without paying for it. Individual investors therefore have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. Since they will reap all the benefits from the information they collect, their information collection activities will be more profitable. They thus have greater incentive to invest in information collection.

5. Suppose you go to your local bank, intending to buy a certificate of deposit with your savings. Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next individual who enters the bank and applies for a

car loan.

During your visit at the bank, you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off. However, you would probably like to know that individual better, in particular, his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time-consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly.

Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan.

6. Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan, the bank will keep the house title until you pay back the loan. Which problem of asymmetric information is the bank trying to solve?

The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general, the bank does not “keep the house title,” but it places a lien on it instead to prevent the house owner from selling the house without its supervision. In this case, the bank wants to make sure that you do not sell the house, get the money, and never pay back the loan.

7. Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards?

One would expect the group of countries with more efficient legal systems to exhibit higher living standards. Legal systems are an important part in the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow, and inefficient legal systems do not promote lending and thereby funding of investment opportunities.

8. Which relationship would you expect to exist between measures of corruption and living standards at the country level? Explain by which channel corruption might affect living standards.

One would expect corruption measures to be negatively correlated with living standards. Corruption usually deters investment, since it undermines the legal system.

Countries in which corruption is prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects living standards by undermining the efficiency of the legal system, thereby lowering investment, one fundamental ingredient to economic growth, the basis of higher living standards.

9. Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why?

Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off.

10. What steps can the government take to reduce asymmetric information problems and help the financial system function more smoothly and efficiently?

The government can produce information about borrowers and provide it to investors free of charge, it can require borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern the behavior of financial institutions so they do not take on too much risk. These prudential regulations for banks include banning certain activities and asset categories considered too risky, establishing minimum capital requirements, and requiring disclosure of financial information to regulators and investors.

11. How can asymmetric information problems lead to a bank panic?

Even though banks are well suited to overcome the adverse selection and moral hazard problems inherent in lending because they make private loans and have incentives to invest in information production about the borrowers to whom they lend, bank depositors face an asymmetric information problem of their own: They do not know as much as bank managers do about how much risk banks are taking and are uncertain about the safety of their deposits and their banks’ ability to pay them back in full. If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not. This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are scrambling to withdraw their deposits before their banks run out of cash, and in extreme cases can lead to a contagion in which a large number of banks fail within a short period of time.

12. In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous value. A few years later, Argentina announced it would pay back 25% of the face value of its debt. Comment on the effects of information asymmetries on government bond markets. Do you think investors are currently willing to buy bonds issued by the government of Argentina?

Information asymmetries are also present in government bond markets. Usually investors resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack of information results in huge losses for bondholders. In this respect, the problem is not significantly different from an investor who decides which corporate bond to buy, although it may be fair to say that information about corporate bonds is more standardized (making it easier to compare firms). After the Argentinean default, investors were willing to buy bonds issued by its government only at a significant risk premium, making it very costly for Argentina to raise funds in bond markets.

13. How does the free-rider problem aggravate adverse selection and moral hazard

problems in financial markets?

The free-rider problem means that private producers of information will not obtain the full benefit of their information-producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

14. Suppose that in a given bond market, there is currently no information that can help potential bond buyers to distinguish between bonds. Which bond issuers have an incentive to disclose information about their companies? Explain why.

The issuer of a good quality (low risk) bond would have an incentive to disclose information, whereas the issuer of a bad quality (high risk) bond would not. This is because when information is created and made available, potential bond buyers can make a better decision. The issuer of the bad quality bond will most probably end up receiving a lower price than the average price. Note that in the absence of information, every bond sells at the average price.

15. How do standardized accounting principles help financial markets work more efficiently?

Standardized accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better. Standardized accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to over- or understate profits, thereby reducing the principal-agent (moral hazard) problem.

16. Which problem of asymmetric information are prospective employers trying to solve when they ask applicants to go through a job interview. Is that the end of the information asymmetry?

When prospective employers ask job applicants to go through a job interview, they are trying to solve the adverse selection problem. Prospective employers want to know more about potential workers, much in the same way loan officers want to know more about potential borrowers. As it is the case with a loan transaction, the information asymmetry does not end here, since if hired, worker and employer will have to solve the moral hazard problem. Usually employers try to solve this problem with paying schemes that encourage workers to provide more effort.

17. How can the existence of asymmetric information provide a rationale for government regulation of financial markets?

Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and prosecuting fraud.

18. ―The more collateral there is backing a loan, the less the lender has to worry about

adverse selection.‖ Is this statement true, false, or uncertain? Explain your answer.

True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less, because the collateral can be sold to make up any losses on the loan. Thus, adverse selection is not as severe a problem.

19. Explain how the separation of ownership and control in American corporations might lead to poor management.

The separation of ownership and control creates a principal-agent problem. The managers (the agents) do not have as strong an incentive to maximize profits as the owners (the principals). Thus, the managers might not work hard, might engage in wasteful spending on personal perks, or might pursue business strategies that enhance their personal power but do not increase profits.

20. Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in the United States.

Explain why this might create more problems than solutions in the financial system of a developing country.

Although it might seem a good idea to ―copy and paste‖ regulatory frameworks that ensure the soundness of a financial system from one country to the other, this is usually not a good idea. Developed and developing countries have quite different financial systems. Incorporating a system of deposit insurance will surely result in an increase in deposits at financial intermediaries. However, without proper regulations (i.e., prudential regulation and supervision) to limit the moral hazard problems associated with a system of deposit insurance, banks will probably accept more risks than they would otherwise do. This is obviously not a desired consequence. The increase in moral hazard problems will probably offset the benefit derived from avoiding bank runs (the most immediate effect of a system of deposit insurance).

21. Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Explain why banks might require that much collateral in such a financial system. Comment on the consequences of such a system for economic growth.

Financial intermediaries operating in countries with relatively weak property rights and legal systems usually require a lot of collateral when making loans. The rationale for that behavior is that in the event that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its loan. Therefore, requesting extra collateral might help the bank speed up the process. In practice, a bank that has requested two other houses as collateral for a mortgage has better chances to recover its loan in the event of default. Of course this means that fewer individuals will have access to mortgages (even those with excellent credit risk are left out), since it is quite difficult to come up with such an amount of collateral (usually having your parents as cosigners and using your parents’ house as collateral is not enough). Inefficient financial systems make access to credit much more difficult in some countries, but it is fair to say that this might be the result of inefficient legal systems. As explained earlier, inefficient financial systems contribute to lower economic growth rates. This example illustrates how difficult it can be for a young individual to buy a house, resulting in less expenditure in residential investment.

ANSWERS TO APPLIED PROBLEMS For Problems 22–25, use the fact that the expected value of an event is a probability weighted average, the sum of each possible outcome multiplied by the probability of the event occurring.

22. You are in the market for a used car and decide to visit a used car dealership. You know that the Blue Book value of the car you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you do, how much are you willing to pay? Why? Assume that you care only about the expected value of the car you will buy and that the car values are symmetrically distributed.

You are willing to pay the average price. If the distribution of car values is symmetric, you are willing to pay $22,000 for a randomly selected car.

23. Refer to Problem 22. Now you believe the dealer knows more about the car than you do. How much are you willing to pay? Why? How can this asymmetric information problem be resolved in a competitive market?

You are willing to pay the average price up front: $22,000. However, the dealer will know this, and only sell you a car worth between $20,000 and $22,000. But you know this. So you will only pay $21,000. And so on. This ends with you paying $20,000, and the car being worth $20,000. This is OK for you, but the dealer can never sell cars worth more than $20,000. The resolution, of course, is to get more information. This may include a test drive, mechanical inspection, warranty, etc.

24. You wish to hire Ron to manage your Dallas operations. The profits from the operations depend partially on how hard Ron works, as follows.

Profit Probabilities Profit = $10,000

Profit = $50,000

Lazy

60%

40%

Hard worker

20%

80%

If Ron is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity. However, Ron views working hard as a ―personal cost‖ valued at $1,000.

What fixed percentage of the profits should you offer Ron? Assume Ron cares only about his expected payment less any ―personal cost.‖ Let P be the percent of profits you pay Ron. If Ron is lazy, his expected payment is 0.60  10,000 P + 0.40  50,000 P = 26,000 P If Ron works hard, his expected payment is

0.20  10,000 P  0.80  50,000 P  1,000  42,000 P  1,000

To induce Ron to work hard, you need

42, 000 P  1, 000  26, 000 P 16, 000 P  1, 000 P  0.0625 So, offer Ron slightly more than 6.25% of the profits, and this should induce him to work hard.

25. You own a house worth $400,000 that is located on a river. If the river floods moderately, the house will be completely destroyed. Moderate flooding happens about once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, and such heavy flooding happens only about once every 200 years. What would be the annual premium for a flood insurance policy that offers full insurance? For a policy that pays only 75% of the home value, what are your expected costs with and without a seawall? Do the different policies provide an incentive to be safer (i.e., to build the seawall)?

With full insurance: Without a seawall, the expected loss is 400,000  0.02 = 8,000 With a seawall, the expected loss is 400,000  0.005 = 2,000 The insurance company will charge the expected loss as a premium. Your expected cost under either scenario each year is the premium.

With partial insurance: Without a seawall, the expected loss is 300,000  0.02 = 6,000 With a seawall, the expected loss is 300,000  0.005 = 1,500 The insurance company will charge the expected loss as a premium. Your expected cost each year is: Without a seawall: [0.02  (300,000  400,000)  0.98(0)]  6,000  8,000

With a seawall: [0.005  (300,000  400,000)  0.98(0)]  1,500  2,000

Unfortunately, neither insurance policy is better nor worse. Although the premiums under the partial insurance policy are lower, the expected cost each year is the same as with full insurance. In either scenario, you will build the seawall if the annual cost of building and maintaining a seawall is less than $6,000/year.

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database and find data on net worth of households (BOGZ1FL192090005Q) and the net percentage of domestic banks tightening standards for auto loans (STDSAUTO). Adjust the units setting for the net worth indicator to ―Percent Change from Year Ago,‖ and download the data into a spreadsheet. a. Calculate the average, over the most recent four quarters and the four quarters prior to that, for the bank standards indicator and the ―percent change in net worth‖ indicator. Do these averages behave as you would expect?

See summary table below for the periods of 2019:Q2 to 2020:Q1 and 2018:Q2 to 2019:Q1. There seems to be a direct relationship between net worth and bank lending standards. When net worth growth increases from 5.0 to 5.1%, bank lending standards are tightened from 2.1% to 3.6% on net by bankers. This is contrary to what you might expect, since a higher net worth of borrowers should help to alleviate adverse selection and moral hazard. Higher net worth individuals have more to lose if they default, and therefore higher net worth borrowers are less likely to default on average, and less inclined to take on risky behavior. In the absence of higher net worth, banks must resort to other methods to ensure moral hazard and adverse selection is reduced, such as higher lending standards to only the most credit-worthy of borrowers.

2019:Q2 to 2020:Q1 2018:Q2 to 2019:Q1

Net Tightening of Auto Lending Standards, Average

Net Worth Average Growth Rate

3.6

5.1

2.1

5.0

b. Use the Data Analysis tool in Excel to calculate the correlation coefficient for the two data series from 2011:Q2 to the most recent quarter of data available. What can you conclude about the relationship between the net worth of households and auto lending standards? Is this result consistent with efforts to reduce asymmetric information?

The correlation coefficient for the two data series over that time is –0.03, which indicates almost no relationship between household net worth and lending standards. This is inconsistent with what one might expect since banks use higher lending standards in mortgage markets to alleviate moral hazard and adverse selection when net worth is low. Thus, you would expect a stronger inverse relationship between the two.

Chapter 9 ANSWERS TO QUESTIONS 1. Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the Fed? Because if the bank borrows too frequently from the Fed, the Fed may restrict its ability to borrow in the future.

2. Rank the following bank assets from most to least liquid: a. Commercial loans b. Securities c. Reserves d. Physical capital They rank from most to least liquid is (c), (b), (a), (d).

3. The bank you own has the following balance sheet: Assets

Liabilities

Reserves

$75 million

Deposits

$500 million

Loans

$525 million

Bank capital

$100 million

If the bank suffers a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, what actions should you take?

The $50 million deposit outflow means that reserves fall by $50 million to $25 million. Since required reserves are $45 million (10% of the $450 million of deposits), your bank needs to acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off $20 million of loans, borrowing $20 million in discount loans from the Fed, borrowing $20 million from other banks or corporations, selling $20 million of securities, or some combination of all of these.

4. If a deposit outflow of $50 million occurs, which balance sheet would a bank rather have initially, the balance sheet in Question 3 or the following balance sheet? Why? Assets

Liabilities

Reserves

$100 million

Deposits

$500 million

Loans

$500 million

Bank capital

$100 million

The bank would rather have the balance sheet shown in this problem, because after it loses $50 million due to deposit outflow, the bank would still have excess reserves of $5 million: $50 million in reserves minus required reserves of $45 million (10% of the $450 million of deposits). Thus, the bank would not have to alter its balance sheet further and would not incur any costs as a result of the deposit outflow. By contrast, with the balance sheet in question 3 the bank would have a shortfall of reserves of $20 million ($25 million in reserves minus the required reserves of $45 million). In this case, the bank will incur costs when it raises the necessary reserves

through the methods described in the text.

5. If no decent lending opportunity arises in the economy, and the central bank pays an interest rate on reserves that is similar to other low-risk investments, do you think banks will be willing to hold large amounts of excess reserves?

Banks should be willing to hold large amounts of excess reserves. This is exactly what happened during the onset of the global financial crisis started in 2007. Banks were willing to hold much larger amounts of excess reserves once the Fed announced that it will pay interest on reserves (IORs) in September 2008. Although the IOR was very low, it was comparable to other very low rates of safe investments like T-bills.

6. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don’t have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs?

No. When you turn a customer down, you may lose that customer’s business forever, which is extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make loans to the customer.

Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.

7. If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE? To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant, but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.

8. If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?

It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements.

9. Why do equity holders care more about ROE than about ROA? Because ROE, the return on equity, tells stock holders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank’s assets are being managed.

10. If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE? ROE will fall in half.

11. What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

The benefit is that the bank now has a larger cushion of bank capital and so is less

likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

12. Why is being nosy a desirable trait for a banker?

In order for a banker to reduce adverse selection she must screen out good from bad credit risks by learning all she can about potential borrowers. Similarly, in order to minimize moral hazard, she must continually monitor borrowers to ensure that they are complying with restrictive loan covenants. Hence, it pays for the banker to be nosy.

13. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why? Compensating balances can act as collateral. They also help establish long-term customer relationships, which make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent the firm from taking on too much risk, thereby not acting in the interest of the bank.

14. If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why or why not?

No, because the bank president is not managing the bank well. The fact that the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. Thus, the bank’s profits are low, and stock in the bank is not a good investment.

15. ―Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard.

16. If you are a banker and expect interest rates to rise in the future, would you prefer to make short-term loans or long-term loans?

You should want to make short-term loans. Then, when these loans mature, you will be able to make new loans at higher interest rates, which will generate more income for the bank.

17. ―Bank managers should always seek the highest return possible on their assets.‖ Is this statement true, false, or uncertain? Explain your answer.

False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. Thus, a bank manager has to consider risk as well as the expected return when deciding to hold an asset.

18. After July 2010, bank customers using a debit card had to specifically opt-in to the bank’s overdraft protection plan. Explain the effect of this regulation on a bank’s noninterest income.

Before this regulation, customers were automatically enrolled in bank’s overdraft protection plans. This meant that debit card transactions would be approved, even if funds were insufficient. However, a bank fee was generated by this transaction. Many customers paid fees in excess of the value of the transaction. After this regulation, customers have to specifically opt-in for an overdraft plan. As many customers do not opt-in, noninterest income was negatively affected.

ANSWERS TO APPLIED PROBLEMS 19. Using the T-accounts of the First National Bank and the Second National Bank given in this chapter, describe what happens when Jane Brown writes a $50 check on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second National Bank.

The T-accounts for the two banks are as follows: First National Bank Assets Reserves

Liabilities –$50

Checkable Deposits

–$50

Second National Bank Assets Reserves

Liabilities $50

Checkable Deposits

$50

20. What happens to reserves at the First National Bank if one person withdraws $1,000 of cash and another person deposits $500 of cash? Use T-accounts to explain your answer.

Reserves drop by $500. The T-account for the First National Bank is as follows: First National Bank Assets Reserves

Liabilities –$500

Checkable Deposits

–$500

21. Angus Bank holds no excess reserves but complies with the reserve requirement. The required reserves ratio is 9%, and reserves are currently $27 million. Determine the

amount of deposits, the reserve shortage created by a deposit outflow of $5 million, and the cost of the reserve shortage if Angus Bank borrows in the federal funds market (assume the federal funds rate is 0.25%).

Deposits = 27/0.09 = 300. The reserve shortage is calculated as outstanding reserves after the deposit outflow, minus required reserves after the deposit outflow: 22 ‒ 295 × 0.09 = ‒ 4.55 Angus Bank has to borrow $4.55 million. Borrowing from the Fed will cost Angus Bank: 0.0025 × 4.5 = $11,250 dollars.

22. Excess reserves act as insurance against deposit outflows. Suppose that on a yearly basis Malcom Bank holds $12 million in excess reserves and $88 million in required reserves. Suppose that Malcom Bank can earn 3.5% on its loans and that the interest paid on (total) reserves is 0.2%. What would be the cost of this insurance policy?

The cost of the insurance policy is the amount of foregone interest income equal to $12 × 0.035 = $0.42 million minus the interest paid on excess reserves = 12 × 0.002 = $0.02 million. Therefore, the yearly cost of holding $12 million in excess reserves is $0.40 million.

23. Victory Bank reports an EM of 25, while Batovi Bank reports an EM equal to 14.

Which bank is better prepared to respond against large losses on loans?

Victory Bank has 1/25 = 0.04 of equity capital as a percentage of assets, while Batovi Bank has 1/14 = 7.13. Batovi Bank is therefore better capitalized than Victory Bank and better suited to take large losses on loans.

24. Suppose you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank’s interest rate risk?

The assets fall in value by $8 million (= $100 million  –2%  4 years) while the liabilities fall in value by $10.8 million (= $90 million  –2%  6 years). Because the liabilities fall in value by $2.8 million more than the assets do, the net worth of the bank rises by $2.8 million. The interest rate risk can be reduced by shortening the maturity of the liabilities to a duration of four years or lengthening the maturity of the assets to a duration of six years. Alternatively, you could engage in an interest rate swap, in which you swap the interest earned on your assets with the interest on another bank’s assets that have a duration of six years.

25. Suppose you are the manager of a bank that has $15 million of fixed rate assets, $30 million of rate-sensitive assets, $25 million of fixed rate liabilities, and $20 million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by 5 percentage points. What actions could you take to reduce the bank’s interest rate risk?

The gap is $10 million ($30 million of rate-sensitive assets minus $20 million of ratesensitive liabilities). The change in bank profits from the interest rate rise is +$0.5 million (5%  $10 million); the interest rate risk can be reduced by increasing ratesensitive liabilities to $30 million or by reducing rate-sensitive assets to $20 million.

Alternatively, you could engage in an interest rate swap in which you swap the interest on $10 million of rate-sensitive assets for the interest on another bank’s $10 million of fixed rate assets.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data for all commercial banks on total liabilities (TLBACBM027SBOG), total deposits (DPSACBM027SBOG), and residual of assets less liabilities (RALACBM027SBOG). a. What is the balance sheet interpretation of the residual of assets less liabilities? b. For the most recent month of data available, use the three indicators listed above to calculate the total amount of borrowings by banks. a. The residual of assets less liabilities is bank capital. b. Since liabilities equal total deposits + borrowings + bank capital, then borrowings can be solved for. Using the data for June 2020: Borrowings = liabilities – deposits – bank capital = $18,200.4 Bil. – $15,544.6 Bil. − $1,999.4 Bil. = $656.4 Bil.

Chapter 10 ANSWERS TO QUESTIONS 1. Why are deposit insurance and other types of government safety nets important to the health of the economy?

A government safety net can short-circuit runs on banks and bank panics, and overcome reluctance by depositors to put funds in the banking system. This helps to eliminate a contagion effect, in which both good and bad banks could become insolvent in the event of a bank panic. Without confidence in the banking system, such panics could result in a collapse of the financial system and severely inhibit investment and economic growth.

2. If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result?

There would be adverse selection, because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem, because a person with a fire insurance policy has less incentive to take measures to prevent fire.

3. Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer.

Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of excessive risk-taking on the part of banks. It would, however, make bank failures and panics more likely, so it might not be a very good idea.

4. How could higher deposit insurance premiums for banks with riskier assets benefit the economy?

The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk, because doing so would increase their deposit insurance premiums. The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are.

5. What are the costs and benefits of a too-big-to-fail policy?

The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives for moral hazard by big banks that know that depositors do not have incentives to monitor the banks’ risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks.

6. Suppose that you have $300,000 in deposits at a bank. After careful consideration, the FDIC decides that this bank is now insolvent. Which method would you like to see the FDIC apply? What if your deposit were $200,000?

If you have deposited $300,000 at the failed bank, it would be better for you if the FDIC uses the purchase and assumption method. This way, the bank never closes, and you do not lose a penny. If the payoff method was used, you will get a check for $250,000 and you will have to wait a few years to get around 90 cents per dollar of the remaining $50,000. If your balance was $200,000, you are indifferent as to which method the FDIC would use to handle this failed bank.

7. Would you recommend the adoption of a system of deposit insurance, like the FDIC in the United States, in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector?

You probably would not recommend the adoption of a system of deposit insurance in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector. The main reason not to implement such a system is that its adoption solves the bank runs problem, but creates moral hazard incentives for banks to engage in risky lending. Decreasing the moral hazard incentives for risky lending requires stringent financial regulation and supervision, which requires strong (and honest) institutions.

8. At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of the largest U.S. banks to accept capital injections in exchange for nonvoting ownership stock, even though some of the banks did not need the capital and did not want to participate. What could be the Treasury’s rationale for doing this?

If the banks that did not need or want the capital injections were not forced to take the capital, then only the weakest banks would be the ones that would have received the needed capital injections to avoid insolvency. This could have started a run on those banks, which then would have accelerated their insolvency problem and created a contagion effect on the rest of the financial system, harming all banks. By forcing all banks to accept capital, this helped to reduce sending unnecessarily adverse signals to investors and depositors of the weakest banks.

9. What special problem do off-balance-sheet activities present to bank regulators, and what have they done about it?

Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Banking regulators have dealt with this problem by imposing an additional risk-based bank capital requirement that banks set aside additional bank capital for different kinds of off-balance-sheet activities.

10. What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3 Accord attempt to address these limitations?

The original Basel Accord takes into account the riskiness of capital, but in practice, the risk weights can differ substantially from the actual risk the bank faces. The Basel 2 Accords were created to address this limitation; however, addressing these shortfalls greatly increased the complexity of the accord, and there was substantial delay with countries adopting and implementing the regulations. More specifically, Basel 2 did not require banks to hold adequate capital to survive financial crises. Moreover, risk weights were dependent on credit ratings, which can be unreliable, particularly in financial crises. In addition, Basel 2 implies procyclical capital requirements, whereas countercyclical capital requirements would be more prudent. Also, there is not a sufficient focus on the need for liquidity, which is necessary particularly during financial crises. Basel 3 attempts to address these shortfalls by increasing the quality and quantity of capital requirements, making capital requirements less procyclical, establishing rules on the use of credit ratings, and requiring firms to have access to more stable funding to increase liquidity.

11. How does bank chartering reduce adverse selection problems? Does it always work?

Chartering banks helps reduce the adverse selection problem because it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs and crooks from controlling them. It will not always work because risk-prone entrepreneurs and crooks have incentives to hide their true nature and thus may slip through the chartering process.

12. Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management?

With the advent of new financial instruments, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk, bank supervisors now are focusing more on whether the risk-management procedures in banks keep them from excessive risk-taking that might make a future bank failure more likely.

13. Suppose that after a few mergers and acquisitions, only one bank holds 70% of all deposits in the United States. Would you say that this bank would be considered too big to fail? What does this tell you about the ongoing process of financial consolidation and the government safety net?

If only one bank holds 70% of all deposits in the United States, it would be a financial catastrophe if this institution fails. We can expect that the FDIC and any other competent office to do everything to prevent this institution to go bankrupt. However, as banks keep merging (with the consequence of a reduction in the number of banks but an increase in their size), this is precisely the type of problem that regulators might have to face in the future. It is a real challenge for actual and future financial regulations to deal with the problem of huge financial institutions and the potential negative effects that their failure might have in the economy.

14. Suppose Universal Bank holds $100 million in assets, which are composed of the following: Required reserves: $10 million Excess reserves: $ 5 million Mortgage loans: $20 million Corporate bonds: $15 million Stocks: $25 million Commodities: $25 million Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and commodities as assets? Why or why not?

Probably not. Since these assets are relatively high risk, the bank is subject to fluctuations in the values of these assets, which can be substantial. This could result in a significant decrease in the value of its assets to the point where it can no longer cover its immediate liabilities, and would become insolvent. It is for this reason that the government places restrictions on the types and amounts of assets that financial

institutions can hold.

15. Why might more competition in financial markets be a bad idea? Would restrictions on competition be a better idea? Why or why not?

With more competition in financial markets, there are more firms making less profits.

Thus, there is greater incentive for financial firms to take on greater risk in an effort to increase profits. Although restrictions on competition would decrease the incentive for risk by financial firms, it may not be altogether beneficial. It is likely that lower competition would result in higher fees to consumers and decreased efficiency of banking institutions.

16. In what way might consumer protection regulations negatively affect a financial intermediary’s profits? Can you think of a positive effect of such regulations on profits?

Consumer protection regulations in general make sure that all relevant information is disclosed to potential borrowers (including costs and conditions of loans) and forbid discrimination against lenders. Complying with these regulations can be costly for financial intermediaries (both in terms of the disclosing of information and lost opportunities if they for example only lend to richer potential borrowers), and thereby negatively affect their profits. However, by disclosing information and not discriminating, financial intermediaries might attract more potential customers, that will now have a fair chance of getting a loan and to thoroughly understand its conditions.

ANSWERS TO APPLIED PROBLEMS 17. Consider a failing bank. A deposit of $350,000 is worth how much to the depositor if the FDIC uses the payoff method given the typical recovery rate? How much is the same deposit worth to the depositor if the purchase-and-assumption method is used?

Which is more costly to taxpayers?

Under the payoff method, the depositor only gets around $0.90/dollar on the amount of the deposit above $250,000.

Hence, the $350,000 is worth only $340,000 ($250,000 + $100,000 × 0.90). Under the purchase and assumption policy, the bank is completely absorbed, and all accounts are worth their full value, so the $350,000 deposit is still worth $350,000. Since the recovery rate for the insurance fund is typically the same whatever method is used, but it pays out more in the purchase and assumption method, the purchase and assumption method cost taxpayers more than the payoff method.

18. Consider a bank with the following balance sheet: Assets Required reserves Excess reserves Municipal bonds

Liabilities $17 million $3 million $65 million

Checkable deposits Bank capital

$205 million $10 million

Residential mortgages Commercial loans

$70 million $60 million

Reserves and T-bills have a zero weight. So, $20 million has zero weight. Municipal bonds and Residential Mortgages carry a 50% weight. Risk-weighted assets = $135 million × 0.50 = $67.5 million. Commercial loans carry a 100% weight. Riskweighted assets = $60 million. Total risk-weighted assets = $67.5 + $60 = $127.5 million.

Calculate the bank’s risk-weighted assets. Problems 19–21 relate to a sequence of transactions at Oldhat Financial.

19. Oldhat Financial starts its first day of operations with $9 million in capital. A total of $130 million in checkable deposits is received. The bank makes a $25 million commercial loan and another $50 million in mortgages with the following terms: 200 standard, 30-year, fixed rate mortgages with a nominal annual rate of 5.25%, each for $250,000.

Assume that required reserves are 8%. a. What does the bank balance sheet look like? b. How well capitalized is the bank? c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day. a.

Assets

Liabilities

Required Reserves Excess

$10.4 million $53.6

Reserves Loans

million

Checkable Deposits Bank Capital

$130 million $9 million

$75 b. The bank is well capitalized, at 9/139 = 6.47%. million c. Reserves have a zero weight. So, $64 million has zero weight. Residential mortgages carry a 50% weight, which implies $25 million in risk-weighted assets. Commercial loans carry a 100% weight, which implies another $25 million in risk-weighted assets; thus, total risk-weighted assets are $50 million.

The bank’s risk-weighted capital ratio = 9/50 = 18%.

20. Early the next day, the bank invests $50 million of its excess reserves in commercial loans. Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%, implying a present value of Oldhat’s current mortgage holdings of $124,798 per mortgage. Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat’s balance sheet look like? How do these events affect its capital position?

The sale of each mortgage would be recorded as:

Debit

Credit

Cash

$124,798

Loss

$125,202

Mortgages

$250,0 00

After the fact, the actual balance sheet is: Assets

Liabilities

Required Reserves Excess

$10.4 million $28.6

Reserves Loans

million

Checkable Deposits Bank Capital

$130 million $16 million

$75 milliondecide to provide the bank with $25 million in bank 21. To avoid insolvency, regulators capital. However, the bad news about the mortgages is featured in the local newspaper, causing a bank run. As a result, $30 million in deposits is withdrawn.

Show the effects of the capital injection and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank? If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further runs on the bank, how much of an additional capital injection is required to reach a 10% capital ratio?

The effect of the capital injection and bank run are shown in the balance sheet below: 22.

Assets

Liabilities

Required Reserves

$ 8 million

Checkable Deposits

Excess Reserves Loans

$26 million

Bank Capital

$100 million $ 9 million

$75 million

The bank now has a 9/109 = 8.3% capital ratio; it is again well capitalized. With the run on the bank, checkable deposits fall to $100 million. In order to have a bank capital ratio of 10%, it must be the case that 0.10 = BC/(100 + BC ), where BC represents the required level of bank capital. Solving for BC yields a level of bank capital needed of $11.1 million. Thus, the regulators would need to inject an additional $2.1 million to reach a 10% capital ratio.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the number of commercial banks in the United States in each of the following categories: average assets less than $100 million (US100NUM), average assets between $100 million and $300 million (US13NUM), average assets between $300 million and $1 billion (US31NUM), average assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15 billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories, as a percentage of the total number of banks, for the most recent quarter of data available and for 1990:Q1.

What has happened to the proportion of very large banks? What has happened to the proportion of very small banks? What does this say about the ―too-big-to-fail‖ problem and moral hazard?

In 1990:Q1, there were 25 ‟very large‖ banks, and 9,529 ‟very small‖ banks, representing 0.2% and 76.5% of total commercial banks in the United States, respectively. For the most recent quarter of 2020:Q1, there were 95 ‟very large‖ banks, and 1,000 ‟very small‖ banks, representing 2.1% and 22.5% of total commercial banks in the United States, respectively. Thus, the proportion of very large banks in the banking system has increased substantially over this period while very small banks have shrunk dramatically; because of the proportional increase in these very large banks, the ―Too Big to Fail‖ problem has steadily worsened over this time. This implies that government safety nets, along with the increase in the number of very large banks, can increase moral hazard in the banking system.

2. Go to the St. Louis Federal Reserve FRED database and find data on the residual of assets less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks (TLAACBM027SBOG). Download the data from January 1990 through the most recent month available into a spreadsheet. For each monthly observation, calculate the bank leverage ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in commercial banks over time?

See the graph below. In January 1990, the leverage ratio was 6.5%, and in the most recent month of June 2020, the leverage ratio was 9.9%. There are three distinct periods in the data. The first from 1990 to the end of 1995 indicates a gradually increasing leverage ratio. At the beginning of 1996, there was a significant dropoff in bank capital, thus the ratio declines to a much lower level at some point below 4%.

Beginning in 2009, as a result of the Global Financial Crisis a number of financial regulations were put into place to raise bank capital and hence the leverage ratio, thus the sharp increase. Overall, the increase in the leverage ratio from 1990 to now indicates that, holding everything else constant, moral hazard in the banking system should be lower now than in 1990.

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Chapter 11 ANSWERS TO QUESTIONS 1. Do you think that before the National Bank Act of 1863 the prevailing conditions in the banking industry fostered or hindered trade across states in the United States?

Two important conditions hindered trade across states before 1863: there was no national currency, and banknotes issued by state banks could become worthless any day. Given these two conditions, individuals interested in conducting their business across states had to use mostly gold as a mean of payment, with all the inconveniences attached to that particular type of money.

2. Why does the United States operate under a dual banking system?

Throughout most of the history of banking in the United States, there has been a fear of centralized banking power. As a result, all banks had been chartered locally by each state. Due to lax regulation by some states, banks regularly failed due to lack of sufficient capital or fraud. To stabilize the banking system, the federal government introduced the National Banking Act of 1863, which created a system of federally chartered banks that were subject to greater regulation and scrutiny. Since federally chartered banks were less prone to failure, they increased in number over the years.

However, the skepticism of centralized power in the banking system still allowed state banks to operate effectively. And although there have been attempts over the years to force all banks to be federally chartered, due to more uniformity in the chartering process, the distinctions between state and federally chartered banks have diminished, and so the two standards are still in operation today.

3. In light of the recent financial crisis of 2007–2009, do you think that the firewall created by the Glass-Steagall Act of 1933 between commercial banking and the securities industry proved to be a good thing or not?

Answers will vary. In general, one could say that the Glass-Steagall Act was a good choice in term of separating a risky industry (the securities industry) from traditional commercial banking. In this sense, the Act of 1933 proved to be a good thing, since the banking industry did not experience many crises during its life (it was repealed in 1999). One could also argue that this Act put U.S. banks at a disadvantage against its foreign competitors in terms of lost opportunities to make profits.

4. Which regulatory agency has the primary responsibility for supervising the following categories of commercial banks? a. National banks b. Bank holding companies c. Nonfederal Reserve member state banks d. Federal Reserve member state banks e. Federally chartered savings and loan associations f. Federally chartered credit unions a. Office of the Comptroller of the Currency

b. The Federal Reserve c. State banking authorities and the FDIC d. The Federal Reserve e. Federal Housing Finance Agency f. National Credit Union Administration.

5. How does the emergence of interest rate risk help explain financial innovation?

Large fluctuations in interest rates during the 1970s and 1980s led to a need for financial products that could help reduce risk related to unexpected interest rate fluctuations. Two examples of this type of innovation are adjustable-rate mortgages and financial derivatives, both developed during the 1970s.

6. Why did new technology make it harder to enforce limitations on bank branching?

Several banks frequently share new technologies such as electronic banking facilities, so these facilities are not classified as branches. Thus, they can be used by banks to escape limitations on offering services in other states and, in effect, to escape limitations from restrictions on branching.

7. ―The invention of the computer is the major factor behind the decline of the banking industry.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting information, both of which have made other financial institutions more competitive with banks and have allowed corporations to bypass banks and borrow directly from securities markets. Therefore, computers were an important factor in the decline of the banking system. However, another source of the decline in the banking industry was the loss of cost advantages for the banks in acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as the rise in inflation and its interaction with regulations, which produced disintermediation.

8. ―If inflation had not risen in the 1960s and 1970s, the banking industry might be healthier today.‖ Is this statement true, false, or uncertain? Explain your answer.

True. Higher inflation helped raise interest rates, which caused the disintermediation process to occur and helped create money market mutual funds. As a result, banks lost cost advantages on the liabilities side of their balance sheets, leading to a less healthy banking industry. However, improved information technology would still have eroded the banks’ income advantages on the assets side of their balance sheet, so the decline in the banking industry would still have occurred.

9. How do sweep accounts and money market mutual funds allow banks to avoid reserve requirements?

With a sweep account, any account funds left at the end of the business day are technically transferred to another account, which is invested in overnight securities.

Since they are no longer classified as checkable deposits, the funds are not subject to reserve requirements. Money market mutual funds are set up such that deposits are used to invest in short-term money market securities. And although money market

mutual fund accounts have check writing functions like checkable deposits, they are also not subject to reserve requirements.

10. If reserve requirements were eliminated in the future, as some economists advocate, what effects would this have on the size of money market mutual funds?

Money market mutual funds are not subject to reserve requirements and so they avoid the tax effect of reserve requirements and have a cost advantage over banks in acquiring funds. Eliminating reserve requirements would reduce the cost advantage of money market mutual funds and would significantly reduce their size.

11. Why is loophole mining so prevalent in the banking industry in the United States?

Since the banking sector is so heavily regulated, there is a strong incentive for banks to find ways to skirt regulations that restrict their ability to earn profits. Through loophole mining, banks can create new financial products that allow them to operate within existing regulations, but make (or increase) profits that were stifled due to regulation.

12. Why have banks been losing cost advantages in acquiring funds in recent years?

The rise in inflation and the resulting higher interest rates on alternatives to checkable deposits meant that banks had a big shrinkage in this low-cost way of raising funds.

The innovation of money market mutual funds also meant that the banks lost checking account business. The abolishment of Regulation Q and the appearance of NOW accounts did help decrease disintermediation, but raised the cost of funds for American banks, which now had to pay higher interest rates on checkable and other deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their cost of funds relative to American banks.

13. Why have banks been losing income advantages on their assets in recent years?

The growth of the commercial paper market and the development of the junk bond market meant that corporations were now able to issue securities rather than borrow from banks, thus eroding the competitive advantage of banks on the lending side.

Securitization has enabled other financial institutions to originate loans, again taking away some of the banks’ loan business.

14. ―The commercial banking industry in Canada is less competitive than the commercial banking industry in the United States because in Canada only a few large banks dominate the industry, while in the United States there are around 4,500 commercial banks.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although there are many more banks in the United States than in Canada, this does not mean that the American banking system is more competitive. The reason for the large number of U.S. banks has been anticompetitive regulations such as restrictions on banking.

15. Why is there a higher percentage of banks with less than $25 million of assets among commercial banks than among savings and loans and mutual savings banks?

Because restrictions on branching are stricter for commercial banks than for savings and loans. Thus, small commercial banks have greater protection from competition

and are more likely to survive than small savings and loans.

16. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did not have restrictions on setting up branches in other states. Why, then, are credit unions typically smaller than the other depository institutions?

Credit unions are small because they only have members who share a common employer or are associated with a particular organization.

17. Why has the number of bank holding companies dramatically increased?

Because becoming a bank holding company allows a bank to: (a) circumvent branching restrictions since it can own a controlling interest in several banks even if branching is not permitted, and (b) engage in other activities related to banking that can be highly profitable.

18. Given the role of the loan originator in the securitization process of a mortgage loan described in the text, do you think the loan originator will be worried about the ability of a household to meet its monthly mortgage payments?

Given that the loan originator or mortgage broker is mostly worried about getting the household to accept the terms of the mortgage loan, so that the servicer can sell it to the bundler, then it is easy to see that he or she is not very worried about the financial constraints of this family. The loan originator is mostly worried about getting its fee, since he or she will not suffer any consequences if the household cannot repay its loan. This was one of the major problems at the origin of the global financial crisis of 2007–2009.

19. How did competitive forces lead to the repeal of the Glass-Steagall Act’s separation of the banking and securities industries?

Brokerage firms began to engage in the traditional banking business of issuing deposit instruments, while foreign bank activities in the United States further eroded the competitive position of U.S. banks. This led to the Federal Reserve’s allowing bank holding companies to enter the underwriting business through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999 was passed to repeal Glass-Steagall.

20. What has been the likely effect of the Gramm-Leach-Bliley Act on financial consolidation?

The Gramm-Leach-Bliley Act opened the door to consolidation, not only in terms of the number of banking institutions, but also across financial service activities.

Banking institutions have thus become larger and increasingly complex organizations, engaging in the full gamut of financial services activities.

21. What factors explain the rapid growth of international banking?

There are three main factors that have contributed to rapid growth in international banking: The growth in international trade and expansion of multinational corporations; the increased profitability of global investment banking; and the expansion of dollar-denominated deposits abroad (Eurodollars).

22. What incentives have regulatory agencies created to encourage international banking? Why have they done this?

International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it will create more banking jobs in the United States.

23. How could the approval of international banking facilities (IBFs) by the Fed in 1981 have reduced employment in the banking industry in Europe?

IBFs encourage American and foreign banks to do more banking business in the United States, thus shifting employment from Europe to the United States.

24. If the bank at which you keep your checking account is owned by foreigners, should you worry that your deposits are less safe than if the bank were owned by Americans?

No, because the foreign-owned bank is subject to the same regulations as the American-owned bank.

25. Why is there only two U.S. bank among the 10 largest banks in the world?

Because of tighter regulation in the United States compared to the rest of the world, there are many more banks, which has kept even the largest banks in the United States relatively small compared to those in other countries. In addition, the United States has been slower to consolidate in the banking sector than most other countries.

However, as the banking sector continues toward consolidation, it is likely that the size of the largest U.S. banks will grow.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the 30-year fixed rate average mortgage rate (MORTGAGE30US) and the 5/1-year adjustablerate mortgage (MORTGAGE5US). a. What are the mortgage rates reported for the most recent week of data available?

For the week of July 30, 2020, the 30-year fixed rate mortgage was 2.99%, and the 5/1 adjustable-rate mortgage (ARM) was 2.94%. b. If the principal payment for a given month were $2,000, then what would be the interest payment per month (using simple interest) for each of the mortgage types, using the most recent week of data?

At 2.99%, the interest payment for the 30-year mortgage using simple interest would be $2000 x 0.0299 = $59.80 per month, and the ARM interest payment would be $2000 x 0.0294 = $58.80 per month. c. Over a one-year period, how much would the difference in interest payments

between the two mortgage types amount to?

The two imply a difference of $1 per month, or $12 per year.

2. Go to the St. Louis Federal Reserve FRED database and find data on the level of money market mutual fund assets (MMMFFAQ027S). Download the data into a spreadsheet. a. When did assets start entering money market mutual funds? What was the total worth of assets in money market mutual funds at the end of 1970?

Assets started entering money market mutual funds at the beginning of 1974 (Q1). By the end of the decade in 1979:Q4 there were $45.2 billion in assets. b. For each decade period, calculate the total percentage change in assets from the beginning of the decade to the end of the decade: 1980:Q1–1990:Q1; 1990:Q1– 2000:Q1; 2000:Q1–2010:Q1; and 2010:Q1 – 2020:Q1. For each decade period, divide the total percentage change by 10 to get the average yearly percentage increase. Which decade had the largest average yearly growth in money market mutual funds?

1980 to 1990 1990 to 2000 2000 to 2010 2010 to 2020

Cumulative Decade % Change 659.8 264.2 46.6 45.4

Average Annual % Change 66.0 26.4 4.7 4.5

c. Calculate the growth rate from the most recent quarter of data available to the same quarter a year prior. How does this growth rate compare to the highest average yearly growth rate for the decades from part (b)?

For the most recent one year period from 2019:Q1 to 2020:Q1, money market mutual fund assets increased by 40.9%, which is close to the highest average yearly growth rate of about 66% per year in the 1980s.

Chapter 12 ANSWERS TO QUESTIONS 1. How does the concept of asymmetric information help to define a financial crisis?

Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.

2. How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?

When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on more risk at the lender’s expense, increasing the moral hazard problem. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an asset-price bubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset-price bust can also lead to a deterioration in financial institutions’ balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

3. How does an unanticipated decline in the price level cause a drop in lending?

An unanticipated decline in the price level leads to firms’ real burden of indebtedness increasing while there is no increase in the real value of their assets. The resulting decline in firms’ net worth increases adverse selection and moral hazard problems facing lenders, making it more likely a financial crisis will occur in which financial markets do not work efficiently to get funds to firms with productive investment opportunities.

4. Define ―financial frictions‖ in your own terms and explain why an increase in financial frictions is a key element in financial crises.

Financial frictions are a set of conditions that prevent financial markets to effectively assign funds to the best investment opportunities. In general, they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channeling of funds through the financial market is interrupted or limited, the economy slows down. This could trigger an asset-price decline, increase in uncertainty, and the deterioration in financial institutions’ balance sheets.

5. How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of

financial institutions, there is a loss of information production in financial markets and a direct loss of banks’ financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and leads to a further contraction in lending and economic activity.

6. How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.

7. What is a credit spread? Why do credit spreads rise significantly during a financial crisis?

Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007–2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.

8. Some countries do not advertise that a system of deposit insurance like the FDIC in the United States exists in their banking system. Explain why some countries would want to do that.

Some countries do not fully advertise the fact that there exists a system of deposit insurance precisely because this information makes depositors and bank clients less likely to monitor bank’s activities. Not advertising deposit insurance may limit the moral hazard problem created by a system of deposit insurance in which banks accept too much risk. If the early stages of a banking crisis occur, then the authorities can advertise the existence of a system of deposit insurance and then prevent a bank panic.

9. Describe the process of ―securitization‖ in your own words. Was this process solely responsible for the Great Recession financial crisis of 2007–2009?

The process of securitization converts a series of financial instruments (i.e., loans) into marketable securities. This process was extensively used in the U.S. financial system starting in the 1970s. However, in the early 2000s, the types of loans that were used to create marketable securities were of dubious quality, a characteristic that was directly translated into these marketable securities. The process of securitization by itself was not solely responsible of the Great Recession. The fact that funds were lent to less-than-prime borrowers and that such loans (mostly mortgages) were securitized was a contributor factor of such crisis.

10. Provide one argument in favor of and one against the idea that the Fed was responsible for the housing price bubble of the mid-2000s.

Supporters of the idea that the Fed was responsible for the Great Recession financial crisis argue that it helped to create the conditions for a housing market bubble by setting the federal funds rate (a benchmark interbank loan rate discussed later in the text) at an extremely low level. This action made funds cheaper to financial intermediaries and were therefore more willing to lend to homeowners. Another argument in favor of such a hypothesis is that the Fed was not stringent enough in its administrative task of regulating and monitoring financial intermediaries. On the other side, supporters of the Fed’s policy during this period cite other facts that contributed to the housing market bubble, in particular, the lowering of lending standards and funds inflows from India and China coupled with no attractive investment opportunities (so that eventually those funds ended up fueling the housing market bubble). This is still an ongoing and very interesting debate.

11. What role does weak financial regulation and supervision play in causing financial crises?

Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.

12. Describe two similarities and two differences between the United States’ experiences during the Great Depression and the Great Recession financial crisis of 2007–2009.

Answers may vary. Both the Great Depression and the Great Recession were preceded by sharp increases in asset prices. During the two episodes, credit spreads widened, the availability of credit shrank, and economic activity sharply declined.

The two episodes differ in the source of asset price increases: During the Great Depression, rising stock prices were the trigger, whereas in the Great Recession a housing bubble was the primary trigger. During the Great Depression, many bank failures lead to a bank panic, causing more banks to fail. During the Great Recession, even though the banking system was hit hard and bank failures did occur, they were much less pronounced, and no bank panic occurred. Finally, although both episodes resulted in significant declines in GDP and increases in unemployment, this was much more pronounced during the Great Depression, when unemployment peaked at 25% (as opposed to the recent crisis, in which the unemployment rate reached 10.2%). In part, this is the result of Federal Reserve policymakers trying much more aggressively to contain the financial crisis and reverse the decline in economic activity during the Great Recession than was true during the Great Depression.

13. What do you think prevented the financial crisis of 2007–2009 from becoming a depression?

Answers may vary. In general, it is believed that the country as a whole probably learned from the experience of the Great Depression, and has put in place more sophisticated policy frameworks to help deal with severe economic downturns more effectively. For instance, bank panics, which were widespread during the Great Depression, were virtually nonexistent during the 2007–2009 crisis; this is probably

due to bank accounts now being insured by the FDIC, when they were not during the Great Depression. Another factor seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by instituting more aggressive, swifter policies to avoid any contagion effects that would unnecessarily deepen or lengthen the crisis.

14. What technological innovations led to the development of the subprime mortgage market?

The use of data mining to give households numerical credit scores that can be used to predict defaults and the use of computer technology to bundle together many small mortgage loans and cheaply package them into securities. Together both enable the origination of subprime mortgages, which then can be sold off as securities.

15. Why is the originate-to-distribute business model subject to the principal–agent problem?

Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.

16. True, false, or uncertain: Deposit insurance always and everywhere prevents financial crises.

False. Deposit insurance is a very good system to prevent bank panics, but these events are just one potential element in a financial crisis. As the events that unfolded during the Great Recession illustrate, financial crises have many aspects evolving at the same time. A system of deposit insurance might help to prevent bank panics, but it is unable to prevent the effects of the asset-price decline in the housing market or the spreading of the crisis to international financial markets. Also, deposit insurance creates moral hazard incentives encouraging risk-taking on the part of banks that might make a financial crisis more likely.

17. How did a decline in housing prices help trigger the subprime financial crisis that began in 2007?

The decline in housing prices led to many subprime borrowers finding that their mortgages were ―underwater‖ because they owed more on them than their houses were worth. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, causing losses to financial institutions, which then deleveraged, causing a collapse in lending.

18. What role did the shadow banking system play in the 2007–2009 financial crisis?

The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms.

They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble. Because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.

19. Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?

During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly.

This leads to the expectation that asset prices may fall further in the future and increases the uncertainty over the value of assets put up as collateral. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. This requires firms to put up increasingly more collateral for the same loans over time. Due to the falling asset prices and rising haircuts, it becomes a ―buyers market‖ for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.

20. How did the global financial crisis promote a sovereign debt crisis in Europe?

The contraction in economic activity reduced tax revenues at the same time that government bailouts of failed financial institutions required an increase in government outlays. The result was a surge in budget deficits that lead to fears that the governments of hard-hit countries would default on their debt. The result was a huge sell off in the sovereign bonds of these countries that led to a surge in interest rates on these bonds.

21. Why is it a good idea for macroprudential policies to require countercyclical capital requirements?

Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.

22. How does the process of financial innovation impact the effectiveness of macroprudential regulation?

The process of financial innovation is generally good for the economy: Its goal is to create new financial instruments as a response to the ever-changing preferences of financial system participants. One of its most beneficial effects is to increase the efficiency of the financial system. This process also can be risky at times. The creation of new financial instruments is often associated with their mismanagement.

Sometimes this can result in the creation of asset-price bubbles, as happened with mortgage-backed securities (or CDOs, or SIVs) in the 2007–2009 crisis. When these instruments are improperly priced, this can disrupt the financial system. Regulators can at best be one step behind in this process, since usually as a profitable opportunity is created (e.g., by trading MBSs, CDOs, etc.) many financial intermediaries will follow this path. Only after there is a thorough understanding of the structure and risk of new financial instruments can proper regulations be written and enforced. But this usually only happens after there is a disruption in the financial system.

23. What are the three approaches to limiting the too-big-to-fail problem? Briefly describe the advantages and disadvantages of each of the approaches.

The S&L crisis can be blamed on the principal-agent problem because politicians and regulators (the agents) did not have the same incentives to minimize costs of deposit insurance as do the taxpayers (the principals). As a result, politicians and regulators relaxed capital standards, removed restrictions on holdings of risky assets, and engaged in regulatory forbearance, thereby increasing the cost of the S&L bailout.

24. Why were consumer protection provisions included in the Dodd-Frank bill, a bill designed to strengthen the financial system? What are some of the problems with these regulations?

One of the main provisions in this section of legislation is the authority to examine and enforce regulations for businesses related to the issuance of residential mortgages. Much of the financial crisis of 2007–2009 was triggered from excesses in the residential housing market in the United States, for instance with the issuance of subprime mortgages, or other types of mortgage structures that would never possibly be repaid in good faith. Had these provisions been in place prior to the housing market crash, it is possible that the effects in the housing market and broader financial markets could have been averted (or could have been much more limited in length and severity). However, this legislation is not without cost. Critics argue that the consumer protections have limited lending to otherwise creditworthy borrowers. In addition, it is costly for banks to implement the more stringent consumer protections.

As a result, although larger banks can absorb these costs more easily due to economies of scale, smaller banks have generally found it much more costly to implement the consumer protection legislation both in terms of compliance costs, and loss of revenue from more stringent lending.

25. Why is it important for the U.S. government to have resolution authority?

Prior to 2009, the U.S. government had no legal authority to seize the largest failing financial institutions, such as bank holding companies, and liquidate their assets in an orderly fashion. This became apparent during the 2007–2009 crisis, as there was no way for the government to rescue Lehman Brothers and unwind its assets. Since these types of financial institutions are considered systemically important, they pose a risk to the overall financial system because their failure can cause widespread damage.

Having resolution authority allows the government to quickly take over a failing firm and wind down its assets, with the health of the overall financial system as a priority.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on house prices (SPCS20RSA), stock prices (NASDAQCOM), a measure of the net wealth of households (BOGZ1FL192090005Q), and personal consumption expenditures (PCE).

For all four measures, be sure to convert the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For all four series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current period data minus the previous quarter data, and then divide by the previous quarter data. Multiply by 100 to change each result to a percent, and multiply by 4 to annualize the data. a. For the four series, calculate the average growth rates over the most recent four quarters of data available. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results.

See the table below. From the most recent available data from 2016:Q2 to 2017:Q1, all four data series are showing healthy gains, and are sensibly related to each other. Since homeowner’s equity and retirement or stock portfolios are the two biggest sources of wealth for households, you would expect those to be closely related to net wealth of households. And since net wealth grew substantially, you would expect autonomous consumption to rise, which appears evident in the growth in consumption of almost 5%. b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results, before and during the crisis.

See table below. The period prior to the financial crisis, and the crisis period itself are starkly different. In the 2005 period, house prices were rising quickly, and stock prices were growing steadily, contributing to a strong increase in household net wealth and strong autonomous consumption growth. During the deepest parts of the financial crisis in late 2008 into 2009, the data reverses strongly, with large, sharp declines in stock prices, house prices, and net wealth leading to shrinking consumption by households. c. How do the current household data compare to the data from the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

The most current data overall shows relatively strong growth in these household indicators somewhat similar to the pre-crisis period in 2005, although in the most recent period stock price growth is very high in comparison, while house price appreciation is very strong in the pre-crisis period. However, despite healthy stock price growth and modest home price appreciation, household net worth is relatively flat, and this translates to the relatively low consumption growth. The current data are significantly better than the crisis period.

2019:Q2 to 2020:Q1 2008:Q3 to 2009:Q2 2005:Q1 to 2005:Q4

NASDAQ Stock Price Growth

CaseShiller Home Price Growth

Household Net Worth

Consumption Growth

18.2

3.4

–0.4

1.9

26.2

17.9

9.0

2.9

6.3

14.7

9.5

6.0

2. Go to the St. Louis Federal Reserve FRED database and find data on corporate net worth of nonfinancial businesses (TNWMVBSNNCB), private domestic investment (GPDIC1), and a measure of financial frictions, the St. Louis Fed financial stress index (STLFSI2). For all three measures, be sure to convert the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For corporate net worth and private domestic investment, calculate the annualized growth rates from quarter to quarter. To do this, take the current period data minus the previous quarter data, then divide by the previous quarter data. Multiply by 100 to change the results to percentage form, and then multiply by 4 to annualize the data. a. Calculate the average growth rates over the most recent four quarters of data available for the corporate net worth and private domestic investment variables.

Calculate the difference between the value of the stress index during the most recent quarter and the value of the stress index one year earlier. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment.

See the table below. The most recent four quarters available from 2019:Q2 to 2020:Q1 indicates that financial frictions as measured by the stress index have fallen slightly, and corporate net worth is growing at 6.8%; both of these factors should lead to an improving lending and investment environment; however, in the most recent period investment grew by a relatively moderate rate of 1.9%. b. Repeat part (a) for the four quarters of 2005 and for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment before and during the crisis as they relate to your results. Assuming the financial stress measure is indicative of heightened asymmetric information problems, comment on how the crisis-period data relate to the typical dynamics of a financial crisis.

See table below. During the pre-crisis period in 2005, financial frictions were essentially flat. However, net worth of corporations was increasing well over 10% on an annual basis, providing significant reassurance to lending institutions that strong corporate balance sheets would reduce lending risk. As a consequence, investment grew at 6.1% on average for the year.

During the crisis period, there was a strong increase in financial frictions (although the net change during the period was slightly negative); with asset prices

declining, this lead to rapid deterioration of corporate balance sheets and net worth, and as a consequence, lending and investment contracted sharply by 28.9%. This is entirely consistent with the first stage of a financial crisis, where declining asset prices lead to lower net worth of firms, and lending contracts sharply. Moreover, financial frictions increased sharply during that time, which is indicative of asymmetric information problems rising. c. How do the current investment data compare to the data for the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

Financial frictions have increased significantly over the last year by 1.5 points, and although corporate net worth has grown substantially, overall investment fell 4.3% on average indicating a bubble is probably not present.

Average Change, Corporate Stress Net Worth Investment Index Growth Rate Growth Rate 2019:Q2 to 2020:Q1 1.5 11.1 –4.3 2008:Q3 to 10.7 28.9 2009:Q2 –0.4 2005:Q1 to 2005:Q4 0.2 10.7 6.1

Chapter 13 ANSWERS TO QUESTIONS 1. Why was the Federal Reserve System set up with 12 regional Federal Reserve Banks, rather than one central bank as in other countries?

Because of traditional American hostility to a central bank and centralized authority, the system of 12 regional banks was set up to diffuse power along regional lines.

2. Why is the Twelfth Federal Reserve district (San Francisco) so geographically large, while the Second Federal Reserve district (New York) is so small by comparison?

When the Federal Reserve districts were created in 1913, the districts were drawn up to reflect roughly equal populations and economic interests that prevailed at the time.

Since the West coast was so sparsely populated relative to the East coast, this implied a much larger area in the 12th district, as compared to New York’s 2nd district.

3. Should the Federal Reserve redraw its district boundaries, similar to the manner in which congressional districts are periodically realigned? Why or why not?

In theory it sounds sensible to redraw the districts to reflect the larger economic interests and population movements to western and southern states since the original Federal Reserve Act of 1913. However, in practice this would require Congress to rewrite the Federal Reserve Act and redraw the boundaries, which could create more opportunities for political interests to interfere with the monetary policy process and could take a long time to resolve.

4. ―The Federal Reserve System resembles the U.S. Constitution in that it was designed with many checks and balances.‖ Is this statement true, false, or uncertain? Explain your answer.

True. Like the U.S. Constitution, the Federal Reserve System, originally established by the Federal Reserve Act, has many checks and balances and is a peculiarly American institution. The ability of the 12 regional banks to affect discount policy was viewed as a check on the centralized power of the Board of Governors, just as states’ rights are a check on the centralized power of the federal government. The provision that there be three types of directors (A, B, and C ) representing different groups (professional bankers, business people, and the public) was again intended to prevent any group from dominating the Fed. The Fed’s independence from the federal government and the setting up of the Federal Reserve banks as incorporated institutions were further intended to restrict government power over the banking industry.

5. Which entities in the Federal Reserve System control the discount rate? Reserve requirements? Open market operations? Interest rate paid on excess reserves?

The Board of Governors sets reserve requirements, the interest rate on excess reserves and the discount rate; the FOMC directs open market operations. In practice however, the FOMC helps make decisions about reserve requirements, interest on excess reserves, and the discount rate.

6. In what ways can the regional Federal Reserve Banks influence the conduct of monetary policy?

The Federal Reserve Banks influence the conduct of monetary policy through their administration of the discount facilities at each bank and by having five of their presidents sit on the FOMC, the main policymaking arm of the Fed. 7. Why is it important for the regional Federal Reserve Bank presidents to attend the FOMC meetings, even if they are nonvoting members?

This is important since, even if they are currently nonvoting members, it gives them an opportunity to provide information on the health of the economy in their region, which could be quite different from other regions, giving important context to any policy decision.

8. Why is the New York Federal Reserve always a voting member of the FOMC? The New York Fed plays an extremely important role in the functioning of the Federal Reserve and monetary policy. Its district contains many of the largest commercial banks in the country, has regulatory authority over bank holding companies, and is very close to most financial market operations, so the New York Fed can maintain close monitoring of how the economy and financial markets are operating. In addition, the open market desk is housed at the New York Fed, which is tasked with executing the directives of monetary policy open market operations. In this capacity, the New York Fed interfaces directly with bond and foreign exchange dealers. In addition, it is a member of the Bank for International Settlements, and houses the largest gold deposit in the United States. For these reasons, the New York Fed is extremely important, and is always given a vote at FOMC deliberations.

9. The presidents of each of the district Federal Reserve Banks (including the New York Federal Reserve Bank) are currently not required to undergo a formal political appointment and approval process. Do you think this is appropriate? Why or why not?

Some may argue that the presidents of the regional Federal Reserve banks should be nominated and go through the same formal process as those on the Board of Governors, to ensure that they are qualified and will serve in a capacity that furthers the interests of the public. After all, the presidents of the regional Federal Reserve banks participate in monetary policy decisions either as voting or nonvoting members on the FOMC, so they can have an influential role in policy matters. Moreover, some worry that because banks within the region help decide who will be their district Fed president, conflicts of interest could result since the district Federal Reserve bank has oversight responsibility of those banks. However, setting up a formal political appointment and approval process could be lengthy, and leave many district Federal Reserve banks without leadership for quite some time, which could create more problems than it solves.

10. Do you think that the 14-year, nonrenewable terms for governors effectively insulate the Board of Governors from political pressure?

The 14-year terms do not completely insulate the governors from political influence.

The governors know that their bureaucratic power can be reined in by congressional legislation and so must still curry favor with both Congress and the president.

Moreover, in order to gain additional power to regulate the financial system, the

governors need the support of Congress and the president to pass favorable legislation.

11. Despite the important role played by the Board of Governors in setting monetary policy, seats to serve on the Board of Governors can sometimes be empty for several years. How might this happen?

Since members on the Board of Governors must be appointed by the president and confirmed by the Senate, the political process involved with empty seats being filled can sometimes be arduous and lengthy, particularly if the Senate majority is from the opposite party of the presidency. Thus finding qualified people who are willing to serve, and endure the vetting process, can be difficult sometimes.

12. How is the president of the United States able to exert influence over the Federal Reserve?

The president can influence the Fed in several ways. For one, the president can influence Congress, which has in the past threatened legislation to reduce independence of the Fed in various ways. Also, it is not uncommon for a president to appoint several members to the Board of Governors, so the president has the opportunity to pick people who may have particular economic ideologies. Also, the president can appoint a new chair of the Board of Governors every four years; although the previous chair can fill out his or her term on the Board, tradition dictates that they are usually expected to resign.

13. Why is it unlikely that the policy recommendation put forth by the chair of the Board of Governors would ever be voted down by the rest of the FOMC? Even though each person on the FOMC gets one vote, the policy deliberations will undoubtedly reflect the preferences of the chairman. For one, the Chair is the face of monetary policy, so if his or her recommendations get voted down on important policy matters, this could create a great amount of uncertainty among the public and financial markets. Moreover, the Chair sets the agenda, and chooses staff for research and analysis purposes, so he or she has an opportunity to shape the way a meeting evolves, as well as present data that would support his or her recommendation well.

14. In what way does the Federal Reserve have a high degree of instrument independence? If it has a specific mandate from Congress to achieve ―maximum employment and low, stable prices,‖ then how does the Fed have goal independence?

It has a high degree of instrument independence in the sense that it can choose any method it wants in order to achieve a given set of policy objectives. This has taken the form of adjusting the money supply in the past; however, the Fed now (along with most other central banks) chooses to use a short-term interest rate as its main policy instrument. The Fed has a fair amount of goal independence, despite the objectives of ―maximum employment‖ and ―low, stable prices‖ because it has a lot of latitude in interpreting exactly what ―maximum employment‖ and ―low, stable prices‖ actually means. In many other countries, goal independence is much lower, particularly for countries with a formal inflation target, which may be mandated by the government.

15. The Fed is the most independent of all U.S. government agencies. What is the main difference between it and other government agencies that explains the Fed’s greater

independence?

The Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget.

16. What is the primary tool that Congress uses to exercise some control over the Fed? The threat that Congress will acquire greater control over the Fed’s finances and budget.

17. Should the Federal Reserve be subject to periodic auditing of its policies, procedures, and finances? Why or why not?

On the one hand, if the Fed were subject to additional scrutiny, particularly on policy matters, it is possible that the prospects of policy auditing could place implicit pressure on the Fed to pursue (or not pursue) particular policies for political reasons.

This could make the Fed less independent, leading to less desirable economic outcomes. On the other hand, auditing the Fed makes it more accountable, which is consistent with democratic principles.

18. In the 1960s and 1970s, the Federal Reserve System lost member banks at a rapid rate. How can the theory of bureaucratic behavior explain the Fed’s campaign for legislation to require all commercial banks to become members? Was the Fed successful in this campaign?

The theory of bureaucratic behavior indicates that the Fed will want to acquire as much power as possible by requiring all banks to become members. Although the Fed did not succeed in obtaining legislation requiring all banks to become members of the system, it was successful in getting Congress to legislate extension of many of the regulations that were previously imposed solely on member banks (for instance, reserve requirements) to all other depository institutions. Thus the Fed was successful in extending its power.

19. ―The theory of bureaucratic behavior indicates that the Fed never operates in the public interest.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Maximizing one’s welfare does not rule out altruism. Operating in the public interest is clearly one objective of the Fed. The theory of bureaucratic behavior merely points out that other objectives, such as maximizing power, also influence Fed decision making.

20. Why might eliminating the Fed’s independence lead to a more pronounced political business cycle?

Eliminating the Fed’s independence might make it more shortsighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the Fed might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

21. ―The independence of the Fed leaves it completely unaccountable for its actions.‖ Is this statement true, false, or uncertain? Explain your answer.

False. The Fed is still subject to political pressure, because Congress can pass legislation limiting the Fed’s power. If the Fed is performing badly, Congress can

make the Fed accountable by passing legislation that the Fed does not like.

22. ―The independence of the Fed means that it takes the long view and not the short view.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although independence may help the Fed take the long view, because its personnel are not directly affected by the outcome of the next election, the Fed can still be influenced by political pressure. In addition, the lack of Fed accountability because of its independence may make the Fed more irresponsible. Thus it is not absolutely clear that the Fed is more farsighted as a result of its independence.

23. The Fed promotes secrecy by not releasing the minutes of FOMC meetings to Congress or the public immediately. Discuss the arguments for and against this policy.

The argument for not releasing the FOMC minutes immediately is that it keeps Congress off the Fed’s back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the minutes immediately is that it would make the Fed more accountable.

And as will be seen in later chapters, increased transparency can help develop market expectations that help to further promote the objectives of monetary policy actions.

24. Which is more independent, the Federal Reserve or the European Central Bank?

Why? The ECB is more independent than the Fed because its charter can only be changed by revision of the Maastricht Treaty, a very difficult process because all signatories to the treaty must agree to accept any proposed change, while the Fed’s charter can be changed by legislation, which is much easier to do. On the other hand, the goal for the ECB is more clearly specified than it is for the Fed because the Maastricht Treaty states that the overriding long-run goal of the ECB is price stability, although it doesn’t specify exactly what ―price stability‖ means.

25. Why did the Bank of England up until 1997 have a low degree of independence?

Prior to 1997, the Bank of England had very little independence, since interest rate policy was determined exclusively by Her Majesty’s Treasury (Chancellor of the Exchequer).

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the unemployment rate in the following states: Kentucky (KYUR), North Dakota (NDUR), Alaska (AKUR), New York (NYUR), Alabama (ALUR), Texas (TXUR), and the national unemployment rate (UNRATE) a. For the most recent month of data available, determine which of those states had the highest, and which had the lowest, unemployment rate; how do these compare to the national average?

For June 2020, the unemployment rates for the states are listed from highest to lowest: New York (15.7%), Alaska (12.4%), National (11.1%), Texas (8.6%), Alabama (7.5%), North Dakota (6.1%), and Kentucky (4.3%). Clearly, some states are well above the national average of 11.1%, and others are well below the

national average. The spread between the highest and lowest state in this group is 11.4 percentage points, which is substantial. b. Given your answer to part (a), what does this say about the need for all 12 Federal Reserve district presidents to participate in the FOMC meetings?

Given the wide variability in unemployment rates in this group of states, it makes sense that all regional presidents participate in the FOMC discussions, so that the voting members on the FOMC are informed about economic conditions in the entire country, not just in their own district or near Washington D.C. If only voting members participated in these discussions, this would leave out important discussions about economic conditions in the rest of the country, which could result in poorly calibrated monetary policy decisions.

2. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate target (DFEDTAR, DFEDTARU, and DFEDTARL) and the discount, or primary credit rate (DPCREDIT). When was the last time the federal funds rate target was changed? When was the last time the primary credit rate was changed?

Did the rates increase or decrease?

As of July 30, 2020, the last time the federal funds rate target was adjusted was at an unscheduled FOMC meeting on Sunday, March 15, 2020. It decreased from a target range of between 1.25% and 1.00% to a range of between 0.00% and 0.25%. The last time the primary credit rate changed was at the same FOMC meeting, decreasing from 1.75% to 0.25%.

Chapter 14 ANSWERS TO QUESTIONS Unless otherwise noted, the following assumptions are made in all questions: the required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

1. Classify each of these transactions as an asset, a liability, or neither for each of the ―players‖ in the money supply process—the federal reserve, banks, and depositors. a. You get a $10,000 loan from the bank to buy an automobile.

Public: Assets rise by $10,000 due to automobile purchase, liabilities rise by $10,000 due to loan.

Banks: Assets rise by $10,000 due to loan; this is offset by a decrease in reserves assets of $10,000. b. You deposit $400 into your checking account at the local bank.

Public: Assets are unaffected ($400 increase in checking deposits is offset by a $400 decrease in currency holdings). Banks: Assets increase by $400 from reserves; liabilities increase by $400 due to checking account balance. Fed: Liabilities are unaffected (reserves increase by $400, currency decreases by $400). c. The Fed provides an emergency loan to a bank for $1,000,000.

Banks: Assets increase by $1,000,000 in reserves; liabilities increase by the same amount due to borrowing from the Fed. Fed: Assets increase by the $1,000,000 from the loan; liabilities increase by $1,000,000 due to the increase in reserves. d. A bank borrows $500,000 in overnight loans from another bank.

Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change due to the loan. e. You use your debit card to purchase a meal at a restaurant for $100.

Public: Assets rise by the value of the meal of $100, and are offset by a fall in assets due to lower checking account balances of $100. Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change as funds are transferred from your bank account to the restaurant’s bank account.

2. The First National Bank receives an extra $100 of reserves but decides not to lend out any of these reserves. How much deposit creation takes place for the entire banking system?

None. Since there are no loans created from the new reserves, no additional deposit creation will occur.

3. Suppose the Fed buys $1 million of bonds from the First National Bank. If the First National Bank and all other banks use the resulting increase in reserves to purchase securities only and not to make loans, what will happen to checkable deposits?

Checkable deposits will remain the same.

4. If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable deposits, and the monetary base?

Reserves will decrease by $1,000, checkable deposits will decrease by $1,000, but the monetary base will be unchanged, since reserves decrease by the same amount as currency increases.

5. If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes, what is the effect on the level of checkable deposits?

None. The reduction of $10 million in discount loans and increase of $10 million of bonds held by the Fed leaves the level of reserves unchanged so that checkable deposits remain unchanged.

6. If you decide to hold $100 less cash than usual and therefore deposit $100 more cash in the bank, what effect will this have on checkable deposits in the banking system if the rest of the public keeps its holdings of currency constant?

The deposit of $100 in the bank increases its reserves by $100. This starts the process of multiple deposit expansion, leading to an increase in the money supply.

7. ―The Fed can perfectly control the amount of borrowed reserves in the banking system.‖ Is this statement true, false, or uncertain?

False. In general, The Fed will loan to banks when the need arises, and based on the desire to act as a lender of last resort. So in this sense, the Fed is at the mercy of banks’ needs for borrowed reserves when it arises and therefore cannot perfectly control the amount of borrowed reserves in the banking system.

8. ―The Fed can perfectly control the amount of the monetary base, but has less control over the composition of the monetary base.‖ Is this statement true, false, or uncertain?

Explain.

False. Since the Fed cannot control the amount of discount lending to financial institutions, it does not have perfect control over the amount of reserves, and hence does not have perfect control over the monetary base.

9. The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio. What will happen to the money supply?

When the Fed buys the $100 million of bonds from the public, this increases currency in circulation (or checkable deposits), leading to an increase in the money supply. The decline in the required reserve ratio would increase the multiplier, also leading to a higher money supply. Thus the effect of both actions unambiguously increases the money supply.

10. Describe how each of the following can affect the money supply: (a) the central bank; (b) banks; and (c) depositors. (a) The central bank can affect the money supply by affecting the amount of reserves or currency in circulation (hence changing the monetary base) through

open market operations, large-scale asset purchases, or discount loans. Additionally, it can affect the money multiplier by affecting the excess reserve ratio, either by changing the interest rate on excess reserves, or by large-scale asset purchases creating substantial excess reserves. (b) Banks can affect the money supply through their choice to hold excess reserves or not. This affects the excess reserve ratio, and thus changes the money supply through changes in the money multiplier. (c) Depositors affect the money supply through their choice to hold money in the form of currency or deposits. This affects the currency ratio, and thus changes the money supply through changes in the money multiplier.

11. ―The money multiplier is necessarily greater than 1.‖ Is this statement true, false, or uncertain? Explain your answer.

False. As the formula in Equation (4) indicates, if rr + e is greater than 1, the money multiplier can be less than 1. In practice, however, e is so small that rr + e is less than 1 and the money multiplier is greater than 1.

12. What effect might a financial panic have on the money multiplier and the money supply? Why? A financial panic would probably decrease the money multiplier and the money supply, for a given monetary base. In a financial panic, you would expect banks to want to make less risky loans, and have more liquidity on hand, which would increase the excess reserve ratio and decrease the money multiplier. In addition, depositors may get worried about the health of banks, and increase their holdings of currency, which also would decrease the money multiplier.

13. During the Great Depression years from 1930–1933, both the currency ratio c and the excess reserves ratio e rose dramatically. What effect did these factors have on the money multiplier?

Both of these factors worked to reduce the money multiplier. This can be seen in the figure in the fourth appendix to this chapter, which indicates a dramatically declining money supply, while the monetary base grew modestly, if at all.

14. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held by banks. How, if at all, might this affect the multiplier process and the money supply?

Paying interest on reserves gives banks incentive to hold more reserves rather than lend them out, which should raise the excess reserve ratio, reduce the money multiplier, and reduce the money supply, holding the monetary base constant.

15. The money multiplier declined significantly during the period 1930–1933 and also during the recent financial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the Depression period but increased by more than 20% during the recent

financial crisis. What explains the difference in outcomes?

The difference is that the monetary base increased dramatically during the recent financial crisis, which was more than enough to offset the fall in the multiplier.

During the Great Depression, the monetary base rose modestly, if at all.

ANSWERS TO APPLIED PROBLEMS Unless otherwise noted, the following assumptions are made in all of the applied problems: the required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

16. If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Reserves and the monetary base fall by $2 million, as the following T-accounts indicate: First National Bank Assets

Liabilities

Reserves

–$2 million

Securities

+$2 million

Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

17. If the Fed sells $2 million of bonds to Irving the Investor, who pays for the bonds with a briefcase filled with currency, what happens to reserves and the monetary base?

Use T-accounts to explain your answer.

Reserves are unchanged, but the monetary base decreases by $2 million due to the currency reduction, as the following T-accounts show: Irving the Investor Assets

Liabilities

Currency

–$2 million

Securities

+$2 million Federal Reserve System

Assets Securities

Liabilities –$2 million

Currency

–$2 million

18. If the Fed lends five banks a total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base?

Use T-accounts to explain your answer.

The initial effect of the loans on the banking system, Federal Reserve, and public are shown below.

Banking System (all five banks) Assets Reserves

Liabilities +$100 million

Loans (borrowings from the Fed)

+$100 million

Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed)

+$100 million Reserves

+$100 million

Public Assets

Liabilities

No change

No change

After the public withdraws $50 million in deposits to hold as currency, the Taccounts look like this: Banking System (all five banks) Assets Reserves

Liabilities +$50 million

Loans (borrowings from the Fed)

+$100 million

Checkable Deposits

–$50 million

Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed) million

+$100

Reserves

+$50 million

Currency

+$50 million

Public Assets

Liabilities

Checkable Deposits

–$50 million

Currency

+$50 million

19. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed lends $1 million to the First National Bank.

The initial effect of the loans provided by the Fed is shown in the T-accounts below: Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed)

+$1 million

Reserves

+$1 million

Banking System Assets Reserves

Liabilities +$1 million

Loans (borrowings from the Fed)

+$1 million

After the banks receive the reserves, those excess reserves are loaned out; through multiple deposit creation, the increase in reserves of the banking system will support $10 million in new loans and checkable deposits, increasing the money supply by $10 million. The final effect of the multiple deposit creation is shown in the Taccounts below: Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed)

+$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Reserves

+$ 1 million

Loans (borrowings from the Fed)

+$1 million

Loans

+$10 million

Checkable Deposits

+$10 million

20. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed sells $2 million of bonds to the First National Bank.

The Fed sale of bonds to the First National Bank reduces reserves by $2 million. The net result is that checkable deposits in the banking system decline by $20 million. The initial effect on the Fed and the banking system is shown below: Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

Banking System Assets

Liabilities

Securities

+$2 million

Reserves

–$2 million

After the decline in bank reserves, the multiple deposit creation process works in reverse, so the final effect on the Fed and banking system balance sheets is shown below: Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

Banking System Assets

Liabilities

Securities +$ 2 million

Checkable Deposits –$20 million

Reserves

–$ 2 million

Loans

–$20 million

21. If the Fed buys $1 million of bonds from the First National Bank, but an additional 10% of any deposit is held as excess reserves, what is the total increase in checkable deposits? (Hint: Use T-accounts to show what happens at each step of the multiple expansion process.)

The total increase in checkable deposits is only $5 million, substantially less than the $10 million that occurs when no excess reserves are held. The reason is that banks now end up holding 20% of deposits as reserves and only lend out 80%, so that the increase in deposits found in the T-accounts is $1,000,000 + $800,000 + $640,000 + $512,000 + $409,600 + . . . = $5 million. The T-accounts below show the effect of the securities purchase: Federal Reserve System Assets Securities

Liabilities +$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Securities

–$1 million

Reserves

+$1 million

After the increase in reserves and the multiple deposit creation process, the Fed and

Banking system balance sheets are as follows: Federal Reserve System Assets Securities

Liabilities +$1 million

Reserves

+$1 million

Banking System Assets

Liabilities

Securities

–$1 million

Reserves

+$1 million

Loans

+$5 million

Checkable Deposits

+$5 million

22. If reserves in the banking system increase by $1 billion because the Fed lends $1 billion to financial institutions, and checkable deposits increase by $9 billion, why isn’t the banking system in equilibrium? What will continue to happen in the banking system until equilibrium is reached? Show the T-account for the banking system in equilibrium.

The banking system is still not in equilibrium because there continues to be $100 million of excess reserves (+$1 billion of reserves minus $900 million of required reserves, 10% of the $9 billion of deposits). The excess reserves will be lent out until equilibrium is reached with an additional $1 billion of checkable deposits. The Taccount for the banking system when it is in equilibrium is as follows: Banking System Assets

Liabilities

Reserves

+$ 1 billion

Loans (borrowings from the Fed)

Loans

+$10 billion

Checkable deposits +$10 billion

+$1 billion

23. If the Fed reduces reserves by selling $5 million worth of bonds to the banks, what will the T-account of the banking system look like when the banking system is in equilibrium?

What will have happened to the level of checkable deposits?

Checkable deposits will decrease by $50 million when the banking system is in equilibrium (as a result of the $5 million decrease in reserves supporting the money supply). The T-account is shown below: Banking System Assets

Liabilities

Reserves

–$ 5 million

Securities

+$ 5 million

Loans

–$50 million

Checkable deposits –$50 million

24. If the Fed sells $1 million of bonds and banks reduce their borrowings from the Fed by $1 million, predict what will happen to the money supply.

The Fed’s sale of $1 million of bonds shrinks the monetary base by $1 million, and the reduction of borrowing from the Federal Reserve lowers the monetary base by another $1 million. The resulting $2 million decline in the monetary base leads to a decline in the money supply.

25. Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and excess reserves are $15 billion. a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.

The money supply is given as M = C + D = $600 billion + $900 billion = $1,500 billion; c = C/D = 600/900 = 0.667; e = ER/D = 15/900 = 0.017; m = (1 + c)/(rr + e + c) = 1.667/0.783 = 2.13. b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1,400 billion due to a sharp contraction in the economy.

Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.

The monetary base will increase to $600 + $90 + $15 + $1,400 = $2,105 billion; given the money multiplier calculated in part (a), this implies the money supply should increase to $2105  2.13 = $4483.65 billion c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

ER = $1415 billion; e = $1415/$900 = 1.57; m = (1 + 0.667)/(0.1 + 1.57 + 0.667) = 0.71. The money supply is still $1,500 billion, since both currency and deposits have not changed. d. During the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this scenario relate to your answer to part (c)?

The results from part (c) demonstrate that if large amounts of reserves enter the banking system but are held as excess reserves, it is possible for the money multiplier to fall below one.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find the most current data available on Currency (CURRNS), Total Checkable Deposits (TCDNS), and Excess Reserves (EXCSRESNS). a. Calculate the value of the currency deposit ratio c. c = CURRNS/TCDNS = 1857.0/3355.9 = 0.55 as of June 2020. b. Calculate the value of the excess reserve ratio e. e = EXCSRESNS/TCDNS = $3043.556/3355.9 = 0.907. c. Assuming a required reserve ratio rr of 11%, calculate the value of the money multiplier m.

Given the data above, m = 1.55/[0.55 + 0.907 + 0.11] = 0.99.

2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 Money Stock (M1SL) and the Monetary Base (BOGMBASE). a. Calculate the value of the money multiplier using the most recent data available and the data from five years prior.

The money multiplier for June 2020 is 5210.0/5002.0 = 1.04; for June 2015 the multiplier is 3020.4/3919.6 = 0.77. b. Based on your answer to part (a), how much would a $100 million open market purchase of securities affect the M1 money supply today and five years ago?

The $100 million open market purchase of securities will increase the monetary base by $100 million, and would hypothetically increase the M1 money supply by 1.04  $100 million = $104 million in June 2020, and the same open market operation would result in 0.77  $100 million = $77 million increase in M1 in June 2015.

Chapter 15 ANSWERS TO QUESTIONS 1. If the manager of the open market desk hears that a snowstorm is about to strike New York City, making it difficult to present checks for payment there and so raising the float, what defensive open market operations will the manager undertake?

The snowstorm would cause float to increase, which would increase the monetary base. To counteract this effect, the manager will undertake a defensive open market sale of securities using a reverse repo transaction.

2. During the holiday season, when the public’s holdings of currency increase, what defensive open market operations typically occur? Why? When the public’s holding of currency increases during holiday periods, the currency–checkable deposits ratio increases and the money supply falls. To counteract this decline in the money supply, the Fed will conduct a defensive open market purchase of securities.

3. If the Treasury pays a large bill to defense contractors and as a result its deposits with the Fed fall, what defensive open market operations will the manager of the open market desk undertake?

As we saw in Chapter 14, when the Treasury’s deposits at the Fed fall, the monetary base increases. To counteract this increase, the manager would undertake an open market sale of securities.

4. If float decreases to below its normal level, why might the manager of domestic operations consider it more desirable to use repurchase agreements to affect the monetary base, rather than an outright purchase of bonds?

Because the decrease in float is only temporary, the monetary base is expected to decline only temporarily. A repurchase agreement only temporarily injects reserves into the banking system, so it is a sensible way of counteracting the temporary decline in the monetary base due to the decline in float.

5. ―The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount rate.‖ Is this statement true, false, or uncertain? Explain your answer.

False. The Fed also can affect the level of borrowed reserves by directly limiting the amount of loans to an individual bank or the broader financial system.

6. ―The federal funds rate can never be above the discount rate.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the discount rate, it would never surpass the discount rate since banks would then borrow directly from the Fed, and not in the fed funds market, which would prevent the fed funds rate from ever rising above the discount rate. However, in practice, the fed funds rate can (and has) been above the discount rate. This may occur due to the stigma associated with banks borrowing directly from the Fed; that is, banks may prefer to pay a higher market rate than to borrow directly from the Fed and incur the perceived stigma. In addition, nonbank financial institutions, which do

not have access to the discount window, can and do participate in the federal funds market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is above the discount rate may not be arbitraged away.

7. ―The federal funds rate can never be below the interest rate paid on excess reserves.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate on excess reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower rate; this should prevent the fed funds rate from ever falling below the interest rate paid on excess reserves. However, in practice, the fed funds rate can (and has) been below the interest rate paid on excess reserves. This is because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds market and provide a significant amount of funding to the market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest rate on excess reserves may not be arbitraged away.

8. Why is paying interest on excess reserves an important tool for the Federal Reserve in managing crises?

During crises, the Fed may need to provide a large amount of liquidity to the banking and financial system, which would reduce the fed funds rate. If the Fed needs to sterilize these effects, it would need to conduct open market sales of securities to maintain a given fed funds rate target. If the liquidity provision is large, then offsetting the liquidity could eventually result in the Fed running out of securities to sell. In this case, the interest rate on excess reserves can be raised to push the fed funds rate up, without having to conduct offsetting open market sales that decrease the holdings of government securities by the Fed. 9. Why are repurchase agreements used to conduct most short-term monetary policy operations, rather than the simple, outright purchase and sale of securities?

Repurchase agreements are used because they are temporary, and allow the Fed to adjust open market operations relatively easy in response to day-to-day changes in conditions in the market for reserves.

10. Open market operations are typically repurchase agreements. What does this tell you about the likely volume of defensive open market operations relative to the volume of dynamic open market operations?

It suggests that defensive open market operations are far more common than dynamic operations because repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the monetary base.

11. Following the global financial crisis in 2008, assets on the Federal Reserve’s balance sheet increased dramatically, from approximately $800 billion at the end of 2007 to over $4.5 trillion in 2015. Many of the assets held are longer-term securities acquired through various loan programs instituted as a result of the crisis. In this situation, how could reverse repos (matched sale–purchase transactions) help the Fed reduce its assets held in an orderly fashion, while reducing potential inflationary problems in the future?

Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public. But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer maturity securities can be drawn off the balance sheet of the Fed. 12. ―Discount loans are no longer needed because the presence of the FDIC eliminates the possibility of bank panics.‖ Is this statement true, false, or uncertain?

This statement is false. The FDIC alone would likely be ineffective in eliminating bank panics without the Fed’s ability to provide discount loans to troubled banks to keep bank failures from spreading. In particular, the FDIC’s insurance only covers about 1% of total bank deposits. Since the Fed has unlimited ability to provide loans to the banking system, it can be much more effective in stabilizing the banking system in a panic.

13. What are the disadvantages of using loans to financial institutions to prevent bank panics?

Providing loans to financial institutions creates a moral hazard problem. If firms know that they will have access to Fed loans, they are more likely to take on risk, knowing that the Fed will bail them out if a panic should occur. As a result, banks that deserve to go out of business because of poor management may survive because of Fed liquidity provision to prevent panics. This might lead to an inefficient banking system with many poorly run banks.

14. ―Considering that raising reserve requirements to 100% makes complete control of the money supply possible, Congress should authorize the Fed to raise reserve requirements to this level.‖ Discuss.

One problem with this proposal is that it provides perfect control over the official measure of the money supply, but it may weaken control over the measure of the money supply that is economically relevant. An additional problem is that it will result in a costly restructuring of the financial system, as banks are forced to get out of the loan business.

15. Following the coronavirus pandemic in March of 2020, the Federal Reserve announced that it reduced the reserve requirement to zero as the size of the Fed’s balance sheet approached $6 trillion. What might be the rationale for implementing such a change?

In addition to helping encourage banks to lend during the coronavirus pandemic, there is a practical reason for reducing reserve requirements to zero. With a large balance sheet and excess reserves near $3 trillion dollars, the reserve requirement was essentially unnecessary. In an ample reserves framework, the amount of excess reserves dwarfs the amount of required reserves, thus the potential for banks to run out of needed reserves at any given time is quite low. The reduction in reserve requirements shifts the reserve demand curve to the left, however with a large balance sheet, the equilibrium interest rate is on the elastic portion of reserve demand, thus this change would not affect the equilibrium fed funds rate.

16. What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the effective lower bound?

Since short-term interest rates cannot be lowered much below the effective lower bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer-term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion.

17. Why is the composition of the Fed’s balance sheet a potentially important aspect of monetary policy during an economic crisis?

By purchasing particular types of securities, the Fed can impact interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision of liquidity where it may be needed the most (as opposed to typical open market purchases, which add reserves to the general banking system). For example, as a result of the global financial crisis the Fed purchased a significant amount of mortgage-backed securities from government sponsored enterprises, which helped to lower mortgage rates and support the housing market.

18. What is the main advantage and the main disadvantage of an unconditional policy commitment?

The main advantage to an unconditional policy commitment is that it provides a significant amount of transparency and certainty, which makes it easier for markets and households to make decisions about the future. The main disadvantage is that it represents a tacit commitment by the central bank; if conditions suddenly change where a change in the policy stance may be warranted, then holding to the commitment could be destabilizing. On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and the central bank could lose significant credibility.

19. In which economic conditions would a central bank want to use a ―forward-guidance‖ strategy? Based on your previous answer, can we easily measure the effects of such a strategy?

In general a central bank would use a strategy of ―forward guidance‖ when other types of conventional tools of monetary policy cannot affect the economy in the desired way. In practice, this strategy was followed by the Fed during the aftermath of the Great Recession to try to lower long-term interest rates (since the federal funds rate had hit the zero bound). As economic conditions are usually quite abnormal during the implementation of these strategies, it is in general difficult to ascertain their effects: during abnormal economic conditions standard models of agent’s behavior are not good representations of their decision making process and economists cannot therefore identify the reasons as to why one variable has changed.

20. How do the monetary policy tools of the European System of Central Banks compare to the monetary policy tools of the Fed? Does the ECB have a discount lending facility? Does the ECB pay banks an interest rate on their deposits?

In general the set of monetary policy tools available to the ECB is quite similar to the one at the Fed’s disposal. The ECB has a discount lending facility, called the marginal lending facility that is ready to supply funds to member banks at the marginal lending rate. This rate also acts as a ceiling for the overnight market rate, as in the United States does the discount rate. The ECB pays bank members an interest rate for their deposits at the ECB, thereby creating a floor for the overnight rate, as the Fed does in the United States.

21. What is the main rationale behind paying negative interest rates to banks for keeping their deposits at central banks in Sweden, Switzerland, and Japan? What could happen to these economies if banks decide to loan their excess reserves, but no good investment opportunities exist?

The rationale behind that idea is to encourage banks to create loans, as opposed to keeping their excess reserves idle at central banks. One can think that if banks are somewhat ―forced‖ to create loans when economic conditions are uncertain, it might result in funds being misallocated, and creating another sort of problem. For example, if banks create loans without the desirable mix of liquidity, term and risk, banks might be in trouble in the future, which also constitutes a problem for central bankers.

22. In early 2016 as the Bank of Japan began to push policy interest rates negative, there was a sharp increase in safes for homes in Japan. Why might this be, and what does it mean for the effectiveness of negative interest rate policy?

Negative policy interest rates have the effect of making deposit rates at banks negative. Thus, people can avoid negative returns on holding cash by simply pulling their money out of deposit accounts and keeping the cash in safes (with a zero return). This has two main implications for the effectiveness of negative interest rate policy. First, it has the potential side effect of decreasing liquidity in the banking sector as depositors pull their money from banks. This can destabilize the banking system, and reduce the amount of money in the banking system available for lending. Second, the intended effect of negative interest rates is to penalize

saving in the form of deposits, and thereby encourage consumption and borrowing, which can help stimulate the economy. However, if depositors are simply pulling their deposits and instead holding them as cash in safes, it does not increase spending and create the intended stimulus.

ANSWERS TO APPLIED PROBLEMS 23. If a switch occurs from deposits into currency, what happens to the federal funds rate? Use the supply and demand analysis of the market for reserves to explain your answer.

The switch from deposits into currency lowers the amount of reserves as was shown in the T-accounts of Chapter 14, and this lowers the supply of reserves at any given interest rate, thus shifting the supply curve to the left. The fall in deposits also leads to lower required reserves and hence a shift in the demand curve to the left. However, because the fall in required reserves is only a fraction of the fall in the supply of reserves (because the required reserve ratio is much less than one), the supply curve shifts left by more than the demand curve. Thus if the discount rate is initially above the fed funds target, the fed funds rate will rise (as shown in the graph below). However, if the fed funds rate is at the discount rate, then the fed funds rate will remain at the discount rate.

24. Why is it that a decrease in the discount rate does not normally lead to an increase in borrowed reserves? Use the supply and demand analysis of the market for reserves to explain.

In most cases, the discount rate is set far enough above the fed funds target rate such that, even if there was a reduction in the discount rate with no change in the target fed funds rate, the equilibrium rate would still be below the discount rate, thus banks would still be better off borrowing at the market rate rather than the discount rate. In other words, even if the discount rate decreases, the amount of borrowed reserves may not change since the equilibrium will still fall below the discount rate, as shown in the graph below.

25. Using the supply and demand analysis of the market for reserves, indicate what happens to the federal funds rate, borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations. a. The economy is surprisingly strong, leading to an increase in the amount of checkable deposits.

A rise in checkable deposits leads to a rise in required reserves at any given interest rate, and thus shifts the demand curve to the right. If the federal funds rate is initially below the discount rate, this then leads to a rise in the federal funds rate.

As shown in the graph below, borrowed reserves and nonborrowed reserves do not change. If the federal funds rate is initially at the discount rate, then the federal funds rate will just remain at the discount rate, but borrowed reserves will increase.

b. Banks expect an unusually large increase in withdrawals from checking deposit accounts in the future.

If banks expect that an unusually large increase in withdrawals will occur in the future, they will want to hold more excess reserves today, meaning the demand for reserves will increase at any given interest rate. This will have the same effect on the fed funds rate, NBR, and BR as in part (a) above. c. The Fed raises the target federal funds rate.

To raise the target fed funds rate, the Fed will have to conduct an open market sale of securities, which will shift the supply of nonborrowed reserves to the left.

The fed funds rate will increase, and as long as the equilibrium fed funds rate remains below the discount rate, borrowed reserves will remain the same.

d. The Fed raises the interest rate on excess reserves above the current equilibrium federal funds rate.

Raising the interest rate on reserves above the current fed funds rate means that the floor of reserve demand will push the equilibrium fed funds rate up along with the interest rate on reserves. Both borrowed reserves and nonborrowed reserves will remain the same.

e. The Fed reduces reserve requirements.

A decrease in required reserves shifts the demand for reserves line to the left, at any given interest rate. The result is that the fed funds rate decreases, and NBR and BR remain unchanged.

f. The Fed reduces reserve requirements and then offsets this action by conducting an open market sale of securities.

With the decrease in required reserves, this reduces reserve demand as shown in part (e) above. This will decrease the equilibrium fed funds rate. In order to sterilize the effects and keep the fed funds rate unchanged, the Fed will conduct an open market sale of securities, shifting the reserve supply line to the left. The end result is that the fed funds rate and borrowed reserves will be unchanged, and nonborrowed reserves will decrease.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on nonborrowed reserves (NONBORRES) and the federal funds rate (FEDFUNDS). a. Calculate the percent change in nonborrowed reserves and the percentage point change in the federal funds rate for the most recent month of data available and for the same month a year earlier.

From June 2019 to June 2020, nonborrowed reserves increased by $1,344,656 million, or 84.0% and the federal funds rate decreased from 2.38% to 0.08%, or a decrease of 230 basis points. b. Is your answer to part (a) consistent with what you expect from the market for reserves? Why or why not?

Nonborrowed reserves increased significantly over the one-year period, while the federal funds rate decreased significantly. This is generally consistent with what you would expect in the market for reserves: as the supply of nonborrowed reserves decreases, the federal funds rate should increase (similar to what is shown in Figure 2, panel (a)). However, given the current ample reserves monetary policy environment, and that the federal funds rate is near the interest rate on excess reserves, it is more likely that decreases in the interest rate on excess reserves are decreasing the federal funds rate (the opposite of what is shown in Figure 5, panel (b)), rather than increases in nonborrowed reserves.

2. In December 2008, the Fed switched from a point federal funds target to a range target (and it’s possible that it will switch back to a point target in the future). Go to the St. Louis Federal Reserve FRED database, and find data on the federal funds targets/ ranges (DFEDTAR, DFEDTARU, DFEDTARL) and the effective federal funds rate (DFF). Download into a spreadsheet the data from the beginning of 2006 through the most current data available. a. What is the current federal funds target/range, and how does it compare to the effective federal funds rate?

As of July 30, 2020, the Fed’s current target is a range of between 0.0% and 0.25%. On this day, the effective federal funds rate was well within this range, at 0.10%. b. When was the last time the Fed missed its target or was outside the target range?

By how much did it miss?

The last time the Fed missed its target was when it switched from a target of between 1.50 and 1.75%% to a target of between 1.0% and 1.25% which occurred on March 3, 2020. At that time, the effective federal funds rate was 1.59% compared to the target of between 1.0% and 1.25%. This represents a miss of 34 basis points.

c. For each daily observation, calculate the ―miss‖ by taking the absolute value of the difference between the effective federal funds rate and the target (use the abs(.) function). For the periods in which the rate was a range, calculate the absolute value of the ―miss‖ as the amount by which the effective federal funds rate was above or below the range. What was the average daily miss between the beginning of 2006 and the end of 2007? What was the average daily miss between the beginning of 2008 and December 15, 2008? What is the average daily miss for the period from December 16, 2008, to the most current date available? Since 2006, what was the largest single daily miss? Comment on the Fed’s ability to control the federal funds rate during these three periods.

From the beginning of 2006 to the end of 2007, the average daily miss was 0.05, or 5 basis points. From the beginning of 2008 to December 15, 2008, the average daily miss was 0.22, or 22 basis points. From December 16, 2008 through July 30, 2020, the federal funds target was specified as a range, and the effective federal funds rate was outside of that range only a few times for brief periods by very small amounts, thus the average miss during that time is essentially zero. The largest single daily miss occurred on October 2, 2008, representing a miss of 1.33, or 133 basis points. In the earlier period, and the most recent period, the Fed has demonstrated relatively good precision in maintaining the federal funds rate close to target, but for somewhat different reasons. In the 2006–2007 period, reserve demand was relatively stable, so it was relatively easier to conduct defensive open market operations to keep the effective federal funds rate close to target. In the most recent period, because a range is specified, it is somewhat easier to keep the federal funds rate within target range. In addition, given the large size of the balance sheet, any variation in reserve demand won’t affect the effective federal funds rate much since it is pinned by the interest rate on excess reserves. The period in 2008 represented much more volatility where the Fed missed its target often, and sometimes by large amounts. Due to the effects of the global financial crisis and uncertainty in financial markets, large unpredictable swings in reserve demand meant greater fluctuations in the effective federal funds rate, and due to the unpredictable nature of these events, made it harder for the Fed to conduct defensive open market operations as effectively to maintain the federal funds rate at target.

Chapter 16 ANSWERS TO QUESTIONS 1. What are the benefits of using a nominal anchor for the conduct of monetary policy?

A nominal anchor helps promote price stability by tying inflation expectations to low levels directly through its constraint on the value of money. It can also limit the timeinconsistency problem by providing an expected constraint on monetary policy.

2. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy?

Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy even though in the long run this just leads to higher inflation with no gains to increasing output or lowering unemployment. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies.

3. Why would it be problematic for a central bank to have a primary goal of maximizing economic growth?

This could pose a problem for a couple reasons. First of all, monetary policy has limited ability to encourage long-run economic growth other than through its ability to maintain low, stable long-run inflation and interest rates. Moreover, a strictly interpreted focus on economic growth may result in an unhealthy focus on keeping short-term interest rates low for a prolonged period of time to raise investment and consumption in the near term. This could lead to imbalances in the economy that, if not properly addressed, could lead to bubbles and financial crises.

4. ―Since financial crises can impart severe damage to the economy, a central bank’s primary goal should be to ensure stability in financial markets.‖ Is this statement true, false, or uncertain? Explain.

Uncertain. Most economists probably would not dispute that trying to maintain stability in financial markets is important to the economy. However, having a constant and prioritized focus on financial market stability in order to prevent crises in most cases is probably unnecessary since financial crises are generally pretty rare. In addition, constantly focusing on maintaining stability in financial markets could come at the expense of ignoring more important factors that can be far more costly to the economy on a day-to-day basis, such as stabilizing output, unemployment, or other related shortterm movements in the business cycle.

5. ―A central bank with a dual mandate will achieve lower unemployment in the long run than a central bank with a hierarchical mandate in which price stability takes precedence.‖ Is this statement true, false, or uncertain? Explain.

False. There is no long-run tradeoff between inflation and unemployment, so in the long run a central bank with a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no more success at reducing unemployment than one whose primary goal is price stability.

6. Why is a public announcement of numerical inflation rate objectives important to the success of an inflation-targeting central bank?

The success of inflation targeting relies on its ability to credibly anchor inflation expectations at a low, desirable level. Without formal public announcements and reminders about the numerical inflation target, markets and the public may have less faith that policymakers are committed to maintaining the inflation target. And if a formal inflation target is not announced at all, market participants and the public may not know the exact target and be forced to infer or estimate the target, creating uncertainty which can raise inflation expectations and unanchor inflation expectations from a low, desirable level.

7. How does inflation targeting help reduce the time-inconsistency problem of discretionary policy?

Inflation targeting increases the accountability of monetary policymakers, and is a mechanism of self-discipline that effectively ties the hands of policymakers to commit to a policy path. Because of the transparency of an inflation targeting framework, it is very easy to verify whether policymakers are faithful to a committed policy path. As a result, there is much less ability and incentive for policymakers to deviate to a discretionary policy which could increase output or raise the inflation rate, therefore mitigating the time-inconsistency problem.

8. What methods have inflation-targeting central banks used to increase communication with the public and to increase the transparency of monetary policymaking?

Inflation-targeting central banks engage in extensive public information campaigns that include the distribution of glossy brochures, the publication of Inflation Reporttype documents, making speeches to the public, and continual communication with the elected government.

9. Why might inflation targeting increase support for the independence of the central bank in conducting monetary policy?

Sustained success in the conduct of monetary policy as measured against a preannounced and well-defined inflation target can be instrumental in building public support for a central bank’s independence and for its policies. Also inflation targeting is consistent with democratic principles because the central bank is more accountable.

10. ―Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations.‖ Is this statement true, false, or uncertain? Explain.

False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targeters do worry about output fluctuations, and inflation targeting may even be able to reduce output fluctuations because it allows monetary policymakers to respond more aggressively to declines in demand because they don’t have to worry that the resulting expansionary monetary policy will lead to a sharp rise in inflation expectations.

11. What are the key advantages and disadvantages of the monetary strategy used by the Federal Reserve under Alan Greenspan, in which the nominal anchor was implicit rather than explicit?

This strategy has the following advantages: (a) it enables monetary policy to focus on domestic considerations; (b) underscoring the importance of price stability has helped it to mitigate the time-inconsistency problem, and (c) it has had a demonstrated success, producing low inflation with the longest business cycle expansion since World War II. However, it has the following disadvantages: (a) it is strongly dependent on the preferences, skills, and trustworthiness of individuals in the central bank and the government; and (b) it has some inconsistencies with democratic principles because the central bank is not highly accountable.

12. ―The effective lower bound on short-term interest rates is not a problem, since the central bank can just use quantitative easing to lower intermediate and longer-term interest rates instead.‖ Is this statement true, false, or uncertain? Explain.

False. Although it is true that quantitative easing and other types of nonconventional policy can be used once the effective lower bound is reached on short-term interest rates, it is not a panacea. In particular, when the economy reaches the effective lower bound, this often can be coupled with deflationary conditions, which can be hard to design effective policies for, since the outcomes from such policies are much more uncertain than conventional interest rate policy under typical conditions. In addition, nonconventional policies such as quantitative easing are more complex to implement, so it may be harder to effectively use these programs to push the economy away from the effective lower bound.

13. If higher inflation is bad, then why might it be advantageous to have a higher inflation target rather than a lower target that is closer to zero?

The zero lower bound on nominal interest rates makes it harder to implement expansionary policy as actual inflation (and hence short-term interest rates) fall closer to zero. As a result, there is less room to use monetary policy as a stabilization tool in a low inflation environment. In this context, it is argued that a higher inflation target may be appropriate to give policymakers more flexibility. The downside of this of course is that in general higher inflation rates can be costly to society, posing a tradeoff for monetary policymakers in terms of flexibility versus efficiency of monetary policy.

14. Why might macroprudential regulation be more effective in managing asset-price bubbles than monetary policy?

There are several reasons why monetary policy may not be effective in eliminating asset-price bubbles. The main reason is that asset-price bubbles are extremely difficult to identify in real time; in many cases, by the time there is a consensus among policymakers and the public that a bubble exists, it is usually too late to implement policies to effectively deflate the bubble. And even if an asset-price bubble is identified in a timely manner, monetary policy is often thought of as too blunt an instrument to be able to deal effectively with most asset-price bubbles. In particular, interest rate changes may have some modest short-term effects on reducing the asset-price bubble, but the interest rate changes may have far more consequential effects on real economic activity and cause far worse collateral damage. Thus,

because of the limitations of monetary policy, proactively identifying potential problems in advance and implementing safeguards in the banking and financial system can provide a more targeted and effective backstop against bubbles than monetary policy can.

15. Why might it be better to lean against credit-driven bubbles rather than just clean up after other types of asset bubbles burst?

In general, the question of appropriate policy response is one of minimizing loss.

Credit-driven bubbles (such as the housing bubble experience that resulted in the global financial crisis) can be far more devastating to the economy if a crash occurs than if policymakers acted to reduce the size of the bubble preemptively. In other words, raising interest rates to try to reduce the bubble may cause collateral damage to the economy, but it would result in far less damage than would presumably occur if nothing were done at all and the bubble were allowed to continue to build. On the other hand, noncredit driven bubbles can more easily be dealt with after a crash; since financial markets generally function relatively normally following these types of bubble crashes, conventional monetary policy can be relatively effective at mitigating any recessionary conditions in the aftermath. Acting preemptively to address the bubble is likely to cause more collateral damage than is inflicted by any downturn related to a noncredit driven bubble crashing.

16. According to the Greenspan doctrine, under what conditions might a central bank respond to a perceived stock market bubble?

Because a stock market bubble may be hard to identify (at least through consensus) and policy could cause more damage than necessary, in general Greenspan would advocate not acting directly on the stock market bubble. However, insofar as the stock market bubble raised wealth and increased consumption and investment, raising interest rates would be seen as prudent in order to maintain low, stable inflation and minimize near-term output fluctuations as a result of the higher wealth. In other words, the Greenspan Doctrine would say not to act directly on the bubble, but to pursue policy as normal to maintain price stability and stability in real economic activity.

17. Classify each of the following as either a policy instrument or an intermediate target, and explain your choice. a. The 10-year Treasury bond rate The ten-year bond is an intermediate target because it is not directly affected by the tools of the Fed, but is linked to economic activity. b. The monetary base The monetary base is a policy instrument because it can be directly affected by the tools of the Fed and is only linked to economic activity through its effect on the money supply. c. M1 M1 is an intermediate target because it is not directly affected by the tools of the Fed and has some direct effect on economic activity. d. The fed funds rate

The fed funds rate is a policy instrument because the tools of the Fed can directly affect it.

18. ―If the demand for reserves did not fluctuate, the Fed could pursue both a reserves target and an interest-rate target at the same time.‖ Is this statement true, false, or uncertain? Explain.

True. In such a world, hitting a reserves target would mean that the Fed would also hit its interest rate target, or vice versa. Thus the Fed could pursue both a reserves target and an interest rate target at the same time, but only if there were no variation in reserve demand.

19. What procedures can the Fed use to control the federal funds rate? Why does control of this interest rate imply that the Fed will lose control of nonborrowed reserves?

The Fed can control the federal funds rate by buying and selling bonds in the open market. When the fed funds rate rises above the target level, the Fed would buy bonds, which would increase nonborrowed reserves and lower the interest rate to its target level. Similarly, when the fed funds rate falls below the target level, the Fed would sell bonds to raise the interest rate to the target level. The resulting open market operations would of course affect the quantity of reserves and the money supply and cause them to change. The Fed would be giving up control of reserves and the money supply to pursue its interest rate target.

20. Compare the monetary base to M1 on the grounds of controllability and measurability. Which do you prefer as an intermediate target? Why? The monetary base is more controllable than M1 because the tools of the Fed more directly influence it. It is measured more accurately and quickly than M1 because the Fed can calculate the base from its own balance sheet data, while it constructs M1 numbers from surveys of banks, which take some time to collect and are not always that accurate.

Even though the base is a better intermediate target on the grounds of measurability and controllability, it is not necessarily a better intermediate target because its link to economic activity may be weaker than that between M1 and economic activity.

21. ―Interest rates can be measured more accurately and quickly than reserve aggregates; hence an interest rate is preferred to the reserve aggregates as a policy instrument.‖ Do you agree or disagree? Explain your answer.

Disagree. Although nominal interest rates are measured more accurately and more quickly than reserve aggregates, the interest rate variable that is of more concern to policymakers is the real interest rate. Because the measurement of real interest rates requires estimates of expected inflation, it is not true that real interest rates are necessarily measured more accurately and more quickly than reserves. Interest rate targets are therefore not necessarily better than reserve targets.

22. How can forward guidance as a tool of the central bank affect the policy instrument, intermediate targets, and goals?

There are two main channels by which forward guidance can ultimately affect goal variables. First off, the central bank can communicate information about the expected

path of future short-term interest rates (policy instrument). This can affect intermediate targets such as longer-term interest rates. Thus changes in borrowing costs such as longer-term interest rates can affect economic activity, and ultimately other related goals such as price or exchange rate stability. The second channel is through the expected holdings of reserves; as the central bank communicates about the expected path of its asset holdings, this impacts the expected reserve aggregates (policy instrument) which then can impact short-term and long-term interest rates (intermediate targets), and similarly affect goal variables.

23. What does the Taylor rule imply that policymakers should do to the fed funds rate under the following scenarios? a. Unemployment rises due to a recession.

If unemployment rises, this would lower the output gap, and trigger a lower fed funds rate according to the Taylor rule. b. An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%.

If inflation rises by 1%, this alone would prompt the fed funds rate to rise by 1.5 percentage points. The decrease in the output gap alone would imply the fed funds rate would fall by 0.5 percentage points. Thus, the two factors together imply a net effect of increasing the fed funds rate by one percentage point according to the Taylor rule. c. The economy experiences prolonged increases in productivity growth while actual output growth is unchanged.

Prolonged increases in productivity growth would increase potential output, and with the same rate of actual output growth this would cause the output gap to decline, resulting in a decline in the fed funds rate according to the Taylor rule. d. Potential output declines while actual output remains unchanged.

If potential output declines, this is the opposite of (c) above, so the fed funds rate would rise according to the Taylor rule. e. The Fed revises its (implicit) inflation target downward.

If the inflation target is revised downward, this would increase the inflation gap at any given inflation rate. This would result in a higher fed funds rate according to the Taylor rule. f. The equilibrium real fed funds rate decreases.

If the equilibrium real fed funds rate decreases, all else equal, the Taylor rule would prescribe a decrease in the nominal fed funds rate.

ANSWERS TO APPLIED PROBLEMS 24. If the Fed has an interest rate target, why will an increase in the demand for reserves lead to a rise in the money supply? Use a graph of the market for reserves to explain.

An increase in the demand for reserves will raise the federal funds rate. In order to maintain the interest rate target, the Fed will buy bonds, thereby increasing the amount of nonborrowed reserves, which shifts the supply curve for reserves to the

right, thereby keeping the fed funds rate from rising, as shown below. The open market purchase will then cause the monetary base and the money supply to rise.

25. Since monetary policy changes made through the fed funds rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate, rather than the current inflation rate. In light of this, suppose that monetary policymakers employ the Taylor rule to set the fed funds rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the inflation and output gaps are ½ the equilibrium real fed funds rate is 2%, the inflation rate target is 2%, and the output gap is 1%. a. If the expected inflation rate is 4%, then at what target should the fed funds rate be set according to the Taylor rule?

Assuming the output gap and all other parameters remain constant, the Taylor rule is ffr = e + 2 + 0.5(e – 2) + 0.5 (1), where e is expected inflation. Thus, if e = 4%, then the fed funds rate should be set to 4 + 2 + 0.5(2) + 0.5 = 7.5%. b. Suppose half of Fed economists forecast inflation to be 3%, and half of Fed economists forecast inflation to be 5%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then e = 0.5 (3% + 5%) = 4%. In this case, again the Taylor rule would imply a setting of the fed funds rate of 7.5%. c. Now suppose half of Fed economists forecast inflation to be 0%, and half forecast inflation to be 8%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according

to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then e = 0.5 (0% + 8%) = 4%. In this case, again the Taylor rule would imply a setting of the fed funds rate of 7.5%. d. Given your answers to parts (a)–(c) above, do you think it is a good idea for monetary policymakers to use a strict interpretation of the Taylor rule as a basis for setting policy? Why or why not?

Probably not. In the situation in part (a), it is assumed that there is very little uncertainty about what inflation will be, thus a Taylor rule approach to policy may work fine. However, in (b) and (c), there is clearly more uncertainty about the state of the economy, and therefore having a mechanical rule to dictate policy without accounting for this uncertainty could be problematic. For instance, in part (c), if future inflation actually turned out to be closer to 0%, the Taylor rule policy may prove to be too tight, and could push the economy into a deflationary situation.

This example highlights why judgment and discretion in interpreting data are important parts of the monetary policy process.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. The Fed’s maximum employment mandate is generally interpreted as an attempt to achieve an unemployment rate that is as close as possible to the natural rate and inflation that is close to its 2% goal for personal consumption expenditure price inflation. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and a measure of the natural rate of unemployment (NROU). For the price index, adjust the units setting to ―Percent Change From Year Ago‖ to convert the data to the inflation rate; for the unemployment rate, change the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet. Calculate the unemployment gap and inflation gap for each quarter. Then, using the inflation gap, create an average inflation gap measure by taking the average of the current inflation gap and the gaps for the previous three quarters. Now apply the following (admittedly arbitrary and ad hoc) test to the data from 2000:Q1 through the most recent data available: If the unemployment gap is larger than 1.0 for two or more consecutive quarters, and/ or the average inflation gap is larger in absolute value than 0.5 for two or more consecutive quarters, consider the mandate ―violated.‖ a. Based on this ad hoc test, in which quarters has the Fed ―violated‖ the price stability portion of its mandate? In which quarters has the Fed ―violated‖ the maximum employment mandate?

See the table below. As of 2017:Q1, the Fed violated the price stability mandate according to this test six times since 2000: 2002:Q2 – 2002:Q4; 2005:Q1 – 2007:Q1; 2007:Q4 – 2008:Q4; 2009:Q2 – 2010:Q2; 2011:Q4 – 2012:Q1; and 2013:Q2 – 2017:Q1 (and still counting). Since 2000, the Fed violated the employment mandate twice: 2003:Q2 – 2003:Q4 and 2008:Q3 – 2014:Q2. b. Is the Fed currently ―in violation‖ of its mandate?

Yes, according to this test, the Fed currently is violating the price stability part of its mandate; the average inflation measure indicates inflation is 0.7 percentage points below the 2% target. The Fed has been in violation of the price stability mandate since 2013:Q2. c. Interpret your results. What do your response to part (a) and the data imply about the challenge that monetary policymakers face in achieving the Fed’s mandate perfectly at all times?

It is clearly very difficult to meet the objectives set forth in the Fed’s mandate, even under ideal conditions. The Fed ―failed‖ the price stability test 46 out of 82 quarters over seven different occasions. The Fed ―failed‖ the employment test 29 out of 82 quarters; this was only over three times, but one was during and after the financial crisis period. There were five different times, totaling 18 quarters in which the Fed ―failed‖ both tests. Overall, there were only 25 out of the 82 quarters in which the Fed did not ‟fail‖ either mandate tests. However, it is important to note that the economy is constantly buffeted by unpredictable shocks, and except for the highly unusual financial crisis and coronavirus pandemic periods, most of the other ―violations‖ noted are somewhat minor in that they do not last for long, or do not significantly deviate from the noted thresholds too much.

2000-0101 2000-0401 2000-0701 2000-1001 2001-0101 2001-0401 2001-0701 2001-1001 2002-0101 2002-0401 2002-0701 2002-1001 2003-0101

4 Qtr Average Inflation Gap

Unemployment Gap

−0.1

−1.2

0.1

−1.3

0.4

−1.2

0.5

−1.3

0.4

−0.9

0.4

−0.8

0.2

−0.3

−0.1

0.3

−0.5

0.6

−0.8

0.7

−0.8

0.6

−0.7

0.8

−0.3

0.8

2003-0401 2003-0701 2003-1001 2004-0101 2004-0401 2004-0701 2004-1001 2005-0101 2005-0401 2005-0701 2005-1001 2006-0101 2006-0401 2006-0701 2006-1001 2007-0101 2007-0401 2007-0701 2007-1001 2008-0101 2008-0401 2008-0701 2008-1001 2009-0101 2009-04-

−0.1

1.0

0.0

1.1

−0.1

0.8

−0.2

0.6

0.1

0.6

0.2

0.4

0.5

0.4

0.7

0.3

0.6

0.1

0.8

0.0

0.8

0.0

0.9

−0.3

1.1

−0.3

1.0

−0.3

0.7

−0.5

0.6

−0.4

0.3

−0.4

0.2

−0.2

0.5

−0.1

0.8

0.1

1.0

0.5

1.5

1.1

1.0

2.0

0.2

3.4

−0.8

4.5

01 2009-0701 2009-1001 2010-0101 2010-0401 2010-0701 2010-1001 2011-0101 2011-0401 2011-0701 2011-1001 2012-0101 2012-0401 2012-0701 2012-1001 2013-0101 2013-0401 2013-0701 2013-1001 2014-0101 2014-0401 2014-0701 2014-1001 2015-0101 2015-0401

−2.1

4.8

−2.1

5.1

−1.5

5.0

−0.9

4.8

−0.3

4.7

−0.3

4.7

−0.4

4.3

−0.2

4.3

0.2

4.2

0.5

3.9

0.7

3.5

0.5

3.5

0.1

3.3

−0.1

3.1

−0.4

3.0

−0.5

2.9

−0.5

2.6

−0.7

2.3

−0.7

2.0

−0.6

1.6

−0.5

1.4

−0.5

1.1

−0.8

0.9

−1.2

0.8

2015-0701 2015-1001 2016-0101 2016-0401 2016-0701 2016-1001 2017-0101 2017-0401 2017-0701 2017-1001 2018-0101 2018-0401 2018-0701 2018-1001 2019-0101 2019-0401 2019-0701 2019-1001 2020-0101 2020-0401

−1.6

0.5

−1.8

0.5

−1.7

0.4

−1.5

0.3

−1.3

0.4

−1.0

0.2

−0.6

0.0

−0.4

−0.1

−0.3

−0.2

−0.2

−0.4

−0.2

−0.4

−0.1

−0.5

0.1

−0.7

0.1

−0.7

0.0

−0.6

−0.2

−0.8

−0.4

−0.8

−0.5

−0.9

−0.5

−0.6

−0.7

8.6

2. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), real GDP (GDPC1), an estimate of potential GDP (GDPPOT), and the federal funds rate (FEDFUNDS). For the price index, adjust the units setting to ―Percent Change From Year Ago‖ to convert the data to the inflation rate; for the federal funds rate, change the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet. Assuming the inflation target is 2% and the equilibrium real fed funds rate is 2%, calculate the inflation gap and the output gap for each quarter, from 2000 until the most recent quarter of data

available. Calculate the output gap as the percentage deviation of output from the potential level of output. a. Use the output and inflation gaps to calculate, for each quarter, the fed funds rate predicted by the Taylor rule. Assume that the weights on inflation stabilization and output stabilization are both ½ (see the formula in the chapter). Compare the current (quarterly average) federal funds rate to the federal funds rate prescribed by the Taylor rule. Does the Taylor rule accurately predict the current rate?

Briefly comment.

For the most recent period in 2020:Q2, the federal funds rate is 0.06%, while the Taylor rule predicts –3.34%, underrepresenting actual policy by a gap of 3.4 percentage points. Compared to other significant deviations, this is a fairly large departure from the baseline Taylor rule. b. Create a graph that compares the predicted Taylor rule values with the actual quarterly federal funds rate averages. How well, in general, does the Taylor rule prediction fit the average federal funds rate? Briefly explain.

See the graph below. The Taylor rule since 2000 has periods in which they are fairly closely correlated, particularly from 2000 to 2002. However, there are significant gaps in other times, or periods in which they do not seem to move together, such as the period from 2002 to 2006. From 2008 onward, there are significant differences between the two, particularly the period late in 2008 through 2010, in which the Taylor rule predicts the federal funds rate should be negative by as much as almost –4%, which is not possible.

It also predicted a significant rise in the federal funds rate in 2011, which did not materialize, and generally speaking, the post-crisis Taylor rule has significantly overprescribed the actual fed funds rate. The coronavirus pandemic period beginning in 2020 created sharp declines in the actual fed funds rate and Taylor rule implied rate. c. Based on the results from the 2008–2009 period, explain the limitations of the Taylor rule as a formal policy tool. How do these limitations help explain the use of nonconventional monetary policy during this period?

Since the Federal funds rate was at the effective lower bound during that time, conventional monetary policy through adjustments in the federal funds rate was not possible, and highlights a limitation of the Taylor rule: under ‟normal‖ conditions the Taylor rule provides a good approximation to appropriate federal funds rate policy. However in extreme situations such as the financial crisis period and the coronavirus pandemic period, the Taylor rule is less useful, since other (nonconventional) monetary policy tools are needed to achieve stimulus. d. Suppose Congress changes the Fed’s mandate to a hierarchical one in which inflation stabilization takes priority over output stabilization. In this context, recalculate the predicted Taylor rule value for each quarter since 2000, assuming that the weight on inflation stabilization is ¾ and the weight on output stabilization is ¼. Create a graph showing the Taylor rule prediction calculated in part (a), the prediction using new ―hierarchical‖ Taylor rule, and the fed funds rate. How, if at all, does changing the mandate change the predicted policy paths? How would the fed funds rate be affected by a hierarchical mandate? Briefly explain.

See the graph below. For the most part, the baseline Taylor rule and the hierarchical Taylor rule predict nearly the same federal funds paths. The only significant deviations are from 2008 to 2014, where the hierarchical version predicts a significantly higher federal funds rate due to the inflation spike during that time. And from about 2010 to 2014, it implied a federal funds rate around 2%, which is much higher than during that time and what the baseline rule predicts, and the actual fed funds rate was. For the most recent period of 2020:Q2, under such a hierarchical Taylor rule, the federal funds rate would be predicted to be about –1.1%, much lower than the current 0.06%. e. Assume again equal weights of ½ on inflation and output stabilization, and suppose instead that beginning after the end of 2008, the equilibrium real fed funds rate declines by 0.05 each quarter (i.e., 2009:Q1 is 1.95, then 1.90, etc.), and once it reaches zero, it remains at zero thereafter. How does it affect the prescribed fed funds rate? Why might this be important for policymakers to take into consideration?

A decline in the equilibrium real fed funds rate has the effect of reducing the implied Taylor rule fed funds rate lower. In fact, under this policy rule, it would have implied the fed funds rate to be negative during 2015, which also coincided with a period of low inflation. Of all three of the variations, the declining equilibrium real rate rule is the closest to the actual path of the fed funds rate since the financial crisis period. This may help explain why the actual path of the fed funds rate was lower than standard Taylor rules would imply. Moreover, if the real equilibrium fed funds rate did decline, but was not taken into account (for instance, by using the baseline rule in part (a)), this would imply that monetary policy would be overly contractionary. The graph below shows the distinction between the baseline Taylor rule and the declining natural rate Taylor rule.

Taylor Rules - Baseline vs. Hierarchical

6

4 Baseline Taylor Rule 2

Hierarchical Taylor Rule Federal Funds Rate

-4

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Implied and Actual Fed Funds Rate -2

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-6 2019-11-01

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Taylor Rules - Baseline vs. Declining Natural Rate

8

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4 Baseline Taylor Rule

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0 Declining Natural Rate Taylor Rule

Federal Funds Rate

Chapter 17 ANSWERS TO QUESTIONS 1. Suppose that you are considering going on vacation abroad and that the euro has appreciated by 15% with respect to the U.S. dollar. Would you be more or less willing to visit Rome and Paris?

Assuming you have to buy euros with U.S. dollars before you travel or that you use a credit card that automatically converts euros into U.S. dollars at the new exchange rate, you would be less willing to visit Rome and Paris, since goods and services will be 15% more expensive to you and your family.

2. ―A country is always worse off when its currency is weak (falls in value).‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy.

3. When the U.S. dollar depreciates, what happens to exports and imports in the United States?

U.S. dollar depreciation makes U.S. domestic goods cheaper, thus both domestic and foreign consumers buy more U.S.-produced goods. At the same time, imported goods become more expensive since they require more dollars per foreign currency to purchase. Thus, U.S. exports will increase and imports into the United States will decrease.

4. If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

It predicts that the value of the yen will fall 5% in terms of dollars.

5. If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will the country’s currency tend to appreciate or depreciate in the long run?

In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain.

6. When the Federal Reserve conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets?

The money supply increases, but this has an insignificant effect on the supply of dollar assets. Since dollar currency is a small part of total U.S. dollar-denominated assets, changes in the money supply are relatively small and therefore do not shift the supply curve.

7. From 2009 to 2011, the economies of Australia and Switzerland suffered relatively mild effects from the global financial crisis. At the same time, many countries in the euro area were hit hard by high unemployment and burdened with unsustainably high government debts. How should this have affected the euro/Swiss franc and euro/Australian dollar exchange rates?

This would reduce the demand for euro-denominated assets, resulting in a depreciation of the euro and an appreciation of the Swiss franc and Australian dollar.

8. In the mid-to-late 1970s, the yen appreciated in value relative to the dollar, even though Japan’s inflation rate was higher than America’s. How can this be explained by improvements in the productivity of Japanese industry relative to American industry?

Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese to continue to sell their goods at a profit at a high value of the yen.

9. Suppose the president of the United States announces a new set of reforms that includes a new anti-inflation program. Assuming the announcement is believed by the public, what will happen to the exchange rate on the U.S. dollar?

The dollar will appreciate. Because expected U.S. inflation falls as a result of the announcement, there will be an expected appreciation of the dollar and so the expected return on dollar assets will rise. As a result, the demand curve will shift to the right and the equilibrium value of the dollar will rise.

10. If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now, what will happen to the value of the Indian rupee today?

The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for rupee-denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises.

11. If nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. dollar exchange rate.

The dollar will depreciate. A rise in nominal interest rates but a decline in the real rate implies a rise in expected inflation that produces an expected depreciation of the dollar that is larger than the increase in the domestic interest rate. As a result, the expected return on dollar assets falls at any exchange rate, shifting the demand curve to the left and leading to a fall in the exchange rate.

12. If American auto companies make a breakthrough in automobile technology and are able to produce a car that gets 200 miles to the gallon, what will happen to the U.S. dollar exchange rate?

The dollar will appreciate. The increase in U.S. productivity raises the expected future exchange rate and thus raises the expected return on dollar assets at any exchange rate. The resulting rightward shift of the demand curve leads to a rise in the

equilibrium exchange rate.

13. If Mexicans go on a spending spree and buy twice as much French perfume and twice as many Japanese TVs, English sweaters, Swiss watches, and bottles of Italian wine, what will happen to the value of the Mexican peso?

The peso will depreciate. Consider Mexico to be the domestic country. An increased demand for imports would lower the expected future exchange rate and result in a lower expected appreciation of the peso. The resulting lower expected return on peso assets at any given exchange rate would then shift the demand curve to the left, leading to a fall in the peso exchange rate.

14. Through the summer and fall of 2008, as the global financial crisis began to take hold, international financial institutions and sovereign wealth funds significantly increased their purchases of U.S. Treasury securities as a safe haven investment.

How should this have affected U.S. dollar exchange rates?

This should (and did) lead to a sharp appreciation of the dollar relative to many other currencies. The strong demand for U.S. treasuries led to a rise in the demand for U.S. dollar-denominated assets during this time, hence appreciating the dollar.

15. In September 2012, the Federal Reserve announced a large-scale asset-purchase program (known as QE3) designed to lower intermediate and longer-term interest rates. What effect should this have had on the dollar/euro exchange rate?

The quantitative easing program should reduce the demand for U.S. dollardenominated assets, and lead to an appreciation of the euro (a depreciation of the dollar). In fact, immediately after the policy announcement on September 13, 2012, the dollar depreciated almost 2% against the euro.

16. On June 23, 2016, voters in the United Kingdom voted to leave the European Union.

From June 16 to June 23, 2016, the exchange rate between the British pound and the dollar increased from 1.41 dollars per pound to 1.48 dollars per pound. What can you say about market expectations regarding the result of the referendum?

As noted in the text, a vote to leave the European Union would lower future UK Exports and thus lead to a lower long-run value of the British pound. The fact that the British pound rose in value prior to the vote suggests that the markets believed that the probability of an exit vote was declining, thus leading to a higher long-run value of the British pound than previously expected.

ANSWERS TO APPLIED PROBLEMS 17. A German sports car is selling for 70,000 euros. What is the dollar price in the United States of the German car if the exchange rate is 0.90 euro per dollar?

70,000 euros  ($1/0.90 euros) = $77,777.77.

18. If the Canadian dollar to U.S. dollar exchange rate is 1.28 and the British pound to U.S. dollar exchange rate is 0.62, what must be the Canadian dollar to British pound exchange rate?

Spot exchange rate = 1.28 CAD/$  ($1/£0.62) = 2.0645 Canadian dollars/pound

19. The New Zealand dollar to U.S. dollar exchange rate is 1.36, and the British pound to U.S. dollar exchange rate is 0.62. If you find that the British pound to New Zealand dollar is trading at 0.49, what can you do to earn a riskless profit?

Complete the following transactions simultaneously: i. Exchange $1.00 into 1.36 New Zealand dollars. ii. Exchange the 1.36 New Zealand dollars into 0.6664 British pounds. iii. Exchange the 0.6664 British pounds into $1.0748.

This yields a riskless $0.0748 per U.S. dollar invested.

20. In 1999, the euro was trading at $0.90 per euro. If the euro is now trading at $1.16 per euro, what is the percentage change in the euro’s value? Is this an appreciation or a depreciation? % Change = (1.16 – 0.90)/0.90 = 28.88%. The euro has appreciated by 28.88%.

21. The Mexican peso is trading at 10 pesos per dollar. If the expected U.S. inflation rate is 2% while the expected Mexican inflation rate is 23% over the next year, given PPP, what is the expected exchange rate in one year?

Expected exchange rate = 10  (1.23/1.02) = 12.059 pesos per dollar.

22. If the price level recently increased by 20% in England while falling by 5% in the United States, by how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.55 pound per dollar.

If prices rise relative to the United States by (20 + 5)% = 25%, then 25% more pounds will be required to buy the same U.S. goods. Thus, this will require the exchange rate to be 1.25  £0.55/$ = £0.6875/$.

For Problems 23–25, use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.

23. If expected inflation drops in Europe, so that interest rates fall there, what will happen to the exchange rate on the U.S. dollar?

The dollar will depreciate. The drop of expected inflation in Europe, which leads to a decline in the foreign interest rate (which is smaller than the drop in expected inflation), leads to a decline in the relative expected return on dollar assets, because the expected euro appreciation is greater than the decline in the foreign interest rate. The result of the decline in the relative expected return on dollar assets is a leftward shift of the demand curve, and the equilibrium U.S. dollar exchange rate falls. The graph is shown below.

24. If the European Central Bank decides to pursue a contractionary monetary policy to fight inflation, what will happen to the value of the U.S. dollar?

25. If a strike takes place in France, making it harder to buy French goods, what will happen to the value of the U.S. dollar?

Consider France to be the domestic country. Because it is harder to get French goods, people will buy more foreign goods and the value of the euro in the future will fall.

The expected depreciation of the euro lowers the expected return on euro assets at any exchange rate, so the demand for euros declines and the demand for dollars shifts to the right, as shown in the graph below. Thus, the dollar will appreciate.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the exchange

rate of U.S. dollars per British pound (DEXUSUK). A Mini Cooper can be purchased in London, England, for £17,865 or in Boston, United States, for $23,495. a. Use the most recent exchange rate available to calculate the real exchange rate of the London Mini per Boston Mini.

According to the exchange rate for July 31, 2020, the real exchange rate is $1.3133/£  [£17,865/London mini]/[$23,495/Boston mini] = 0.9986 Boston mini/London mini, or 1.001 London mini/Boston mini. b. Based on your answer to part (a), are Mini Coopers relatively more expensive in Boston or in London?

Since you can buy 1.001 minis in London for every one purchased in Boston, they are slightly relatively less expensive in London. c. What price in British pounds would make the Mini Cooper equally expensive in both locations, all else being equal?

If the real exchange rate equaled 1, this would imply 1 Boston mini/London mini = $1.31334/£  [X/London mini]/[$23,495/Boston mini]; solving for X yields a price of £17,890.05 for a London mini.

2. Go to the St. Louis Federal Reserve FRED database and find data on the daily dollar exchange rates for the euro (DEXUSEU), British pound (DEXUSUK), and Japanese yen (DEXJPUS). Also find data on the daily three-month London Interbank Offer Rate, or LIBOR, for the United States dollar (USD3MTD156N), euro (EUR3MTD156N), British pound (GBP3MTD156N), and Japanese yen ( JPY3MTD156N). LIBOR is a measure of interest rates denominated in each country’s respective currency.

31-Jul20 31-Jul19

USD LIBOR

EUR LIBOR

GBP LIBOR

JPY LIBOR

0.24875

−0.44471

0.08438

−0.05517

2.26563

−0.41971

0.77263

−0.07333

31-Jul-20 31-Jul-19 One Year Change

USD-EUR LIBOR 0.69346 2.68534 −1.99188

USD-GBP LIBOR 0.16437 1.49300 −1.32863

USD-JPY LIBOR 0.30392 2.33896 −2.03504

USD per EUR 1.1822 1.1130 EUR appreciated

USD per GBP 1.3133 1.2220 GBP appreciated

JPY per USD 105.78 108.58 JPY appreciated

31-Jul-20 31-Jul-19

a. Calculate the difference between the LIBOR rate in the United States and the LIBOR rates in the three other countries using the data from one year ago and the most recent data available.

See the table above for data from July 31, 2020. b. Based on the changes in interest rate differentials, do you expect the dollar to

depreciate or appreciate against the other currencies?

All three LIBOR rates for the euro currency area, United Kingdom, and Japan all increased relative to LIBOR rates in the United States. Thus, you would expect all three currencies should appreciate relative to the U.S. dollar. c. Report the percentage change in the exchange rates over the past year. Are the results you predicted in part (b) consistent with the actual exchange rate behavior?

See the table above. The British pound, the euro, and Japanese yen all appreciated according to prediction.

Chapter 18 ANSWERS TO QUESTIONS 1. If the Federal Reserve sells dollars in the foreign exchange market but conducts an offsetting open market operation to sterilize the intervention, what will be the effect on international reserves, the money supply, and the exchange rate?

The sale of dollars involves a purchase of foreign assets which means that both international reserves, the monetary base and the money supply, increase. However, the offsetting open market sale means that the monetary base and the money supply will remain unchanged. There is thus no change in the domestic interest rate and therefore in the expected return on dollar assets, so the demand curve does not shift and the exchange rate also remains unchanged.

2. If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

The purchase of dollars involves a sale of foreign assets, which means that international reserves fall and the monetary base decreases. The resulting fall in the money supply causes interest rates to rise and lowers the future price level, thereby raising the future expected exchange rate. Both of these effects raise the expected return on dollar assets at any given exchange rate, shifting the demand curve to the right and raising the equilibrium exchange rate.

3. For each of the following, identify whether they increase or decrease the current account balance: a. An American citizen’s purchase of an airline ticket from Air France decrease b. A Japanese citizen’s purchase of California oranges increase c. $50 million of foreign aid to Honduras decrease d. A worker in California who sends money to his parents in Mexico decrease e. The services an American accounting firm provides to a German firm increase

4. Suppose that you travel to Cali (Colombia), where the exchange rate is 1 USD to 2,900 Colombian pesos. As you enter a McDonald’s restaurant, you realize you need 17,400 Colombian pesos to buy a Big Mac. Assuming a Big Mac sells for $5 in the United States, would you say that the Colombian peso is over- or undervalued in terms of PPP? Since the exchange rate is 1 USD to 2,900 COP (Colombian pesos), a Big Mac should sell for 14,500 COP if it has the same 5 USD cost as in the United States.

However, a Big Mac sells for more than that, indicating that currently the COP is overvalued in terms of PPP because the Big Mac is more expensive in Columbia at the current exchange rate.

5. Refer to the previous exercise. Which type of foreign market intervention must the central bank of Colombia conduct to keep the exchange rate at a level where the currency is not under- or overvalued in terms of PPP? To eliminate the overvaluation in terms of PPP, the exchange rate for the Columbian peso needs to decline. The central bank of Colombia should undertake an unsterilized foreign market intervention in which it will sell the domestic currency (COP) and buy foreign reserves, in order to increase reserves of its banking system, decrease the domestic interest rate, and shift the expected return on domestic currency denominated assets curve to the left.

6. What would be the effect of a devaluation on a country’s imports and exports? If a country imports most of the goods included in the basket of goods and services used to calculate the CPI, what do you think the effect will be on this country’s inflation rate?

When a country devalues its currency, the fixed exchange rate is set at a lower level, meaning that the central bank will no longer exchange domestic currency at the previous (higher) exchange rate. This means that foreigners with the same amount of foreign currency can get more units of domestic currency, thereby making that country’s exports cheaper for them, leading to an increase in the country’s exports.

On the other hand, domestic buyers of foreign products now need more units of domestic currency to buy the same amount of foreign currency, so imports become more expensive and will decrease. If many of the goods that are taken into consideration to measure the cost of living are imported, then the cost of living (as measured by the percentage change in the CPI) will most probably increase after the devaluation.

7. Under the gold standard, if Britain became more productive relative to the United States, what would happen to the money supply in the two countries? Why would the changes in the money supply help preserve a fixed exchange rate between the United States and Britain?

The increase in British productivity would create a tendency for the pound to appreciate relative to the dollar. The higher value of the pound would now cause Americans to exchange dollars for gold, ship the gold to Britain, and then buy British pounds with the gold. The result is that British holdings of gold (international reserves) would increase, which would raise the money supply because the monetary base would increase. The higher British money supply would then tend to lower the exchange rate back down to its par level because it would cause the price level to rise, which would

lead to a depreciation of the pound.

8. What is the exchange rate between dollars and Swiss francs if one dollar is convertible into 1/20 ounce of gold and one Swiss franc is convertible into 1/40 ounce of gold?

Two francs per dollar.

9. ―Inflation is not possible under the gold standard.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Inflation occurred when the world was under the gold standard before World War I. The gold discoveries in the Klondike and South Africa before World War I led to a continuing increase in the quantity of gold, which caused a more rapid growth in money supplies throughout the world. The result was worldwide inflation.

10. What are some of the disadvantages of China’s pegging the yuan to the dollar?

There are several disadvantages to China’s exchange rate strategy. First, diversification is a problem in that the Chinese own a very large amount of U.S. assets, including low-yielding U.S. treasuries. Second, it has created a backlash among trading countries that have threatened trade sanctions due to the cheap prices of Chinese exports due to the low yuan peg. Finally, having the undervalued yuan has resulted in the central bank selling large amounts of yuan currency and raising the domestic Chinese monetary base and money supply, which has the potential to create high inflation in the future.

11. If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange rate regime, what kind of intervention would that country’s central bank be forced to undertake, and what effect would the intervention have on the country’s international reserves and money supply?

The situation would be as depicted in Figure 2, Panel (b). The central bank would need to sell domestic currency and buy foreign assets, thus increasing its international reserves and the monetary base. The resulting rise in the money supply would then lead to a decline in the domestic interest rate, which would shift demand for domestic assets to the left so that the equilibrium exchange rate would be at par.

12. Why might a country that is suffering a recession not want to intervene in the foreign exchange market if its currency is overvalued? Assume this country participates in a fixed exchange rate regime.

When a country is engaged in a fixed exchange rate regime, it has a commitment to intervene in the foreign exchange market to maintain the system of fixed exchange rates. However, the combination of a recession and an overvalued currency is quite complicated to solve. The required unsterilized foreign exchange market intervention implies buying the domestic currency, decreasing reserves of the banking system and thereby increasing the domestic interest rate. This increase in domestic interest rates negatively affects the economy, reducing credit and expenditure on durable goods.

This is why countries engaged in fixed exchange rate regimes were sometimes reluctant to intervene in the foreign exchange market.

13. ―If a country wants to keep its exchange rate from changing, it must give up some control over its monetary policy.‖ Is this statement true, false, or uncertain? Explain your answer.

True, because when the exchange rate is falling, the central bank must buy its currency, which lowers its holdings of international reserves and its monetary base.

Similarly, when the exchange rate is rising, it must sell its currency, which raises its holdings of international reserves and its monetary base. The necessary central bank intervention to keep its exchange rate fixed thus affects the monetary base and hence the money supply and interest rates.

14. Why is it that in a pure, flexible exchange rate system, the foreign exchange market has no direct effect on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

There are no direct effects on the money supply, because there is no central bank intervention in a pure flexible exchange rate regime; therefore, changes in international reserves that affect the monetary base do not occur. However, monetary policy can be affected by the foreign exchange market, because monetary authorities may want to manipulate exchange rates by changing the money supply and interest rates.

15. Why did the exchange rate peg lead to difficulties for the countries in the ERM after the German reunification?

German reunification produced tight monetary policy in Germany to limit inflation, which raised interest rates for the other ERM countries because their currencies were pegged to the German mark. The high interest rates then slowed economic growth and increased unemployment in the other countries.

16. How can exchange rate targets lead to a speculative attack on a currency?

With a pegged exchange rate, speculators are sometimes presented with a one-way bet in which the only direction for a currency to go is down in value when a country’s central bank is unable or unwilling to defend the currency’s value. In this case, selling the currency before the likely depreciation gives speculators an attractive profit opportunity with potentially high expected returns. As a result, they jump on board and attack the currency.

17. The IMF does not enjoy a great reputation in many countries that were recipients of IMF loans or bailouts. Explain why many citizens were not happy with the role played by the IMF. In general, IMF loans provided to help countries cope with either financial or currency crises were accompanied by various conditions. These conditions usually meant that recipient governments should increase taxes, increase the domestic interest rate, and reduce expenditures, thereby making the downturns that these economies were facing even worse. On top of this, the recovery of the recessions created by financial or currency crises were usually very severe and countries saw their social cohesion badly affected. Eventually, real GDP per capita started to increase again, but it took a long time for this to occur.

18. How can the long-term bond market help reduce the time-inconsistency problem for monetary policy? Can the foreign exchange market also perform this role?

The long-term bond market can help reduce the time-inconsistency problem because politicians and central banks will realize that pursuing an overly expansionary policy will lead to an inflation scare in which inflation expectations surge, interest rates rise, and there is a sharp fall in long-term bond prices. Similarly, they will realize that overly expansionary monetary policy will result in a sharp fall in the value of the currency. Avoiding these outcomes constrains policymakers and politicians so timeinconsistent monetary policy is less likely to occur.

19. What are the key advantages of exchange rate targeting as a monetary policy strategy?

First, the exchange rate target directly keeps inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country to which its currency is pegged. Second, it provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem. Third, it has the advantage of simplicity and clarity.

20. When is exchange rate targeting likely to be a sensible strategy for industrialized countries? When is exchange rate targeting likely to be a sensible strategy for emerging market countries?

Exchange rate targeting is likely to be a sensible strategy for industrialized countries when domestic monetary and political institutions are not conducive to good monetary policymaking, and when there are other important benefits of an exchange rate target that have nothing to do with monetary policy. Exchange rate targeting is likely to be sensible for emerging market countries whose political and monetary institutions are weak so that it is the only way to break inflationary psychology and stabilize the economy.

21. What are the advantages and disadvantages of currency boards and dollarization over a monetary policy that uses only an exchange rate target?

22. Calculate the overvaluation of the Thai baht (THB) if you can get 34.6 THB per USD at the exchange counter, but a lunch menu that costs 25 USD in Boston sells for 948.25 THB in Bangkok.

The implicit exchange rate is 25 USD to 948.25 THB, or 1 USD to 37.93 THB. Using the THB as the domestic currency, the exchange rate is 0.0289 = 1/34.6 and the implicit exchange rate is 0.02636 = 1/37.93. The THB is thereby [(0.0289 / 0.02636) ‒ 1] × 100 = 9.64% overvalued.

ASWERS TO APPLIED PROBLEMS 23. Suppose the Federal Reserve purchases $1,000,000 worth of foreign assets. a. If the Federal Reserve purchases the foreign assets with $1,000,000 in currency, show the effect of this open market operation, using T-accounts. What happens to the monetary base?

The Fed’s assets increase by $1 million, and it increases currency in circulation by $1 million. This results in the monetary base increasing by $1 million.

Federal Reserve System Assets

Liabilities

Foreign assets (international reserves)

+$1 million

Currency in circulation

+$1 million

b. If the Federal Reserve purchases the foreign assets by selling $1,000,000 in Tbills, show the effect of this open market operation, using T-accounts. What happens to the monetary base?

The Fed’s assets increase by the increased foreign assets, but this is offset by a decrease in T-bill holdings of the same amount. Overall, the Fed’s assets are unchanged, and its liabilities and hence the monetary base are also unchanged.

Federal Reserve System Assets

Liabilities

Foreign assets (international reserves)

+$1 million

Government bonds

–$1 million

Currency in circulation

24. Suppose the Mexican central bank chooses to peg the peso to the U.S. dollar and commits to a fixed peso/dollar exchange rate. Use a graph of the market for peso assets (foreign exchange) to show and explain how the peg must be maintained if a shock in the U.S. economy forces the Fed to pursue contractionary monetary policy. What does this say about the ability of central banks to address domestic economic problems while maintaining a pegged exchange rate?

An increase in U.S. interest rates as a result of the contractionary monetary policy will increase the demand for dollar assets and reduce the demand for peso assets from D1 to D2, which will appreciate the dollar and depreciate the peso. This results in the peso being valued below the peg; in order to maintain the peg, the Mexican central bank must increase domestic interest rates by selling foreign assets, and buying domestic peso currency. This results in the demand for peso assets to increase back up to D1 as shown in the graph below. This demonstrates one of the main disadvantages to pegging the domestic currency in that domestic monetary policy in the pegging country is dependent on foreign business cycles, meaning that there is no scope for domestic monetary policy stabilization. In this case, Mexico was forced to

import a contractionary policy, which could create unexpected and undesirable contraction in the domestic economy.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on net exports (NETEXP), transfers (A123RC1Q027SBEA), and the current account balance (NETFI). a. Calculate net investment income for the most recent quarter available, and for the same quarter a year earlier.

See the table below. Net investment income is equal to the current account – transfers – net exports. b. Calculate the percentage change in the current account balance from the same quarter one year earlier. Which one of the three items making up the current account balance had the largest effect in percentage terms on the change of the current account? Which one had the smallest effect?

In percentage terms, the current account balance declined significantly (became more negative). Among the three items, net exports changed the most, decreasing by 19.7% (becoming more negative), while transfers changed the least, increasing by only 2.7%.

2020:Q1 2019:Q1 Percent Change

Current Account Balance ($Bil.) Transfers 423.4 316.7 532.0 308.4 0.4

2.7

Net Net Investment Exports Income 494.3 245.8 615.5 224.9 19.7



2. Go to the St. Louis Federal Reserve FRED database and find data on the monthly U.S. dollar exchange rate to the Chinese yuan (EXCHUS), the Canadian dollar (EXCAUS), and the South Korean won (EXKOUS). Download the data into a spreadsheet. a. For the most recent five-year period of data available, use the average, max, min, and stdev functions in Excel to calculate the average, highest, and lowest exchange rate values, as well as the standard deviation of the exchange rate to the dollar (this is an absolute measure of the volatility of the exchange rate). b. Using the maximum and minimum values of each exchange rate over the last five years, calculate the ratio of the difference between the maximum and minimum values to the average level of the exchange rate (expressed as a percentage by multiplying by 100). This value gives an indication of how tightly the exchange rate moves. Based on your results, which of the three countries is most likely to peg its currency to the U.S. dollar? How does this country’s currency compare with the other two? c. Calculate the ratio of the standard deviation to the average exchange rate over the last five years (expressed as a percentage by multiplying by100). This value gives an indication of how volatile the exchange rate is. Based on your results, which of the three currencies is most likely to be pegged to the U.S. dollar? How does this currency compare with the other two? a. See table below for July 2015 to July 2020.

Average Maximum Minimum Standard Deviation

South Korean Won 1148.53 1228.13 1065.64 41.5

Chinese Yuan 6.73 7.11 6.30 0.24

Canadian Dollar 1.32 1.42 1.23 0.04

Max Min Difference/Average SD/Average

0.14 0.04

0.12 0.04

0.15 0.03

b. (b) See the table above. The Chinese yuan has a smaller band that it moves in relative to the average value; at only 12% of the average, this is slightly smaller than the South Korean won and the Canadian dollar bands that they fluctuated in over the last five years. Hence the Chinese yuan is the most likely to be pegged. c. The results are somewhat consistent with part (b) in that the fluctuations of all three currencies are somewhat similar, although Canada’s currency is slightly less volatile than China’s or South Korea’s.

Chapter 19 ANSWERS TO QUESTIONS 1. How would you expect velocity to typically behave over the course of the business cycle?

Since nominal GDP falls during recessions, and as a result expansionary monetary policy, which increases the money supply is implemented, in most cases velocity will decline during recessions. During expansions, the money supply will be less expansionary, and nominal GDP will rise, typically leading to an increase in velocity.

2. If velocity and aggregate output are reasonably constant (as the classical economists believed), what will happen to the price level when the money supply increases from $1 trillion to $4 trillion?

The price level will quadruple.

3. If credit cards were made illegal by congressional legislation, what would happen to velocity? Explain your answer.

Velocity would fall because a greater quantity of the money supply (M) would be needed to carry out the same level of transactions (PY); PY/M = V would then fall.

4. ―If nominal GDP rises, velocity must rise.‖ Is this statement true, false, or uncertain?

Explain your answer.

False. Velocity is equal to nominal GDP divided by the money supply. If nominal GDP increases but the money supply increases by an even greater amount, velocity will decline.

5. Why would a central bank be concerned about persistent long-term budget deficits?

Persistent long-term budget deficits can lead to the perception or worry that policymakers will satisfy the government budget constraint by monetizing the debt in the future, leading to large increases in the monetary base that would be highly inflationary. Even if the central bank has no intention of monetizing the debt, the belief or appearance that the central bank may do this will increase inflation expectations, making it harder for monetary policymakers to keep inflation anchored at a low, stable level.

6. ―Persistent budget deficits always lead to higher inflation.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. As long as a country (such as the United States) has reliable access to bond markets and bond holders are willing to accept and hold treasury debt, a country can continue to rely on borrowing to meet financial obligations. This relies on the perception that the government will be able to repay the debts in the future, and there is low risk of default. However, once bond holders believe that budget deficits have reached unsustainable levels, they may decide not to hold bonds anymore, and this could force the government to monetize the debt in order to meet financial obligations. In this case, higher inflation may result.

7. Why might a central bank choose to monetize the debt, knowing that it could lead to higher inflation?

If the government is running large deficits, this could lead to higher interest rates, which could be contractionary to the economy or be misaligned from the central bank’s optimal policy interest rate to the point where the central bank may want to reduce interest rates. Thus, by purchasing bonds and monetizing the debt, even though it may be increasing the monetary base and raising inflation risk, it can be beneficial in reducing interest rates (or slowing the increase in interest rates) as a result of elevated debt issuance by the treasury. This is particularly useful in situations where output or employment goals may need to be prioritized over price stability objectives.

8. Consider two central banks: one with a history of maintaining price stability and low inflation, and the other with a history of high inflation and poor inflation management. All else equal, if the same level of government budget deficit is monetized in both countries, how is inflation likely to behave in each country?

Central banks with a poor history of inflation management can easily experience an unanchoring of (or sharp increase in) inflation expectations. So if the monetary base increases by the same amount in both countries as a result of the monetization of the debt, it is likely that inflation will increase much more in the country with poor inflation management than the one with a history of price stability.

9. Some payment technologies require infrastructure (e.g., merchants need to have access to credit card swiping machines). In most developing countries historically this infrastructure has either been nonexistent or very costly however recent mobile payment systems have expanded rapidly in developing countries as they have become cheaper. Everything else being equal, would you expect the transaction component of the demand for money to be increasing or decreasing in a developing country relative to a rich country?

In general the need for costly infrastructure to support new payment technologies would mean that cash would be used more in developing countries relative to rich countries. As a result, the transactions demand for money would be large in comparison. However with rapid improvements in mobile payments technology in developing countries, this would decrease the transactions demand for money relative to rich countries.

10. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? On the basis of these motives, what variables did he think determined the demand for money?

The three motives are: precautionary, speculative, and transactions motives. From these three motives, Keynes believed that money demand was positively related to income and negatively related to the nominal interest rate.

11. In many countries, people hold money as a cushion against unexpected needs arising from a variety of potential scenarios (e.g., banking crises, natural disasters, health problems, unemployment, etc.) that are not usually covered by insurance markets.

Explain the effect of such behavior on the precautionary component of the demand for money.

This would lead to an increase in demand for money through the precautionary motive.

12. Why is Keynes’s analysis of the speculative demand for money important to his view that velocity will undergo substantial fluctuations and thus cannot be treated as constant?

Because it indicates that money demand and hence velocity is affected by interest rates, and since interest rates fluctuate a lot, velocity will as well. Furthermore, as the answer to problem 11 suggests, changes in people’s expectations about what the normal level of interest rates are will cause money demand and hence velocity to fluctuate. Keynes’s analysis of the speculative demand for money thus suggests that velocity will be far from constant; rather, it will undergo substantial fluctuations.

13. According to the portfolio theories of money demand, what are the four factors that determine money demand? What changes in these factors can increase the demand for money?

The four factors determining money demand under portfolio theory are: interest rates (decreases in interest rates increase money demand); wealth (higher wealth leads to higher money demand); risk of alternative assets (a higher risk of alternative assets increases money demand); and liquidity of other assets (a decrease in liquidity of alternative assets increases the demand for money).

14. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a. The economy experiences a business cycle contraction.

Since risk of alternative assets increases, liquidity of alternative assets likely decreases, and interest rates likely will fall, this will lead to an increase in money demand. Note that even though wealth decreases, this will have a modest negative effect on money demand. b. Brokerage fees decline, making bond transactions cheaper.

Cheaper bond transactions make the bond market more liquid, leading to an increase in demand for bond holdings, and hence a decrease in the demand for money. c. The stock market crashes. (Hint: Consider both the increase in stock price volatility following a market crash and the decrease in wealth of stockholders.)

The stock market crash would lead to higher volatility, and hence risk in stocks, which would increase demand for money. The stock market crash would reduce wealth, but this would likely have a modest negative effect on money demand, leaving money demand overall higher.

15. Suppose a given country experienced low and stable inflation rates for quite some time, but then inflation picked up and over the past decade has been relatively high and quite unpredictable. Explain how this new inflationary environment would affect the demand for money according to portfolio theories of money demand. What would happen if the government decided to issue inflation-protected securities?

The demand for money would likely fall. Compared to other assets, money would be

more risky so people would rather hold more stable assets and less money. In addition, high and unpredictable inflation will result in very high interest rates, which would reduce money demand. If the government issues inflation-protected securities, then the demand for money would decrease further as an alternative to risky money holdings.

16. Consider the portfolio choice theory of money demand. How do you think the demand for money would be affected during a hyperinflation (i.e., monthly inflation rates in excess of 50%)?

The demand for money would decrease, similar to problem 15 above, but much more sharply. Compared to other assets, money would be more risky so people would rather hold more stable assets and less money. In addition, hyperinflation will result in very high interest rates, which would further reduce money demand.

17. Both the portfolio choice and Keynes’s theories of the demand for money suggest that as the relative expected return on money falls, demand for it will fall. Why does the portfolio choice approach predict that money demand is affected by changes in interest rates? Why did Keynes think that money demand is affected by changes in interest rates?

In Keynes’s view, a rise in interest rates leads to a lower relative expected return of money and hence a lower demand for money. In the portfolio choice view, a rise in interest rates leads to an increase in the implicit interest paid on checkable deposits, so the relative expected return of money only falls by a small amount. Hence, in the portfolio choice view, the demand for money changes little when interest rates rise.

18. Why does the Keynesian view of the demand for money suggest that velocity is unpredictable?

In Keynes’s view, velocity is unpredictable because interest rates, which have large fluctuations, affect the demand for money and hence velocity. In addition, Keynes’s analysis suggests that if people’s expectations of the normal level of interest rates change, the demand for money changes. Keynes thought that these expectations moved unpredictably, meaning that money demand and velocity are also unpredictable.

19. What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand, and how has this conclusion affected monetary policymaking?

Velocity is used to indicate if the money demand function is stable. If velocity is predictable and stable, then the money demand function is also stable, and vice versa.

Up until the early 1970s, the money demand function was stable, but after that, financial innovation made velocity relatively unpredictable and hence implied a more unstable money demand function. Because of this, the Federal Reserve moved away from using the money supply as its main policy indicator, and moved to interest rates as its main monetary policy indicator.

20. Suppose that a plot of the values of M2 and nominal GDP for a given country over 40 years shows that these two variables are very closely related. In particular, a plot of their ratio (nominal GDP/M2) yields very stable and easy-to-predict values. On the

basis of this evidence, would you recommend that the monetary authorities of this country conduct monetary policy by focusing mostly on the money supply rather than on setting interest rates? Explain.

This stable relationship implies that the velocity of the M2 money supply is very stable, and hence money demand is relatively stable. In this case, adjusting the money supply would provide a tight link to aggregate spending, so should be used in the conduct of monetary policy rather than interest rate adjustment.

ANSWERS TO APPLIED PROBLEMS 21. Suppose the money supply M has been growing at 10% per year, and nominal GDP, PY, has been growing at 20% per year. The data are as follows (in billions of dollars):

M PY

2021

2022

2023

100 1,000

110 1,200

121 1,440

Calculate the velocity for each year. At what rate is the velocity growing?

Velocity is approximately 10 in 2021, 10.9 in 2022, and 11.9 in 2023. The rate of velocity growth is approximately 9% per year.

22. Calculate what happens to nominal GDP if velocity remains constant at 5 and the money supply increases from $200 billion to $300 billion.

Nominal GDP increases from $1 trillion to $1.5 trillion.

23. What happens to nominal GDP if the money supply grows by 20% but velocity declines by 30%?

Nominal GDP declines by approximately 10%.

24. If velocity and aggregate output remain constant at 5 and $1,000 billion, respectively, what happens to the price level if the money supply declines from $400 billion to $300 billion?

The price level declines from 2 (= 2,000/1,000) to 1.5 (= 1,500/1,000).

25.

Period Period Period Period Period Period Period 1 2 3 4 5 6 7 Y (in Interest billions) rate

12,00 0.05 0

12,50 0.07 0

12,25 0.05 12,50 0.03 0 0

12,80 0.07 0

13,00 0.04 0

13,200 0.06

Period 1

Period 2

Period 3

Period 4

Period 5

Period 6

Period 7

Y (in billions)

12,000

12,500

12,250

12,500

12,800

13,000

13,200

Interest Rate

0.05

0.07

0.03

0.05

0.07

0.04

0.06

L(i, Y)

1450

1492.5

1501.25

1512.5

1530

1585

1590

V = Y/L(i, Y)

8.28

8.38

8.16

8.26

8.37

8.20

8.30

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 Money Stock (M1SL), M1 Money Velocity (M1V), and Real GDP (GDPC1). Convert the M1SL data series to ―Quarterly‖ using the frequency setting, and for all three series, use the ―Percent Change from Year Ago‖ setting for units. a. Calculate the average percentage change in real GDP, the M1 money stock, and velocity since 2000:Q1.

From 2000:Q1 to 2020:Q2, average growth in real GDP is about 1.9%, average growth in velocity has been –2.5%, and the M1 money stock has grown about 6.9% per year. b. Based on your answer to part (a), calculate the average inflation rate since 2000 as predicted by the quantity theory of money.

Based on part (a), the average inflation rate should be about %ΔM + %ΔV – %ΔY = 6.9 – 2.5 – 1.9 = 2.5%. c. Next, find the data on the GDP deflator price index (GDPDEF), download the data using the ‟Percent Change from Year Ago‖ setting, and calculate the average inflation rate since 2000:Q1. Comment on the value relative to your answer in part (b).

Average inflation per year for the period using GDPDEF is 1.9%, which is lower than the implied inflation rate calculated above, so is not entirely consistent with the quantity theory of money.

2. Go to the St. Louis Federal Reserve FRED database and find data on the budget deficit (FYFSD), the amount of federal debt held by the public (FYGFDPUN), and the amount of federal debt held by the Federal Reserve (FDHBFRBN).

Convert the two “debt held” series to “Annual” using the frequency setting. Download all three series into a spreadsheet. Make sure that the rows of data align properly to the correct dates. Note that for the deficit series, a negative number indicates a deficit; multiply the series by –1 so that a deficit is indicated by a positive number. Manipulate the three series so that all data are given in terms of the same units (either millions or billions of dollars). To do this, if a series is in millions and you are converting it to billions, divide the series by 1,000. Finally, for each year, convert the two

“debt held” series into one “changes in debt holdings by the public and the Federal Reserve” series by calculating, for each year, the difference in bond holdings from the preceding year. a. Create a scatterplot showing the deficit on the horizontal axis and the change in bond holdings by the public on the vertical axis, using the data from 1980 through the most recent period of data available.

Insert a fitted line into the scatterplot, and comment on the relationship between the deficit and the change in public bond holdings. b. Create a scatterplot showing the deficit on the horizontal axis and the change in bond holdings by the Federal Reserve on the vertical axis, using the data from 1980 through the most recent period of data available. Insert a fitted line into the scatterplot, and comment on the relationship between the deficit and the change in Federal Reserve bond holdings. c. Now repeat part (b), but create separate scatter plots for the period of 1980 to 2007, and 2008 to the most recent year. Comment on how, if at all, the monetizing of the debt is exhibited in the data. Do you think the relationship between the deficit and the change in bond holdings of the Federal Reserve has changed since 2008?

Why or why not? a. See the graphs below. Not surprisingly, from 1980 to 2019, there appears to be a very strong relationship between deficits and the change in bond holdings by the public, as the fitted line is very steep (and has a high R-squared if using a regression line), and has close to a one-to-one relationship. Thus, from this data it appears that the public absorbs all of the new debt issued.

Deficit and Change in Public Bond Holdings 1980 to 2019 Change in Publically Held Debt

2000000

y = 1.0856x + 9171.3 R² = 0.9439

1500000 1000000 Series1 500000

Linear (Series1)

0

-500000 -500000

0

500000

Deficit - $ Mil.

1000000

1500000

b. See the graphs below. For the change in holdings by the Federal Reserve, there appears to be a positive relationship suggesting some monetization of the debt, but this is much less obvious (and using a fitted regression line indicates a much smaller relationship, with less predictive power). In particular, for each $1 of deficit, the Fed absorbs about 16 cents of it in debt holdings.

Deficit and Change in Fed Bond Holdings 1980 to 2019 Change in Fed Bond Holdings

800000

y = 0.1589x + 2941.3 R² = 0.1229

600000 400000 Series1

200000

Linear (Series1)

0

-500000 0 -200000 -400000

500000

1000000

1500000

Deficit - $Mil.

c. See the graphs below. There appears to be some amount of debt monetization in the scatter plot data in the post-crisis period: in general, as the deficits get significantly larger during 2008 to 2019, the change in bond holdings by the Fed gets larger, indicating the central bank is facilitating higher deficits.

Looking separately at the period of 1980 to 2007 shows virtually no relationship between Federal Reserve debt holdings and deficits (see below; both the R-squared and the coefficient are close to zero). This is not surprising, since the Federal Reserve instituted several large-scale asset purchase programs during the post-crisis period, much of which was purchases of U.S. Treasuries, at a time when the United States was running very large deficits.

Deficit and Change in Fed Bond Holdings Pre- and Post-Crisis Change in Fed Held Debt

800000 y = 0.0142x + 21415 R² = 0.0184

600000 400000

1980 to 2007 2008 to 2019

200000

Linear (1980 to 2007)

0

-500000 0 -200000 -400000

500000

1000000

1500000

Linear (2008 to 2019) y = 0.1758x - 3658.9 R² = 0.0382

Deficit - $ Mil.

Chapter 20 ANSWERS TO QUESTIONS 1. ―When the stock market rises, investment spending is increasing.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Stocks do not add directly to investment in a macroeconomic sense; since the buying and selling of stocks represents transfers of existing assets, it does not directly create new production. However, increases in the stock market are likely to coincide with increases in investment, since higher stock market prices may occur during periods of higher economic growth, which could cause firms to increase autonomous investment.

2. Why is inventory investment counted as part of aggregate spending if it isn’t actually sold to the final end user?

Since inventories of unsold goods are goods that have been produced, then in an accounting sense, they add to output and hence aggregate demand. However, since the final end user hasn’t purchased them yet, they are counted as inventory until they are sold.

3. ―Since inventories can be costly to hold, firms’ planned inventory investment should be zero, and firms should acquire inventory only through unplanned inventory accumulation.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although inventories are costly to hold, many firms prefer to have extra inventories of unsold goods on hand in the event that there is an unpredictable increase in demand for their goods, because this allows firms to satisfy customers’ demands. As a result, planned inventory investment may very well be positive.

4. During and in the aftermath of the financial crisis of 2007–2009, planned investment fell substantially despite significant decreases in the real interest rate. What factors related to the planned investment function could explain this?

During the height of the crisis, financial frictions f increased dramatically, which effectively raised the real cost of investment. In addition, firms’ planned autonomous investment I decreased dramatically as the prospects for economic growth and profits in the future weakened sharply. Both of these factors reduced planned investment, even though real interest rates may have decreased.

5. If households and firms believe the economy will be in a recession in the future, will this necessarily cause a recession, or have any impact on output at all?

These shifts in ―animal spirits,‖ according to Keynes, could very well create a recession. If the beliefs are strong enough, this could significantly reduce autonomous consumption and autonomous planned investment to the point where equilibrium output decreases substantially, leading to a recession.

6. Why do increases in the real interest rate lead to decreases in net exports, and vice versa?

When the real interest rate increases, this increases the demand for domestic assets, resulting in an appreciation of the domestic currency. As a result, imported goods become cheaper domestically, and exported goods become more expensive to foreigners. This reduces net exports, implying an inverse relationship between the real interest rate and net exports.

7. How would a decline in house prices, or decrease in stock market prices affect the IS curve?

Either a decline in house prices or a decrease in stock market prices would reduce household wealth. As a result, autonomous consumption would decline, leading to a leftward shift of the IS curve. In addition, the decline in house prices could discourage the building of new housing because of reduced profitability of housing. This would reduce planned investment spending, and also shift the IS curve to the left.

8. If firms suddenly become more optimistic about the profitability of investment and planned investment spending rises by $100 billion, while consumers become more pessimistic and autonomous consumer spending falls by $100 billion, what happens to aggregate output?

Nothing. The $100 billion increase in planned investment spending is exactly offset by the $100 billion decline in autonomous consumer expenditure, and autonomous spending and aggregate output remain unchanged.

9. If an increase in autonomous consumer expenditure is matched by an equal increase in taxes, will aggregate output rise or fall?

Rise. The fall in spending from an increase in taxes is always less than the change in taxes because the marginal propensity to consume is less than 1. By contrast, autonomous spending rises one-for-one with a change in autonomous consumer expenditure. If taxes and autonomous consumer expenditure rise by the same amount, autonomous spending must rise, and aggregate output also rises.

10. If a change in the interest rate has no effect on planned investment spending or net exports, what does this imply about the slope of the IS curve?

In this case, as interest rates fall, planned investment spending and net exports do not change, so equilibrium output remains unchanged. This means that the IS curve is vertical.

11. Inventories typically increase starting at the beginning of recessions, and begin to decline near the end of recessions. What does this say about the relationship between planned spending and aggregate output over the business cycle?

At the beginning of recessions, planned spending falls as consumers reduce spending and firms reduce investment, while production generally stays constant. As a result, an excess supply of goods is produced, leading to rising inventories. In the middle stages of recessions, firms may reduce production, but this may also be met with further decreases in planned spending leading to further buildup of inventories.

However, near the end of a recession, firms are slow to increase production, while

planned spending typically increases; this leads to reductions in inventories due to the excess demand for goods.

12. Why do companies cut production when they find that their unplanned inventory investment is greater than zero? If they didn’t cut production, what effect would this have on their profits? Why? Companies cut production when their unplanned inventory investment is greater than zero, because they are then producing more than they can sell. If they continue at current production, profits will suffer because they are building up unwanted inventory, which is costly to store and finance.

13. ―Firms will increase production when planned investment is less than (actual) total investment.‖ Is this statement true, false, or uncertain? Explain your answer.

False. In this case, if actual investment is greater than planned investment, firms are adding to inventory, thus unplanned inventory investment is positive. This leads firms to reduce production in order to bring inventories to more desirable levels.

14. In each of the cases below, determine whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift. a. The real interest rate rises.

This is a movement along the IS curve, and so does not shift the IS curve. b. The marginal propensity to consume declines.

This results in a decrease in equilibrium output at any given interest rate, which shifts the IS curve to the left. c. Financial frictions increase.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. d. Autonomous consumption decreases.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. e. Both taxes and government spending decrease by the same amount.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. f. The sensitivity of net exports to changes in the real interest rate decreases.

Equilibrium output increases at any given interest rate, which shifts the IS curve to the right. g. The government provides tax incentives for research and development programs for firms.

Equilibrium output increases at any given interest rate, which shifts the IS curve to the right.

15. ―Financial frictions are not a problem for the economy, since they do not affect the safe policy rate which is controlled by the central bank.‖ Is this statement true, false, or uncertain? Explain your answer False. When financial frictions increase, they lead to an increase in market borrowing rates that are independent of the safe policy interest rate. As a result, assuming policy interest rates are unchanged, planned (investment) spending would be reduced (potentially very sharply), and thus shift the IS curve left and lead to declines in aggregate output.

16. When the Federal Reserve reduces its policy interest rate, how, if at all, is the IS curve affected? Briefly explain.

The IS curve is not affected at all, that is, it does not shift. Changes in the real interest rate represent movements along a given IS curve, and do not shift the curve.

17. Suppose you read that prospects for stronger future economic growth have led the dollar to strengthen and stock prices to increase. a. What effect does the strengthened dollar have on the IS curve?

A more expensive dollar will result in fewer U.S. exports and more U.S. imports (everything else the same), therefore decreasing net exports. Graphically, this shifts the IS curve to the left, decreasing aggregate output at every interest rate. b. What effect does the increase in stock prices have on the IS curve?

Usually the increase in stock prices is interpreted as having a positive effect on autonomous planned investment, as investors become more confident about the future prospects of the economy. Therefore, we should expect autonomous planned investment to increase and the IS curve to shift to the right. c. What is the combined effect of these two events on the IS curve?

This is an example in which it is quite difficult to measure the net effect of these events. Depending on the relative magnitude of the shifts, the IS curve might end up shifting to the left, to the right, or not shifting at all. This problem arises because these events have opposite effects on the IS curve.

ANSWERS TO APPLIED PROBLEMS 18. Calculate the value of the consumption function at each level of income in the table below if autonomous consumption = 300, taxes = 200, and mpc = 0.9.

Income Y Disposable Income YD Consumption C 0 100 200 300 400 500 600 Income Y Disposable Income YD Consumption C 0

–200

120

100

–100

210

200

0

300

300

100

390

400

200

480

500

300

570

600

400

660

19. Assume that autonomous consumption is $1,625 billion and disposable income is $11,500 billion. Calculate consumption expenditure if an increase of $1,000 in disposable income leads to an increase of $750 in consumption expenditure.

If an increase of $1,000 in disposable income leads to an increase of $750 in consumption expenditure, then mpc = 0.75. Using this implies that C = 1,625 + 0.75  11,500 = 10,250. Consumption expenditure is therefore $10,250 billion.

20. Suppose that Dell Corporation has 20,000 computers in its warehouses on December 31, 2022, ready to be shipped to merchants (each computer is valued at $500). By December 31, 2023, Dell Corporation has 25,000 computers ready to be shipped, each valued at $450. a. Calculate Dell’s inventory on December 31, 2022.

Dell’s inventory on December 31, 2022, is the market value of the 20,000 computers at its warehouses. Therefore, Dell’s inventory equals 20,000 × $500 = $10,000,000 on December 31, 2022. b. Calculate Dell’s inventory investment in 2023.

Dell’s inventory spending is the change in the level of its inventory during the course of 2023. On December 31, 2023, Dell’s inventory equals 25,000 × $450 =

$11,250,000. Therefore, Dell’s inventory spending in 2023 is $1,250,000 = $11,250,000 − $10,000,000. c. What happens to inventory spending during the early stages of an economic recession?

During the early stages of an economic recession, as soon as households’ income starts to fall, firms realize that their sales drop. This results in fewer orders by their dealers and therefore an increase in the number of goods they stock at their warehouses (since they probably have already decided about production levels for that period). The consequence is that inventory spending will be positive for some time, but firms will quickly cut production and will try to sell their already manufactured goods before increasing production again.

21. If the consumption function is C = 100 + 0.75YD, I = 200, government spending is 200, and net exports are zero, what will be the equilibrium level of output? What will happen to aggregate output if government spending rises by 100?

Equilibrium output of 2,000 occurs when Y = Yad and the aggregate demand function Yad = C + I + G + NX = 500 + 0.75Y. Solving for Y implies 0.25Y = 500, or Y = 2,000.

If government spending rises by 100, equilibrium output will rise by 400 to 2,400.

22. If the marginal propensity to consume is 0.75, by how much would government spending have to rise to increase output by $1,000 billion? By how much would taxes need to decrease to increase output by $1,000 billion?

The change in output Y is given as the change in spending G, multiplied by 1/(1 – mpc). Thus $1,000 = 4G, implying government spending would have to increase by $250 billion in order to increase equilibrium output by $1,000 billion. Alternatively, the change in output is given as the change in taxes T, multiplied by [–mpc]/(1 – mpc). Thus $1,000 = –3T, implying taxes would have to decrease by $333.3 billion in order to increase equilibrium output by $1,000 billion.

23. Assuming both taxes and government spending increase by the same amount, derive an expression for the effect on equilibrium output.

Formally, the effects on output from a change in government spending and a change in taxes are given, respectively, as YG = G/(1 – mpc) and YT = –T  mpc/(1 – mpc).

If both taxes and spending increase by the same amount, then G = T and the net effect on output is given as Y = YG + YT = G/(1 – mpc) – T  mpc/(1 – mpc) = G[1/(1 – mpc) – mpc/ (1 – mpc)] = G. Thus, if both taxes and government spending increase by the same amount, output will increase by exactly the amount of the increase in spending (or increase in taxes).

24. Consider an economy described by the following data: ̅

= $3.25 trillion

̅

= $1.3 trillion

̅

= $3.5 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= - $1.0 trillion

̅

=1

mpc

= 0.75

d

= 0.3

x

= 0.1

a. Derive simplified expressions for the consumption function, the investment function, and the net export function.

C = 3.25 + 0.75(Y – 3) = 1 + 0.75Y. I = 1.3 – 0.3(r + 1) = 1 – 0.3r. NX = –1 – 0.1r. b. Derive an expression for the IS curve.

The IS curve can be found by setting Y = Yad and solving: Y = 1 + 0.75Y + 1 – 0.3r + 3.5 –1 – 0.1r. This implies 0.25Y = 4.5 – 0.4r, or Y = 18 – 1.6r. c. If the real interest rate is r = 2, what is equilibrium output? If r = 5, what is equilibrium output?

At r = 2, equilibrium output is Y = 18 – 1.6(2) = $14.8 trillion; At r = 5, equilibrium output is Y = 18 – 1.6(5) = $10 trillion. d. Draw a graph of the IS curve showing the answers from part (c) above.

e. If government purchases increase to $4.2 trillion, what will happen to equilibrium output at r = 2? What will happen to equilibrium output at r = 5? Show the effect

of the increase in government purchases in your graph from part (d).

An increase of government spending of $0.7 trillion will lead to an 0.7/(1 – 0.75) = $2.8 trillion increase in equilibrium output at any given interest rate. Thus, the IS curve will shift horizontally to the right by $2.8 trillion.

25. Consider an economy described by the following data: ̅

= $4 trillion

̅

= $1.5 trillion

̅

= $3.0 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=0

mpc

= 0.8

d

= 0.35

x

= 0.15

a. Derive an expression for the IS curve.

Using equation (12) in the chapter, the IS curve is given as Y = 35.5 – 2.5r. b. Assume that the Federal Reserve controls the interest rate and sets the interest rate at r = 4. What is the equilibrium level of output?

At an interest rate of Y = 35.5 – 2.5(4) = 25.5. c. Suppose that a financial crisis begins, and ̅ increases to ̅ = 3. What will happen to equilibrium output? If the Federal Reserve can set the interest rate, then at what level should the interest rate be set to keep output from changing?

The IS curve is now Y = 30.25 – 2.5r; at an interest rate of 4, equilibrium output is now Y = 20.25. In order to maintain the output level from part (b), the Federal Reserve would have to set the interest rates such that 25.5 = 30.25 – 2.5r, implying the interest rate setting of to offset the increase in f of 3. Thus, the Federal Reserve will reduce d. Suppose the financial crisis causes ̅ to increase as indicated in part (c) and also causes planned autonomous investment to decrease to ̅ = $1.1 trillion. Will the change in the interest rate implemented by the Federal Reserve in part (c) be effective in stabilizing output? If not, what additional monetary or fiscal policy changes could be implemented to stabilize output at the original equilibrium output level given in part (b)? f I , Y = $25.5 trillion.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on Personal Consumption Expenditures (PCEC), Personal Consumption Expenditures: Durable Goods (PCDG), Personal Consumption Expenditures: Nondurable Goods (PCND), and Personal Consumption Expenditures: Services (PCESV). a. According to the most recent data: What percentage of total household expenditures is devoted to the consumption of goods (both durable and nondurable goods)?

For 2020:Q2, total personal consumption expenditures are $13,017.8 billion, nondurable consumption is $2875.7 billion, and durables consumption is $1474.2 billion. Thus, nondurables represent 100*2875.7/13,017.8 = 22.1%, and durables represents 100*1474.2/13,017.8 = 11.3%. Services is the largest part of consumption, at 100*8667.8/13,017.8 = 66.6% b. Given these data, which specific component of household expenditures would be most impacted by a reduction in overall household spending? Explain.

Since services are a much larger fraction of consumption than either nondurables or durable consumption, it would be reasonable to conclude a decline in household spending would most likely impact services spending. However, most of the services component is due to housing expenses, which do not change much over business cycles, thus it is more likely that nondurables, the second largest component, is affected most.

2. Go to the St. Louis Federal Reserve FRED database and find data on Real Private Domestic Investment (GPDIC1), a measure of the real interest rate; the 10-year Treasury Inflation-Indexed Security, TIIS (FII10); and the spread between Baa corporate bonds and the 10-year U.S. Treasury (BAA10YM), a measure of financial frictions. For (FII10) and (BAA10YM), convert the frequency setting to ―Quarterly,‖ and download the data into a spreadsheet. For each quarter, add the (FII10) and (BAA10YM) series to create ri, the real interest rate for investments for that quarter.

Then calculate the change in both investment and ri as the change in each variable from the previous quarter. a. For the eight most recent quarters of data available, calculate the change in

investment from the previous quarter, and then calculate the average change over the eight most recent quarters.

From 2018:Q3 to 2020:Q2, the average change in investment was –$64.4 (billion) per quarter. b. Assume there is a one-quarter lag between movements in ri and changes in investment; in other words, if ri changes in the current quarter, it will affect investment in the next quarter. For the eight most recent lagged quarters of data available, calculate the one-quarter-lagged average change in ri.

From 2018:Q2 to 2020:Q1, the average change in ri was 0.01. c. Take the ratio of your answer from part (a) divided by your answer from part (b).

What does this value represent? Briefly explain.

The ratio of the changes is –64.4/0.01 = –6440; the absolute value of this represents the coefficient on the investment function; that is, for every one percentage point increase in ri, real private domestic investment decreases by about $6440 billion. Note that this is what you should expect in theory, as the real interest rate for investments and investment should be negatively related. d. Repeat parts (a) through (c) for the period 2008:Q3 to 2009:Q2. How do financial frictions help explain the behavior of investment during the financial crisis? How do the coefficients on investment compare between the current period and the financial crisis period? Briefly explain.

From 2008:Q3 to 2009:Q2, the average change in investment was –$166.0 (billion), and from 2008:Q2 to 2009:Q1, the average change in ri was 0.71. The coefficient on investment d during that period is the absolute value of – 166.0/0.71, or d = 233.8. Thus, for every one percentage point increase in ri, real private domestic investment would fall by about $233.8 billion. The financial frictions component partly helps explain the significant decline in investments during the financial crisis period despite real interest rates being relatively low; however, other factors are clearly at play that are affecting the value of the two coefficients that can’t be captured by the financial frictions data series.

Chapter 21 ANSWERS TO QUESTIONS 1.

2.

3.

4. If  = 0, what does this imply about the relationship between the nominal interest rate and the inflation rate?

When  = 0, this means that the real interest rate will stay constant at r even when inflation changes. The implication is that as inflation increases, the nominal interest rate will increase by exactly the same as the inflation rate, so that the real interest rate stays constant.

5. How does an autonomous tightening or easing of monetary policy by the Fed affect the MP curve?

An autonomous tightening of policy results in r increasing, and the MP curve shifting upward; an autonomous easing of policy results in r decreasing, shifting the MP curve downward.

6.

7.  8.  9.  10. ―Autonomous monetary policy is more effective at changing output when  is higher.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Since  is independent of the autonomous component of monetary policy r , any change in r will affect the real interest rate the same regardless of the value of .

Thus, for a given IS curve, any change in autonomous monetary policy will have the same impact on output, independent of the value for .

11.

12. If an asset-price bubble begins to form, assuming the central bank responds, how is it likely to respond, and what will be the effect on the MP curve?

If the central bank wishes to directly address the asset-price bubble, it would likely autonomously tighten policy by increasing ̅ . This would increase the real policy interest rate at any given inflation rate, and shift the MP curve up.

13. a. b. c. d. e. f.

 14. What would be the effect of an increase in U.S. net exports on the aggregate demand curve? Would an increase in net exports affect the monetary policy curve? Explain.

An increase in U.S. net exports directly affects the IS curve, since planned expenditure increases at every real interest rate. Assuming the goods market is in equilibrium, aggregate output increases, shifting the IS curve to the right. The monetary policy curve does not shift, since net exports are not a determinant of the monetary policy curve. The monetary policy curve represents the monetary authorities’ willingness to set a given real interest rate in the short run according to current inflation rates. Given the same monetary policy curve and a new IS curve, the aggregate demand curve shifts to the right. This means that aggregate output increases at every inflation rate.

15. Why does the aggregate demand curve shift when ―animal spirits‖ change?

The aggregate demand curve shifts because a change in ―animal spirits‖ causes autonomous consumer expenditure or planned investment spending to change, which then causes the quantity of aggregate output demanded to change at any given inflation rate.

16. Suppose that government spending is increased at the same time that an autonomous monetary policy tightening occurs. What will happen to the position of the aggregate demand curve?

The effect on the aggregate demand curve is uncertain because increased government spending would shift the AD curve to the right while the autonomous policy tightening shifts the AD curve to the left.

17. If financial frictions increase, how will this affect credit spreads, and how might the central bank respond? Why? The increase in financial frictions, if left alone, will increase the cost of borrowing and result in higher credit spreads. This will lead to a decrease in planned investment, shifting the AD curve to the left and reducing aggregate output demanded. Thus if the central bank wants to avoid a recession, it needs to reduce the real interest rate for investments. It can do this through an autonomous easing of policy by reducing ̅ , which reduces the real policy interest rate r. This will help offset the negative effects of the financial frictions and shift the AD curve back to the right. Alternatively, as discussed in the upcoming Chapter 23, the central bank can pursue policies to directly reduce financial frictions by providing liquidity to key credit markets. This reduces financial frictions at the source and allows the policy real interest rate to remain the same, while directly reducing the real interest rate for investments and lowering credit spreads.

18. f f, f

ANSWERS TO APPLIED PROBLEMS 19. Assume that the monetary policy curve is given by r = 1.5 + 0.75. a. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%.

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 3%, 3.75%, and 4.5%, respectively. b. Draw a graph of the MP curve, labeling the points from part (a).

See graph in (d) below. c. Assume now that the monetary policy curve is given by r = 2.5 + 0.75. Does the new monetary policy curve represent an autonomous tightening or loosening of monetary policy?

Since r increases, this represents an autonomous tightening of policy. d. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%, and

draw the new MP curve, showing the shift from part (b).

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 4%, 4.75%, and 5.5%. The graph is given below.

20.

21. Suppose the monetary policy curve is given by r = 1.5 + 0.75, and the IS curve is given by Y = 13 − r. a. Calculate an expression for the aggregate demand curve.

Y = 11.5 – 0.75. b. Calculate the real interest rate and aggregate output when the inflation rate is 2%, 3%, and 4%.

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 3%, 3.75%, and 4.5%, respectively. Aggregate output is 10, 9.25, and 8.5, respectively. c. Draw graphs of the IS, MP, and AD curves, labeling the points from part (b) on the appropriate graphs.

Graphs are given below.

22. Consider an economy described by the following: ̅

= $4 trillion

̅

= $1.5 trillion

̅

= $3.0 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=0

mpc

= 0.8

d

= 0.35

x

= 0.15



= 0.5

r

=2

a. Derive expressions for the MP curve and the AD curve.



b. Calculate the real interest rate and aggregate output when  = 2 and  = 4.

 c. Draw a graph of the MP curve and the AD curve, labeling the points given in part (b).

23. Consider an economy described by the following: ̅

= $3.25 trillion

̅

= $1.3 trillion

̅

= $3.5 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=1

mpc

= 0.75

d

= 0.3

x

= 0.1



=1

r

=1

a.

 b. 

c. r r r d. r r.

24. a.

 b.  c. d.

25.  a. 

At  b. 



c.

ANSWERS TO DATA ANALYSIS PROBLEMS

1. A measure of real interest rates can be approximated by the Treasury InflationIndexed Security, or TIIS. Go to the St. Louis Federal Reserve FRED database and find data on the five-year TIIS (FII5) and the personal consumption expenditure price index (PCECTPI), a measure of the price index. Choose ―Quarterly‖ for the frequency setting of the TIIS, and download both data series. Convert the price index data to annualized inflation rates by taking the quarter-to-quarter percent change in the price index and multiplying it by 4. Be sure to multiply by 100 so that your results are percentages. a. Calculate the average inflation rate and the average real interest rate over the most recent four quarters of data available, and the four quarters prior to that.

For the period of 2019:Q3 to 2020:Q2, average inflation was 0.58%, and the average real interest rate was –0.09%. For 2018:Q3 to 2019:Q2, inflation averaged 1.51% and the real interest rate averaged 0.76%. b. Calculate the change in the average inflation rate between the most recent annual period and the year prior. Then calculate the change in the average real interest rate over the same period.

The change in average inflation was 0.58 – 1.51 = –0.94%. The change in average real interest rate was –0.09% – 0.76% = –0.85%. c. Using your answers to part (b), compute the ratio of the change in the average real interest rate to the change in the average inflation rate. What does this ratio represent? Comment on how it relates to the Taylor principle.

The ratio equals –0.94%/–0.85% = 1.11. This is an estimate of the coefficient λ, which represents the slope of the MP curve. Since λ = 1.11 is positive, this means that according to this data, monetary policy over the last couple years has adhered to the Taylor Principle.

2. A measure of real interest rates can be approximated by the Treasury InflationIndexed Security, or TIIS. Go to the St. Louis Federal Reserve FRED database and find data on the five-year TIIS (FII5) and the personal consumption expenditure price index (PCECTPI), a measure of the price index. Choose ―Quarterly‖ for the frequency setting for the TIIS, and choose ―Percent Change From Year Ago‖ for the units setting on (PCECTPI). Plot both series on the same graph, using data from 2007 through the most current data available. Use the graph to identify periods of autonomous monetary policy changes. Briefly explain your reasoning.

See the graphs below. Periods of autonomous monetary policy change are characterized by a decoupling of real rates and inflation rates. From the middle of 2007 to late 2008, inflation increased, while the real interest rate fell, indicating an autonomous easing of policy. The period from late 2008 through mid-2009 was consistent with a move along the MP curve, where policy was reacting to variation in inflation. From mid-2009 through mid-2011, inflation rose steadily, while the real interest rate continued to decline, suggesting autonomous easing of policy. From mid2011 to early 2013, both inflation and the real interest rate fell, again suggesting a movement along the MP curve as policy reacted to changes in inflation. From 2015 to 2019, inflation and the real interest rate largely moved together, indicating a movement along the MP curve. Through much of 2019, real interest rates declined while inflation increased modestly, indicating some autonomous easing during that

period of time. By early 2020, both inflation and real interest rates were falling significantly, representing a movement along the MP curve.

Real Interest Rate and Inflation 4.00 3.00

Real Interest Rate

1.00

Inflation

0.00 -1.00 -2.00

2007-01-01 2007-10-01 2008-07-01 2009-04-01 2010-01-01 2010-10-01 2011-07-01 2012-04-01 2013-01-01 2013-10-01 2014-07-01 2015-04-01 2016-01-01 2016-10-01 2017-07-01 2018-04-01 2019-01-01 2019-10-01

Rate

2.00

Chapter 22 ANSWERS TO QUESTIONS 1. Explain why the aggregate demand curve slopes downward and the short-run aggregate supply curve slopes upward.

A rise in inflation causes monetary policymakers to raise the real interest rate. This reduces planned expenditures and lowers the level of output necessary for goods market equilibrium. The opposite occurs if inflation falls. Therefore, goods market equilibrium will occur at lower levels of output when the inflation rate rises and at higher levels of output when inflation falls. The downward slope of the aggregate demand curve reflects this. The short-run aggregate supply curve slopes upward to reflect the increase in the inflation rate that occurs when the economy’s aggregate output of goods and services exceeds the potential output level in the short run and the decrease in inflation that occurs when output is below potential output.

2. Identify three factors that can shift the aggregate demand curve to the right and three different factors that can shift the aggregate demand curve to the left.

The following changes shift the aggregate demand curve to the right: monetary policy easing, increase in government purchases, decrease in taxes, autonomous increase in consumption, autonomous increase in investment, autonomous increase in net exports, and a decrease in financial frictions. The opposite changes in these factors shift the aggregate demand curve to the left.

3. ―The appreciation of the dollar from 2012 to 2018 had a negative effect on aggregate demand in the United States.‖ Is this statement true, false, or uncertain? Explain your answer.

The statement is correct. An appreciation of the U.S. dollar makes U.S. exports more expensive for foreign consumers at the same time it makes imports into the United States cheaper. As a result, exports decrease, imports increase, and net exports decrease. According to aggregate demand and supply analysis, the aggregate demand curve shifts downward and to the left, and reducing output. Note that the appreciation of the U.S. dollar might also affect the short-run aggregate supply curve if U.S. firms import many of their inputs. A decrease in the price of inputs will shift the short-run aggregate supply curve down and to the right, which will mitigate some of the declines in output from the aggregate demand shift.

4. In many countries around the world, the population is aging and large segments of the population are retiring or close to retirement. What effect would this have on a countries’ long-run aggregate supply curve? What will happen to income as a result?

If the labor supply is reduced as a result of large portions of the population retiring, this reduces the productive capacity of the economy, resulting in a leftward shift of the long-run aggregate supply curve. All else equal, this will result in a decline in income in the country.

5. If the labor force becomes more productive over time, how would the long-run aggregate supply curve be affected?

As labor productivity grows, the long-run aggregate supply curve shifts to the right.

This is because the existing labor force, along with a given amount of capital and other resources, can produce more output, indicating a greater amount of potential output.

6. Why are central banks so concerned with inflation expectations?

When inflation expectations rise, it shifts the short-run aggregate supply curve up, leading to higher actual inflation in the short run in addition to any inflationary effects that may occur, for instance through negative price shocks. This illustrates the danger when inflation expectations become ―unanchored‖ from a low level, in that it is more difficult for the central bank to then stabilize inflation, particularly when a temporary inflation shock leads to higher expected inflation.

7. ―If prices and wages are perfectly flexible, then γ = 0 and changes in aggregate demand have a smaller effect on output.‖ Is this statement true, false, or uncertain? Explain your answer.

False. As prices and wages become more flexible, γ becomes larger, and the short-run aggregate supply curve becomes steeper. (In the limit, with perfect flexibility, γ approaches infinity.) Thus, for a given aggregate demand shock, as the short-run aggregate supply curve becomes steeper the effects on output are smaller.

8. What factors shift the short-run aggregate supply curve? Do any of these factors shift the long-run aggregate supply curve? Why? Shifts in the short-run aggregate supply curve result from changes in expected inflation, price shocks, and persistent output gaps. None of these factors shift the longrun aggregate supply curve because price and wage flexibility ensures that in the long run the economy produces at its potential output level. Potential output depends not on actual or expected inflation but rather on the capital, labor, and technology available for producing goods and services. However, a change in potential output shifts the long-run aggregate supply curve and also the short-run aggregate supply curve because it changes the output gap at any given level of actual output.

9. If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the short-run aggregate supply curve when budget deficits rise?

The short-run aggregate supply curve will shift upward because wages and production costs rise, since workers and firms expect prices to be higher.

10. In the aftermath of the financial crisis in the United States, labor mobility has decreased significantly. How, if at all, might this affect the natural rate of unemployment?

If labor mobility decreases within an economy, it makes it harder for workers and firms to find each other; thus it is likely to take much longer for the job matching process to occur, and for those that don’t move to other areas where jobs are plentiful, this could also result in elevated structural unemployment. As a result, the natural rate of unemployment will increase.

11. When aggregate output is below the natural rate of output, what happens to the inflation rate over time if the aggregate demand curve remains unchanged? Why?

When output is less than potential output, unemployment is above the natural rate and labor market slack causes wages to rise less rapidly. As the Phillips curve suggests, this causes firms to raise their prices less rapidly and thus decreases the inflation rate.

As a result, expected inflation will be lower in the following time period and the short-run aggregate supply curve will shift downward. This adjustment process in which inflation and expected inflation fall and the short-run aggregate supply curve shifts downward continues over time until output increases to the potential output level, the output gap increases to zero, and the economy reaches long-run equilibrium.

12. Suppose the public believes that a newly announced anti-inflation program will work and so lowers its expectations of future inflation. What will happen to aggregate output and the inflation rate in the short run?

The inflation rate will be lower than it otherwise would be and aggregate output will be higher. The lower expected inflation will cause the short-run aggregate supply curve to shift down, so that the intersection of the short-run aggregate supply curve with the aggregate demand curve will be at a higher level of output and a lower inflation rate.

13. If the unemployment rate is above the natural rate of unemployment, holding other factors constant, what will happen to inflation and output?

When the unemployment rate is above the natural rate of unemployment, there is slack in the labor market and output is below potential. This causes the short-run aggregate supply curve to shift downward, leading to lower inflation and higher output over time, until the economy reaches a long-run equilibrium.

14. What happens to inflation and output in the short run and in the long run when taxes decrease?

A decrease in taxes will lead to a rightward shift of the aggregate demand curve. In the short run, inflation and output will both rise. This leads to tightness in the labor market, which raises inflation expectations and shifts the short-run aggregate supply curve up; as this occurs, the economy moves to a new long-run equilibrium, output falls back to potential, and inflation increases.

15. If stagflation is bad (high inflation and high unemployment), does this necessarily mean low inflation and low unemployment is good?

Not necessarily. Even though low unemployment is desirable, if unemployment is too low relative to the natural rate of unemployment, future inflation risk could build even if the current inflation rate remains relatively low. In addition, as discussed in Chapter 16, having too low of an inflation rate could mean that an adverse shock could result in the conventional policy instrument hitting the effective lower bound and inflation turning negative, potentially triggering a deflationary episode which can be particularly damaging.

16. Why did the Federal Reserve pursue inherently recessionary policies in the early 1980s?

The Federal Reserve’s policies during that time were not intentionally recessionary; however, they were necessary in order to re-anchor inflation (and inflation

expectations) at a permanently lower level. The only way to achieve this, given that the Federal Reserve had very little credibility in fighting inflation at the time, was to pursue highly contractionary policies to bring the inflation rate down, a necessary side effect of which was a sharp decrease in aggregate demand.

17. In what ways is the Volcker disinflation considered a success? In what ways is it considered a failure?

The Volcker disinflation is considered a success in that the Chair of the Federal Reserve, Paul Volcker, was finally able to bring inflation down to a permanently lower, stable level after a decade of high and volatile inflation through most of the 1970s. Unfortunately, the policies to get the economy on a path of low, stable longterm inflation required significantly contractionary policies. These policies resulted in two recessions in the early 1980s, with unemployment rising above 12% at its peak.

So although the policies to reduce inflation from the high levels of the 1970s achieved their purpose, they did not come without some costs.

ANSWERS TO APPLIED PROBLEMS 18. Suppose the president gets Congress to pass legislation that encourages investment in research and the development of new technologies. Assuming this policy leads to a positive productivity change for the U.S. economy, use aggregate demand and supply analysis to predict the effects on inflation and output. Demonstrate these effects on a graph.

Technological change and infrastructure improvements affect the long-run aggregate supply curve. More fuel-efficient cars result in a decrease in the demand for gas at the same time that innovations in energy production make it possible to increase the supply of energy at any price level. Innovations in these fields result in a shift to the right in both the short- and long-run supply curves. Improvements in infrastructure make transportation of goods to market more efficient, and raise productivity in a variety of ways. In conclusion, inflation decreases and output increases in the long run.

19. Proposals advocating the implementation of a national sales tax have been presented before Congress. Predict the effects of such a tax on the aggregate supply and demand curves, showing the effects on output and inflation. Use a graph of aggregate supply and demand to demonstrate these effects.

Because goods would cost more, the national sales tax would raise production costs, and the short-run aggregate supply curve would shift to the left. The intersection of the short-run aggregate supply curve with the aggregate demand curve would then be at a higher inflation rate and a lower level of the aggregate output index; aggregate output would fall, and the inflation rate would rise.

20. Suppose the inflation rate remains relatively constant while output decreases and the unemployment rate increases. Using an aggregate demand and supply graph, show how this scenario is possible.

In order for the unemployment rate to rise and inflation to remain constant, both the aggregate supply and demand curves would have to shift to the left. If they shift horizontally to the left by the same amount, the result is inflation remaining the same, but output falling and the unemployment rising in the short run, as shown in the graph below.

21. Classify each of the following as a supply shock or a demand shock. Use a graph to show the effects on inflation and output in the short run and in the long run. a. Financial frictions increase.

Negative demand shock. An increase in financial frictions reduces aggregate demand. The aggregate output index and inflation fall in the short run; in the long run, the aggregate output index rises back to potential, and inflation falls.

b. Households and firms become more optimistic about the economy.

This increases autonomous consumption and investment, which increases aggregate demand. The aggregate output index and inflation increase in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases.

c. Favorable weather produces a record crop of wheat and corn in the Midwest.

This shifts the short-run aggregate supply curve to the right (down). The aggregate output index increases and inflation decreases in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases, returning to the original level.

d. Auto workers go on strike for four months.

This shifts the short-run aggregate supply curve to the left (up). The aggregate output index decreases and inflation increases in the short run; in the long run, the aggregate output index increases back to potential, and inflation decreases,

returning to the original level.

22. During 2017, some Fed officials discussed the possibility of increasing interest rates as a way of fighting potential increases in expected inflation. If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve? Use an aggregate demand and supply graph to illustrate your answer.

If the public assumes that the current Fed officials are not that worried about inflation, expected inflation will increase, shifting the short-run aggregate supply curve upward and to the left (as shown in the graph below). During 2017, Fed officials were in the difficult position of worrying when they might have to increase interest rates to fight inflation as the economy was largely recovered, but inflation remained low. Increasing interest rates too late could fuel expectations about higher inflation, while increasing interest rates too soon will slow down the recovery or even send the economy back into recession. It is quite difficult to make this decision, which is why most of the time the conduct of monetary policy is more an art than a science.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on real GDP (GDPC1), potential GDP (GDPPOT), and the unemployment rate (UNRATE) from 1960 to the most recent period. For the unemployment rate data, convert the frequency to Quarterly. Download all of the data into a spreadsheet, and calculate the output gap and aggregate output index for each quarter. a. In which quarter is the output gap the most negative? What is the Aggregate Output Index for that quarter?

From the period of 1960 through the second quarter of 2020, the most negative output gap occurred during Q2 2020. During this quarter, the output gap was – 9.9%, or an AOI of 90.1. b. In which quarter is the unemployment rate highest?

The highest unemployment rate during this period occurred in Q2 2020, at 13.0%. c. Are these periods of time close to each other? What does this tell you about the relationship between output gaps and the unemployment rate?

Yes, since 1960, both the highest unemployment rate and most negative output gap coincide at the same time in Q2 2020. This indicates that higher unemployment rates are consistent with more negative output gaps, and vice versa.

2. Go to the St. Louis Federal Reserve FRED database and find data on real government spending (GCEC1), real GDP (GDPC1), taxes (W006RC-1Q027SBEA), and the personal consumption expenditure price index (PCECTPI), a measure of the price level. Download all of the data into a spreadsheet, and convert the tax data series into real taxes. To do this, for each quarter, divide taxes by the price index and

then multiply by 100. a. Calculate the level change in real GDP over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. b. Calculate the level change in real government spending and real taxes over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. c. Are your results consistent with what you would expect? How do your answers to part (b) help explain, if at all, your answer to part (a)? Explain using the IS and AD curves.

No, this is not entirely consistent with what would be expected for tax and spending changes. Over the most recent year period of 2019:Q1 to 2020:Q1, a mixed fiscal policy change took place with government spending increasing, while taxes decreased. With government spending much higher than taxes, you would expect this should increase output by shifting both the IS and AD curves to the right, which appears to be the case since output rose over that period. In the period from 2018:Q1 to 2019:Q1 the results are similar, but the magnitude of changes is reversed: government spending increases modestly, while tax receipts increases much more. In this case, you might expect the IS and AD curves to shift to the left and decrease output given the magnitude effects, however, output actually went up anyway. Clearly, there are other factors in the economy that are offsetting the contractionary tax effects to increase GDP overall in the economy.

Gov’t Spending Chg., $Bil.

Real Tax Chg., $Bil.

Real GDP Chg., $Bil.

2019:Q1 to 2020:Q1



9.3

60.5

2018:Q1 to 2019:Q1

55.7



419.9

3. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), a measure of the price level; real compensation per hour (COMPRNFB); the nonfarm business sector real output per hour (OPHNFB), a measure of worker productivity; the price of a barrel of oil (MCOILWTICO); and the University of Michigan survey of inflation expectations (MICH). Use the frequency setting to convert the oil price and inflation expectations data series to ―Quarterly,‖ and use the units setting to convert the price index to ―Percent Change from Year Ago.‖ Download all of the data into a spreadsheet, and convert the compensation and productivity measures to a single indicator. To do this, for each quarter, take the compensation number and subtract the productivity number. Call this difference ―Net Wages Above Productivity.‖ d. Calculate the change in the inflation rate over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. e. Calculate the changes in net wages above productivity, the price of oil, and inflation expectations over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. f. Are your results consistent with what you would expect? How do your answers to part (b) help explain, if at all, your answer to part (a)? Explain using the shortrun aggregate supply curve.

The data from part (b) move in somewhat different directions, so it is difficult to explain the inflation behavior consistent with what would be expected to explain part (a). In the most recent period, inflation expectations, oil prices, and net wages all decreased (which would shift the AS curve down). Despite this, inflation increased slightly during that time. In the previous period, the results are more consistent: inflation expectations fell slightly, oil prices declined, and net wages were flat. In this backdrop, inflation decreased modestly, and is consistent with a shift downward of the AS curve.

Inflation Chg.

Inflation Exp. Chg.

Oil Price Chg., $/Brl.

Net Wages Chg.

2019:Q1 to 2020:Q1

0.2

0.2

9.1

0.2

2018:Q1 to 2019:Q1

0.5

0.1

8.1

0.0

Chapter 23 ANSWERS TO QUESTIONS 1. What does it mean when we say that the inflation gap is negative?

When the inflation gap is negative, this means that the current inflation rate is less than the target inflation rate.

2. ―If autonomous spending falls, the central bank should lower its inflation target in order to stabilize inflation.‖ Is this statement true, false, or uncertain? Explain your answer.

False. If the central bank pursues stabilization policy, it can stabilize both inflation and output simultaneously by an autonomous easing of policy. If it lowered its inflation target, this would stabilize inflation temporarily; however, output would still be below potential. In addition, as the economy recovered from the recession, inflation would naturally begin to fall more due to the self-correcting mechanism.

Thus, in order to allow the economy to move back to the potential level of output, the central bank would need to then continuously adjust its inflation target. Constant adjustment of the inflation target would be inefficient, and could send mixed signals to the public about what it is doing and why.

3. For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a longrun equilibrium. a. Consumers reduce autonomous consumption.

A reduction in autonomous consumption reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity. b. Financial frictions decrease.

A reduction in financial frictions increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity c. Government spending increases.

An increase in government spending increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity. d. Taxes increase.

An increase in taxes reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity. e. The domestic currency appreciates.

An appreciation of the domestic currency leads to lower exports and higher imports, which reduces net exports and aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity

4. During the global financial crisis, how was the Fed able to help offset the sharp increase in financial frictions without the option of lowering interest rates further?

Did the Fed’s plan work?

The Fed lowered the fed funds rate to zero during the crisis to offset falling aggregate demand; however, this was insufficient to stabilize aggregate demand and output. As a result, the Fed resorted to nonconventional monetary policy to help offset the financial frictions. This involved liquidity provision and asset purchases, which helped to lower medium and longer-term interest rates, and helped to increase aggregate demand, despite having reached the effective lower bound on the federal funds rate. However, due to the severity of the crisis, these policies were insufficient to fully stabilize economic activity and bring output to potential.

5. Why does the divine coincidence simplify the job of policymakers?

The divine coincidence exists when policies that are appropriate to achieve price stability also stabilize economic activity. In this case, policymakers have easier jobs because there is no tradeoff between policy objectives and that they do not have to choose between them. They can, in other words, have their cake and eat it, too. The divine coincidence occurs when the economy is beset with aggregate demand shocks, but not when it experiences supply shocks. When faced with a demand shock, policymakers can stabilize both inflation and economic activity by enacting policies to shift the economy’s aggregate demand curve and return to long-run equilibrium at potential output. In the case of a supply shock, however, policies that shift the aggregate demand curve to achieve inflation stability will move the economy further away from potential output and those aimed at stabilizing economic activity at potential output will cause the inflation rate to move further away from the target rate.

6. Why do negative supply shocks pose a dilemma for policymakers?

With negative supply shocks, both inflation and the unemployment rate increase. In order to reduce the unemployment rate, an expansionary policy must be pursued, which further increases inflation. On the other hand, pursuing a policy to reduce the inflation rate requires a contractionary policy, which further increases the unemployment rate. Thus, with negative supply shocks stabilization policy requires a tradeoff between achieving the objectives of inflation stabilization and stabilization of real economic activity.

7. Suppose three economies are hit with the same negative supply shock. In country A, inflation initially rises and output falls; then inflation rises more and output increases. In country B, inflation initially rises and output falls; then both inflation and output fall. In country C, inflation initially rises and output falls; then inflation falls and output eventually increases. What type of stabilization approach did each country take?

In country A, policymakers chose a policy to stabilize output. In country B, policymakers chose a policy to stabilize inflation. In country C, policymakers chose no policy response, that is, left autonomous monetary policy unchanged.

8. ―Policymakers would never respond by stabilizing output in response to a positive supply shock.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. A positive supply shock has the dual benefits of increasing output and also reducing inflation, so in some sense policymakers get the best of both worlds by not pursuing any type of stabilization policy. However, if the supply shock is large enough, it could reduce inflation and/or increase output enough such that it could create more variability and hence uncertainty in inflation, which could actually be destabilizing. In this case, it may be in the best interest of policymakers to pursue a policy that stabilizes the inflation rate in the short run, until the supply shock wears off (this would have the added benefit of temporarily increasing output more than if policymakers did nothing).

9. The fact that it takes a long time for firms to get new plants and equipment up and running is an illustration of what policy problem?

This demonstrates the problem of effectiveness lags in the implementation of monetary policy. Changes in monetary policy impact interest rates, which affect the cost of investment in new plant and equipment. Since it can be many months before new plants and equipment are purchased and put into use, the interest rate effects of monetary policy occur with a lag.

10. In the United States, many observers have commented in recent years on the ―political gridlock in Washington D.C.‖ and referred to Congress as a ‟Do Nothing Congress.‖ What type of policy lag is this describing?

This refers to the legislative lag (of fiscal policy).

11. Is stabilization policy more likely to be conducted through monetary policy or through fiscal policy? Why? Stabilization policy is conducted more frequently using monetary policy rather than fiscal policy because implementing fiscal policy requires making changes in taxes and government spending that take longer to deliberate and enact than monetary policy decisions do.

12. ―If the data and recognition lags could be reduced, activist policy probably would be more beneficial to the economy.‖ Is this statement true, false, or uncertain? Explain your answer.

True. If the first parts of the statement could be achieved, the objection to activist policy would no longer be as serious. For instance, in response to aggregate demand shocks, the aggregate demand curve could be more quickly shifted to potential output, resulting in less variation in both inflation and output, and making an activist policy more desirable.

13. If the economy’s self-correcting mechanism works slowly, should the government necessarily pursue discretionary policy to eliminate unemployment? Why or why not?

Not necessarily, because an activist policy to eliminate unemployment could lead to the demand-pull and cost-push inflations depicted in Figure 7 and Figure 8 in the chapter. In addition, the activist policy might lead to a higher probability that workers will push up their wages, which results in episodes of high unemployment.

14. In the early 1970s, an unexpected productivity slowdown led most economists to believe that potential output was larger than it actually was. How are policymakers likely to respond under this situation and what do you expect to be the outcome?

In this case, policymakers are likely to pursue overly expansionary policies to try to increase output above potential and lower unemployment below the natural rate. The result is that inflation will rise substantially as the economy begins to produce far beyond the sustainable level of production.

15. In both the 1960s and 1970s in the United States, inflation increased significantly.

However, unemployment behaved very differently in the two decades. Why is this?

Even though inflation increased significantly in both decades, the sources of the increase were different, leading to much different effects on unemployment. In the case of the 1960s, much of the inflationary pressures were generated from demandpull inflation policies due to highly expansionary fiscal and monetary policy pushing the aggregate demand curve far to the right, similar to Figure 8 in the chapter. This helped to reduce unemployment to low levels. On the other hand, in the 1970s, most of the inflation came from cost-push sources, such as adverse price shocks, declines in productivity, and sharp increases in inflation expectations. This resulted in substantial shifts of the short-run aggregate supply curve upward, and triggering spiraling inflation and higher unemployment similar to Figure 7 in the chapter.

16. Given a relatively steep and a relatively flat short-run aggregate supply curve, which curve would support the case for nonactivist policy? Why? When the short-run aggregate supply curve has a steeper slope, wages and prices in general are more flexible (i.e., changes in output result in larger changes in the inflation rate). This situation constitutes a stronger argument in favor of nonactivist policy, since changes in the aggregate demand curve will result in smaller changes in output and unemployment when the short-run aggregate supply curve is steeper.

Alternatively, one might think that further efforts in terms of activist monetary or fiscal policy are needed to affect output if prices and wages are less flexible (which is the case when the short-run aggregate supply curve is flatter).

17. ―Because government policymakers do not consider inflation desirable, their policies cannot be the source of inflation.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Even though policymakers do not want inflation, if they pursue goals such as high employment or choose to run high budget deficits, inflationary monetary policy and inflation can result through the mechanisms discussed in this chapter.

18. How can monetary authorities target any inflation rate they wish?

Monetary policymakers can target any inflation rate they want to simply by implementing autonomous monetary policy easing (to target a higher inflation rate) or tightening (to target a lower one). However, although they can exert this control over inflation in the long run, they have no control over real interest rates or potential output in the long run, so the classical dichotomy and monetary neutrality hold just as they do in the classical framework.

19. What will happen if policymakers erroneously believe that the natural rate of unemployment is 7% when it is actually 5% and therefore pursue stabilization policy?

If policymakers believe that the natural rate of unemployment is 7% when it is actually 5%, then once the unemployment rate begins to drop below 7%, they are likely to pursue contractionary policy to avoid a perceived potential demand-pull inflation problem. In actuality, this would represent a situation where policymakers are contracting the economy when it is already in recession. The result of these policies is that this could create a downward spiral in inflation, which could lead to deflation and a severe economic downturn.

20. How can demand-pull inflation lead to cost-push inflation?

When inflation increases due to demand-side conditions, this could prompt workers to demand higher wages (which are greater than the growth in labor productivity) in anticipation of future higher inflation. This results in the aggregate supply curve shifting upward, and creating cost-push inflation (which was initiated by a demandpull inflation source).

21. How does the policy rate hitting a floor a little below zero lead to an upward sloping aggregate demand curve?

When the effective lower bound is hit, a lower inflation rate leads to a higher real interest rate because the nominal interest rate is fixed at zero, and this higher real interest rate then causes planned expenditure and therefore aggregate output to decline. The fall in aggregate output as inflation falls, then results in an upward sloping aggregate demand curve.

22. Why does the self-correcting mechanism stop working when the policy rate hits the effective lower bound?

Because a negative output gap, which leads to a fall in the short-run aggregate supply curve, which lowers inflation, which then causes aggregate output to fall along the lines outlined in the answer to question 13, then leads to an even more negative output gap. The result is then a downward spiral where inflation keeps falling and output does as well, so the self-correcting mechanism is not operational.

23. In what ways can nonconventional monetary policy affect the real interest rate for investments when the economy reaches the effective lower bound? How are credit spreads affected?

There are a number of ways the central bank can reduce the real interest rate for investments at the effective lower bound. By providing liquidity to key credit markets, the central bank can directly reduce financial frictions, which lowers the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The second way is by purchasing private assets. This has the effect of reducing financial frictions in specific asset classes, and therefore reducing the real interest rate for investments in those markets (Mortgage-Backed Securities and the housing market, for instance). The result of this is to lower the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The central bank can also purchase long-term government securities, which

directly lowers the longer-term real interest rate at any given level of financial frictions. This results in a decline in the real interest rate for investments, but does not affect (at least directly) financial frictions or credit spreads. Finally, through forward guidance, information about the future path of policy can lower longer-term real interest rates, thereby lowering the real interest rate for investments.

ANSWERS TO APPLIED PROBLEMS 24. Suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit. a. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.

According to aggregate demand and supply analysis, the decrease in government expenditures results in a shift to the left in the aggregate demand curve, as aggregate expenditures decrease at every inflation rate. As a result, the new intersection point with the short-run aggregate supply curve determines a lower inflation rate and aggregate output index than before, as shown below. At this point, output is below potential output and inflation is below its target. b. What will be the effect on the real interest rate, the inflation rate, and the aggregate output index if the Federal Reserve decides to stabilize the inflation rate?

If the Federal Reserve decides to use its monetary policy tools to stabilize inflation, it will effectively decrease the real interest rate at every inflation rate, thereby shifting the MP curve downward. This action will shift the AD curve to the right and restore the economy to its long-run equilibrium, where the inflation rate returns to its target  T and the aggregate output index is at potential again. The only long-run effect of this policy is to affect the real interest rate, which is now set at a lower level than the previous long-run equilibrium.

25. Use a graph of aggregate demand and supply to demonstrate how lags in the policy process can result in undesirable fluctuations in output and inflation.

Suppose the economy is currently in recession at point A in the graph, and policymakers wish to stabilize output. Given current assumptions about the state of the economy, policymakers may devise a policy that they anticipate will shift aggregate demand out to ADA and stabilize the economy. However, because of lags in the policy process (which were presumably unaccounted for or unknown), it may take some time before the policy changes actually take effect. If the economy begins to recover and demand begins to expand independent of the policy effects, then once the policy actually takes hold, it could expand aggregate demand beyond potential output, to a point such as point C. In this case, the aggregate output index overshoots potential and inflation is higher than anticipated, which can lead to further increases in inflation as inflation expectations adjust upward. Moreover, once at point C, policymakers may try to correct the overshoot, which could lead to aggregate demand shifting back below ADA and lead to further volatility in both inflation and output.

26. As monetary policymakers become more concerned with inflation stabilization, the slope of the aggregate demand curve becomes flatter. How does the resulting change in the slope of the aggregate demand curve help stabilize inflation when the economy is hit with a negative supply shock? How does this affect output? Use a graph of aggregate demand and supply to demonstrate.

As seen in the graph below, when the aggregate demand curve becomes flatter, then for a given negative aggregate supply shock this implies that the increase in inflation is smaller, and the reduction in the aggregate output index is larger. Thus, as the aggregate demand curve becomes flatter, inflation is kept closer to the original level; however, the output effects are more pronounced.

27. In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a ―soft patch‖ in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary. a. How might fears of the effective lower bound justify such a policy, even if the economy was not actually in a recession?

Policymakers were worried that a shock could push the economy into a deflationary spiral, in which the short-term nominal policy rate would be bound at the effective lower bound. At that point, conventional monetary policy would be ineffective. Policymakers viewed the risk of economic damage in the event of a deflationary spiral to be significant enough to overcome any potential inflation risk in implementing the policy. Thus, policymakers chose to err on the side of attempting to eliminate the deflationary threat. b. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

With the economy starting out at point A, an adverse shock would push the economy into a destabilizing deflation. An autonomous easing of policy would shift the MP curve down, and in the short run the economy would end up at point B. Note that even though the economy is not at a long-run equilibrium, at that point, the self-correcting mechanism can move the economy to a stable long-run equilibrium since the ELB inflection point lies to the right of the LRAS curve.

28. Suppose that f is determined by two factors: financial panic and asset purchases. a. Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the effective lower bound and into a destabilizing deflationary spiral.

A financial panic will increase f , thus raising the real interest rate on investments at any given inflation rate. A sufficiently large panic will push the economy to point B, where the self-correcting mechanism will lower inflation, and real rates will rise since the economy is beyond the ELB. This results in a deflationary spiral in which the economy will move toward (and past) a point such as point C.

b. Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases can reverse the effects of the financial panic depicted in part (a).

A sufficient enough asset purchase will lower f , reversing the effects of the panic, and lower the real interest rate on investments at any given inflation rate.

This moves the economy from point A, to a point such as point B, where the economy is no longer at risk of a deflationary spiral. At point B, the selfcorrecting mechanism can move the economy to a stable long-run equilibrium since the ELB inflection point lies to the right of the LRAS curve along that AD curve.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. On January 24, 2020, the Federal Reserve released its amended statement on longerrun goals and monetary policy strategy. It stated: ―The Committee reaffirms its judgment that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.‖ and that ―the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.4%.‖ Assume this statement implies that the natural rate of unemployment is believed to be 4.4%. Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), real GDP (GDPC1), and real potential gross domestic product (GDPPOT), an estimate of potential GDP. For the price index, adjust the units setting to ―Percent Change From Year Ago.‖ For the unemployment rate, adjust the frequency setting to ‟Quarterly.‖ Download the data into a spreadsheet.

a. For the most recent four quarters of data available, calculate the average inflation gap using the 2% target referenced by the Fed. Calculate this value as the average of the inflation gaps over the four quarters. b. For the most recent four quarters of data available, calculate the average output gap using the GDP measure and the potential GDP estimate. Calculate the gap as the percentage deviation of output from the potential level of output. Calculate the average value over the most recent four quarters of data available. c. For the most recent four quarters of data available, calculate the average unemployment gap, using 4.4% as the presumed natural rate of unemployment. Based on your answers to parts (a) through (c), does the divine coincidence apply to the current economic situation?

Why or why not? What does your answer imply about the sources of shocks that have impacted the current economy? Briefly explain. a. From 2019:Q3: 2020:Q2, the average inflation gap was –0.7%. b. From 2019:Q3: 2020:Q2, the average output gap was –2.2% c. From 2019:Q3: 2020:Q2, the average unemployment gap was 1.6%. Yes, the divine coincidence applies based on the current data. Expansionary policy would close a negative inflation gap, a positive unemployment gap, and a negative output gap. Given that the divine coincidence applies and based on the data, the economy would seem to be characterized by somewhat weak demand-side conditions over the period of 2019:Q3: 2020:Q2.

2. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to ―Percent Change From Year Ago.‖ For the unemployment rate, adjust the frequency setting to ‟Quarterly.‖ Select the data from 2000 through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or cost-push movements in the inflation rate. Briefly explain your reasoning.

See the graphs below. The period from around early 2001 to around the end of 2003 appears to be influenced by demand-pull inflation conditions, since inflation is a bit lower than what appears to be normal at the time (2.5%), and the unemployment rate rises and remains above the estimated natural rate during this time. For a brief time from the middle of 2007 to the middle of 2008, the economy appears to be hit by a cost-push inflation episode, since the inflation rate spikes, and the unemployment rate rises above the natural rate of unemployment. From the middle of 2008 to about early 2014, inflation remains mostly at or below the 2% target, while the unemployment rate is well above the natural rate, suggesting that demand-pull forces are at work.

From 2015 to 2019, inflation generally increased, while

unemployment declined, indicating demand-pull factors. In late 2019 into 2020 with the coronavirus pandemic resulting in an economic lockdown, inflation fell and the unemployment rate spiked, indicative of severe adverse demand-pull conditions.

Inflation and Unemployment 14.0

Unemployment Rate

12.0 10.0

Natural rate of Unemployment Unemployment Gap

6.0 4.0

2% Inflation Target

2.0 PCE Inflation Rate 2019-11-01

2018-09-01

2017-07-01

2016-05-01

2015-03-01

2014-01-01

2012-11-01

2011-09-01

2010-07-01

2009-05-01

2008-03-01

2007-01-01

2005-11-01

2004-09-01

2003-07-01

-4.0

2002-05-01

-2.0

2001-03-01

0.0 2000-01-01

Rate

8.0

Inflation Gap

Chapter 24 ANSWERS TO QUESTIONS 1. What does the Lucas critique state about the limitations of our current understanding of the way in which the economy works?

The Lucas critique says that policymakers’ priors about the effects of a given policy will generally be wrong, since it is difficult for policymakers to accurately take into account the reaction by people to changes in policies. This points out the limitation to our understanding of how the economy works in that current research cannot fully explain and model accurately the behavior of individuals, and therefore policymakers have to rely on fundamentally flawed models to estimate the effects of policies on the economy.

2. ―The Lucas critique casts doubt on the ability of discretionary stabilization policy to be beneficial.‖ Is this statement true, false, or uncertain? Explain your answer.

True, because the Lucas critique indicates that the effect of policy on inflation and output depends on the public’s expectations about the policy. The outcome of a particular policy is therefore less certain in Lucas’s view than if expectations about it do not matter, and it is harder to design a beneficial activist stabilization policy.

3. Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate.

Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth. a. Discuss the implications of the econometric model’s predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

According to the rational expectation theory, individuals might interpret this increase in the federal funds rate target as a signal that the Fed will commit to fight inflation. The increase in the federal funds rate determines an increase in real interest rates in the short run and results in a higher user cost of capital. Although this might reduce investment, it is possible that individuals recognize the Fed’s intentions and therefore decide to increase investment in anticipation of a low inflation economic environment that encourages investment. b. What would be Lucas’s critique of this model?

Lucas’s critique will point out the fact that the model was probably constructed by using past data in which domestic investment decreased after interest rates increased. But that model does not take into consideration that individuals might revise their expectations quite quickly and might decide to alter the way in which they respond to changes in economic variables, like the interest rate.

4. If the public expects the Fed to pursue a policy that is likely to raise short-term interest rates permanently to 5%, but the Fed does not go through with this policy change, what will happen to long-term interest rates? Explain your answer.

Long-term interest rates will fall. Theories of the term structure suggest that longterm interest rates are related to the expected average of future short-term interest rates. When the public expects the Fed to raise short-term interest rates permanently, they raise their expectations of future short-term rates and long rates are higher. Then, when the Fed does not go through with the expected policy of raising short-term rates, the public will realize that their expectations were mistaken and will revise their expectations of short-term rates downward. The result is that the Fed’s decision not to go through with the policy change causes long-term interest rates to fall.

5. In what sense can greater central bank independence make the time-inconsistency problem worse?

When central banks are more independent, there is less formal accountability by them to pursue stable inflation policies. In this sense, it is easier for central banks to give the appearance of desiring to pursue low inflation policies, while in actuality pursuing more expansionary policies to lower the unemployment rate and increase output. However, even with greater central bank independence, the time-inconsistency problem can be somewhat alleviated through greater transparency and communication, which means that there is less ability for the public to be fooled into false expectations, and therefore less ability for the central bank to pursue overly inflationary policies to increase output and lower unemployment in the short run.

6. What are the arguments for and against policy rules?

Advocates of rules argue that they solve the time-inconsistency problem so that policymakers will achieve good long-run economic outcomes, that they will prevent repeating serious policy mistakes that have been made in the past, and that they will avoid political business cycles that might result if policymakers were free to adopt expansionary policies before an election followed by contractionary policies afterward. Opponents argue that rules are too rigid and deny policymakers the flexibility they need to deal with unforeseeable problems, that they do not allow any role for judgment in policy making, that they may be based on incorrect models of the economy, and that they will lead to bad economic outcomes if the economy undergoes structural changes.

7. If, in a surprise victory, a new administration that the public believes will pursue inflationary policy is elected to office, predict what might happen to the level of output and inflation even before the new administration comes into power.

The rise in expected inflation as a result of the election would shift the short-run aggregate supply curve upward, which would lead to a rise in inflation and a fall in output.

8. Many economists are worried that a high level of budget deficits may lead to inflationary monetary policies in the future. Could these budget deficits have an effect on the current rate of inflation?

Yes, if budget deficits are expected to lead to an inflationary monetary policy and expectations about monetary policy affect the short-run aggregate supply curve. In this case, a large budget deficit would cause the short-run aggregate supply curve to shift upward because expected inflation would be higher. The result is that the increase in the current inflation rate would be higher.

9. In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

When a president has the authority to nominate or lay off the head of the central bank, it is quite plausible that the conduct of monetary policy would be discretionary.

Adherence to monetary policy rules involves imposing some hardship on the economy sometimes. If the president can pressure the head of the central bank, then most likely monetary policy will be discretionary and follow the dictates of the president or his/her political party. This is actually what happened in many South American countries in the 1970s and 1980s. Not surprisingly, most of these countries could not reach long-run goals such as price stability during this period. Also, frequent changes in monetary policy (and fiscal policy) resulted in increased output volatility and low growth. Although most central banks are still subject to pressure from politicians, it is widely understood that some independence is desirable.

10. How would an unexpected change in the equilibrium real fed funds rate be an argument against using a Taylor rule for monetary policy implementation?

One of the criticisms of using rules is that often times, once implemented, structural changes in the economy necessitate updating the rule regularly to reflect appropriate policy outcomes. However, in this case, if the equilibrium real fed funds rate changes and policymakers do not know it has changed, are uncertain of the magnitude or direction of change, or recognize the change but simply fail to update the policy rule, it is likely that monetary policy will be either too tight, or too loose relative to what it should be. As a result, rather than relying solely on a mechanical rule, policymakers may be better off using discretion which can much more flexibly account for these types of frequent and unexpected structural changes in the economy.

11. How is constrained discretion different from discretion in monetary policy? How are the outcomes of these policies likely to differ?

Constrained discretion is a more transparent and disciplined type of discretion in which the general objectives and tactics of the policymaker are committed to in advance. This allows for some flexibility in policy actions (as in a purely discretionary regime), but

somewhat limits the ability of policymakers to pursue overly expansionary policies as long as they are committed to the general objectives and tactics laid out. The difference in outcomes is that under constrained discretion, since policymakers are likely to have more credibility through commitment and transparency, inflation and inflation expectations are likely to be lower than under pure discretion, without giving up much flexibility to address changes in the real economy.

12. In general, how does credibility (or lack thereof) affect the aggregate supply curve?

In general, when central banks lack credibility, there is little faith by the public that the central bank will pursue policies that will result in low, stable inflation. As a result, inflation expectations are likely to be higher, leading to an upward shift in the short-run aggregate supply curve. This results in higher actual inflation and lower output, which is obviously less desirable an outcome than if the central bank were to have full credibility.

13. In Japan, the government and central bank have enacted policies recently to raise inflation permanently from persistently low levels, however inflation continues to remain near zero. How, if at all, might credibility of the central bank explain the low inflation persistence?

Normally, expansionary fiscal or monetary policies (especially when implemented together) should result in higher inflation and consequently raise inflation expectations to permanently higher levels. However, in the case of Japan since inflation has been near zero for many years, this has anchored inflation expectations near zero as well. More specifically, it has created a mindset among market participants and the public in Japan that even if the central bank or government acts, it may be less likely to be successful in raising inflation.

Because of the lack of credibility by the central bank in its efforts to raise inflation, this is reflected in permanently low inflation expectations, and low actual inflation.

14. As part of its response to the global financial crisis, the Fed lowered the federal funds rate target to nearly zero by December 2008 and quadrupled the monetary base between 2008 and 2014, a considerable easing of monetary policy. However, surveybased measures of five- to ten-year inflation expectations remained low throughout most of this period. Comment on the Fed’s credibility in fighting inflation.

This is a clear sign that the Fed enjoys a high level of credibility. This credibility was probably earned over the last three decades. Although the Fed never explicitly stated an inflation target until 2012, many people believe that Fed officials had an inflation target in their minds during this period. Even though it was not announced, this target was assumed to be above zero, and (here is where opinions differ) around 1.5% to 2.5% annual inflation rate. Even if the Fed had not announced an inflation target, and can therefore not be held accountable for missing it, it is quite clear that individuals believe that the Fed is and has been concerned about keeping inflation at low and stable levels. Finally, even more impressive is the fact that the monetary base

increased significantly as a consequence of the Fed’s actions to support the U.S. financial system, but this did not result in high expected inflation, either.

15. ―The more credible the policymakers who pursue an anti-inflation policy, the more successful that policy will be.‖ Is this statement true, false, or uncertain? Explain your answer.

True, if expectations about policy affect the wage- and price-setting process. In models in which expectations about policy are relevant, a credible anti-inflation policy reduces inflation faster and at lower output costs than an anti-inflation policy that is not believed (and hence not expected) by the public.

16. Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks of 2007?

As Figure 3 in the chapter demonstrates, the oil price shocks in the 1970s resulted in significantly higher inflation and unemployment as compared to the shock that affected the economy beginning in 2007. The main distinction between the two episodes is the role of policy credibility. In the case of the 1970s, the Federal Reserve’s commitment to keeping inflation low was weak, so the oil price shocks shifted the aggregate supply curve upward not only due to the shock itself, but also due to higher inflation expectations as a result of weak Fed credibility. In contrast, the Federal Reserve’s commitment to keep inflation low and stable in the last couple of decades has created strong Fed credibility. This kept inflation expectations from rising very much as a result of the 2007 shock, so the effects on actual inflation and the unemployment were more subdued than in the 1970s episodes.

17. Central banks that engage in inflation targeting usually announce the inflation target and time period for which that target will be relevant. In addition, central bank officials are held accountable for their actions (e.g., they could be fired if the target is not reached), and their success or lack thereof is also public information. Explain why transparency is such a fundamental ingredient of inflation targeting.

Announcements about the inflation targets and potential punishments for central bank officials are crucial for inflation targeting. It is very important for the public to be able to check whether the target has been reached or not. When central bank officials know that the public can easily check their performance, they have an extra incentive to do everything in their power to attain their goals, as their reputation is at stake.

Even if their reputation is not that important to them, they have an incentive to do their job, since they might be fired otherwise. When the central bank officials and the general public know ―the rules of the game,‖ there is a higher probability that monetary policy will be more credible. In conclusion, transparency could be a good ingredient in the conduct of any specific type of monetary policy. This was recognized by the Federal Reserve some time ago. Even if the Fed is not engaged in inflation targeting (or any monetary policy with an explicit nominal anchor), it recognized the need to communicate with the public its decisions about the federal funds rate target some years ago.

18. In recent years, central banks have dramatically increased the amount of communication with market participants and the public, and at the same time in many

of these countries, average inflation has declined and become less volatile. Is this coincidence, or is there a connection? Explain.

In general this is not a coincidence. With increased communication, this increases transparency by the central bank and reduces the time-inconsistency problem inherent with discretionary monetary policy. As a result, inflation expectations, and credibility more broadly are more closely aligned with policies of the central bank.

Thus, one would expect that with greater transparency, greater accountability and credibility will result. And as demonstrated in the chapter in Figures 1, 2, and 4, this leads to better inflation outcomes and less volatile inflation.

19. What are the purposes of inflation targeting, and how does this monetary policy strategy achieve them?

Inflation targeting has two basic purposes, to keep inflation under control and to increase the credibility of monetary policymakers’ commitment to price stability.

These are achieved by announcing a numerical target for inflation and a commitment to price stability as the primary long-run goal of monetary policy, increasing communications with the public and financial market participants about the goals and processes of monetary policy making, and holding policymakers accountable for achieving the inflation target that has been set.

20. How can the establishment of an exchange rate target bring credibility to a country with a poor record of inflation stabilization?

Tying its domestic currency to another country’s currency is an easy way for a country with a poor inflation record to establish credibility. This is because a formal exchange rate target provides a simple and clear rule for monetary policymakers to follow, which is easily verifiable. Thus, commitment to the exchange rate target significantly reduces the time-inconsistency problem by limiting discretionary policy.

Moreover, committing to an exchange rate target with a country that has a good record of low, stable inflation means that the domestic economy will import that low inflation environment, as long as it maintains its commitment to the target.

21. What traits characterize a ―conservative‖ central banker?

A conservative central banker is one who has a strong and notable dislike for inflation.

In other words, a conservative central banker would be appointed to project a strong aversion to inflation and be committed to keeping inflation low and stable.

ANSWERS TO APPLIED PROBLEMS 22. Suppose the central bank is following a constant-money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank’s credibility if it abandons the money growth rule to respond to the downturn?

A severe downturn would result in the aggregate demand curve shifting sharply to the left to AD2 below. With a strict constant money growth rule, this would result in a limited expansionary effect on aggregate demand, shifting aggregate demand back to AD3. However, this would be inadequate to fully stabilize output, and a recessionary condition would still persist. This could reflect poorly on the central bank in the sense that, by failing to stabilize output, it may be viewed by the public as not doing its job.

The central bank could abandon the constant money growth rule and expand aggregate demand enough to move the economy back to potential output (at AD1), however this would be moving away from a rules-based policy, which helps keep credibility high and inflation expectations low, to a more discretionary framework in which credibility would be lower and inflation expectations higher.

23. Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country’s central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

In country A, the public is more likely to believe announcements about future policy changes, and therefore adjust inflation expectations in anticipation of changes in future policy. As a result, aggregate supply will adjust more quickly to policy announcements compared to country B in which the central bank has no credibility. If the central banks both announce an autonomous tightening policy to reduce the target inflation rate, the aggregate supply curve will shift down much quicker in country A than country B. With no credibility, country B would likely have to contract aggregate demand first and let expectations adjust after the policy is implemented to achieve the same lower long-term inflation rate as country A. The implication is that output will be more stable in country A than in country B, and the adjustment process is faster in country A than country B.

24. Suppose two countries have identical aggregate demand curves and potential levels of output, and  is the same in both countries. Assume that in 2016, both countries are hit with the same negative supply shock. Given the table of values below for inflation in each country, what can you say, if anything, about the credibility of each country’s central bank? Explain your answer.

2021 2022 2023 2024 2025

Country A 3.0

Country B 3.0

% % 3.8 5.5 % % 3.5 5.0 % % 3.2 4.3 % % 3.0 3.8 % % Since the aggregate demand curve, potential output, the parameter , and the price

shock are identical in both countries, the only factor that can explain the difference in inflation between the two countries is expected inflation. Country B’s inflation rate jumps much higher and stays elevated for much longer than country A’s inflation rate, which must be reflective of higher inflation expectations in country B. The implication is that the central bank in country B has less credibility at maintaining low, stable inflation than country A, thus as a result of the negative supply shock, households and firms raised inflation expectations more as a result of the weak commitment by the central bank in country B. 25. How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

Positive aggregate demand shocks shift the aggregate demand curve to the right, causing both inflation and the aggregate output index to rise. Without a credible nominal anchor, the increase in inflation causes expected inflation to rise, which shifts the short-run aggregate supply curve upward and causes the inflation rate to increase further to 3. With a credible nominal anchor, however, expected inflation does not change, so there is no upward shift in the short-run aggregate supply curve.

Thus, with a credible nominal anchor, inflation is more stable following the demand shock.

The outcome is similar when a negative aggregate supply shock occurs. Inflation increases and the aggregate output index falls as the short-run aggregate supply curve shifts upward, but with a credible nominal anchor, expected inflation does not increase. As a result, no further upward shifts of the short-run aggregate supply curve occur and the increase in inflation and decrease in the aggregate output index are not as great as they otherwise would be. Thus the credible nominal anchor brings about better outcomes for both inflation and output when a negative supply shock occurs, as shown in the graph below.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI). Convert the units setting to ―Percent Change from Year Ago,‖ and download the data. Beginning in January 2012, the Fed formally announced a 2% inflation goal over the ―longer-term.‖ a. Calculate the average inflation rate over the last four and the last eight quarters of data available. How does it compare to the 2% inflation goal?

From 2019:Q3 to 2020:Q12 inflation averaged 1.3%, which is below the current 2% target. Over the two-year horizon from 2018:Q3 to 2020:Q2, inflation averaged 1.6%, which is still below the 2% target. b. What, if anything, does your answer to part (a) imply about Federal Reserve credibility?

Over both the one-year and two-year horizons the Fed missed its target by a meaningful amount. Consistently missing the target, all else equal, may lead the public to believe that the Fed has lost its ability to keep inflation stable, which can potentially unanchor inflation expectations and lead to a decline in credibility.

This is a concern in this case since falling inflation expectations in a very low inflation environment can eventually lead to falling actual inflation, and at a relatively low rate of inflation, can turn into deflation.

2. Go to the St. Louis Federal Reserve FRED database and find data on the core PCE price index (PCEPILFE) and the spot price of a barrel of oil (WTISPLC). For both variables, convert the units setting to ―Percent Change from Year Ago,‖ and download the data from 1960 to the most recent available data. a. Identify periods in which oil price inflation is 80% or higher. b. In the periods identified in part (a), for how many months was oil price inflation 80% or higher? What was the average core inflation rate during each of those episodes? c. Based on your answers to parts (a) and (b) above, what can you conclude about the credibility of more recent monetary policy compared to its credibility in the earlier periods?

a. See the graphs below. Oil price inflation was 80% or higher during the periods of January 1974–December 1974; September 1979–July 1980; July 1987; November 1999–March 2000; May 2008–June 2008; and December 2009–February 2010.

Oil and Core Inflation

Core PCE Inflation (Left Axis)

2018-07-01

2016-05-01

2014-03-01

2012-01-01

2009-11-01

2007-09-01

2005-07-01

2003-05-01

2001-03-01

1999-01-01

1996-11-01

1994-09-01

1992-07-01

1990-05-01

1988-03-01

-100.0 1986-01-01

0.0 1983-11-01

-50.0 1981-09-01

2.0 1979-07-01

0.0

1977-05-01

4.0

1975-03-01

50.0

1973-01-01

6.0

1970-11-01

100.0

1968-09-01

8.0

1966-07-01

150.0

1964-05-01

10.0

1962-03-01

200.0

1960-01-01

12.0

Oil Price Inflation (Right Axis)

b. For the 1974 episode, it lasted 12 months, and average inflation during that time was 7.9%. The 1979–1980 episode was 11 months long, with average core inflation of 8.5%. The 1987 episode was only one month long, with average core inflation of 3.2%. The 1999–2000 episode was five months long, with average core inflation of 1.6%. The 2008 episode was only two months long, and average core inflation was 2.3%. The 2009–2010 episode was three months long, and average core inflation was 1.7%. c. Clearly, the recent monetary policy has been much more credible in keeping inflation low and stable. In particular, looking at the average inflation during each episode, it is clear that sharp increases in oil prices in the 1970s led to much bigger changes in the inflation rate. More recent episodes of similar magnitude left inflation rates relatively low and stable, suggesting an anchoring of expectations inherent with high credibility.

Chapter 25 ANSWERS TO QUESTIONS 1. From 2008 to 2015, auto loan rates in the United States declined from around 8% to near historic lows of around 4%. At the same time, auto sales increased dramatically.

How, if at all, does this relate to the monetary transmission mechanism?

Assuming that monetary policy was relatively accommodative during that period of time that would have contributed to the decline in auto loan interest rates, and thus encouraged greater purchases of automobiles. This effect highlights one dimension of the traditional interest rate channel, where accommodative monetary policy led to an increase in consumer durable goods (automobiles).

2. ―Considering that consumption accounts for nearly two-thirds of total GDP, this means that the interest rate, wealth, and household liquidity channels are the most important monetary policy channels in the U.S.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although consumption is the largest part of overall U.S. GDP, and there is no doubt that these channels can be important to monetary policy effectiveness, some may disagree with this statement. For instance, even though investment is closer to 15% of U.S. GDP, investment fluctuations are much more pronounced over the business cycle than changes in consumption, leading to the possibility that interest rate effects on investment could be potentially more important. In addition, proponents of the credit view believe that credit market effects are much more important than interest rate effects, and since the credit view primarily impacts investment, credit effects on investment could be potentially more powerful than consumption effects from monetary policy changes.

3. How can the interest rate channel still function when short-term nominal interest rates are at the effective lower bound?

If the central bank commits to a higher inflation policy while maintaining low nominal interest rates, this will raise inflation expectations and therefore lower real interest rates, even if the nominal interest rate is near zero. In addition, the central bank can commit to keeping short-term interest rates low for a long time, which can have the effect of lowering longer-term nominal interest rates, which also reduces real longer-term interest rates.

4. Lars Svensson, a former Princeton professor and deputy governor of the Swedish central bank, proclaimed that when an economy is at risk of falling into deflation, central bankers should be ―responsibly irresponsible‖ with monetary expansion policies. What does this mean, and how does it relate to the monetary transmission mechanism?

Part of the problem with deflation is that lower (negative) inflation raises the real interest rate, which raises the cost of capital and lowers investment and consumption through the interest rate channel, creating further deflationary pressure. In addition, short-term nominal interest rates reach the effective lower bound, meaning traditional monetary policy is rendered ineffective. Thus, by being ―responsibly irresponsible,‖ central banks can commit to creating strong but temporary inflationary policies that are

designed to raise inflation expectations (and hence lower real interest rates) enough to create stimulus through the interest rate channel and expand aggregate demand safely and surely to get out of a deflationary spiral.

5. Describe an advantage and a disadvantage of the fact that monetary policy has so many different channels through which it can operate.

An advantage to monetary policy having so many channels through which it can impact the economy is that if policy is rendered ineffective through any one particular channel, it doesn’t mean the policy is entirely ineffective, as there are other channels and other sectors of the economy in which the same policy can still impact the economy. On the other hand, having so many different channels through which monetary policy operates can increase uncertainty over the effects of any given policy.

6. ―If countries fix their exchange rate, the exchange rate channel of monetary policy does not exist.‖ Is this statement true, false, or uncertain? Explain your answer.

True. When countries fix their exchange rate, they must use monetary policy to affect the interest rate in order to maintain the exchange rate. In other words, the central bank must change the real interest rate to maintain the exchange rate, which means net exports and aggregate demand will be unaffected as long as the exchange rate peg is maintained.

7. During the 2007–2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.

There are four main mechanisms through which the decline in stock prices could have reduced aggregate demand and contributed to the severity of the recession. First, the decline in stock prices lowered Tobin’s q and might have reduced investment spending.

Second, the decline in financial wealth, as a result of the stock price decline, could have caused a drop in consumption because consumers’ lifetime resources were reduced. Third, the decline in stock prices lowered the value of financial assets, which increased the public’s probability of financial distress, and so they cut back on their purchases of consumer durables and housing. Fourth, the decline in stock prices lowers the net worth of business firms, which increases adverse selection and moral hazard problems in lending and might have resulted in a reduction in lending and less investment spending.

8. ―The costs of financing investment are related only to interest rates; therefore, the only way that monetary policy can affect investment spending is through its effects on interest rates.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Monetary policy can affect stock prices, which affect Tobin’s q and adverse selection and moral hazard problems in lending, thereby affecting investment spending. In addition, monetary policy can affect loan availability, which may influence investment spending.

9. From March 2009 to February 2020, the S&P 500 stock index increased by over 350%. Over the same period, University of Michigan’s index of consumer confidence

increased from 57.3 to 101.0 (an increase of 75%). Explain how this relates to the monetary transmission mechanism.

Assuming that monetary policy was relatively accommodative during that period of time, this could have contributed to the increase in stock prices. The higher value of the stock portfolio leads to higher wealth of households, and is reflected in the higher consumer confidence.

As a result, you would expect that through this wealth effect, consumption would increase, demonstrating the wealth channel of the monetary transmission mechanism.

10. From mid-2008 to early 2009, the Dow Jones Industrial Average declined by more than 50%, while real interest rates were low or falling. What does this scenario suggest should have happened to investment?

The lower real interest rates would stimulate investment spending because the cost of financing investments would fall. However, the stock market decline would cause the market value of firms to fall and so Tobin’s q to fall. The decline in Tobin’s q would then lead to a decline in investment spending. Because the stock market and the Tobin’s q decline was so large, investment spending actually fell dramatically during this period.

11. Nobel Prize winner Franco Modigliani found that the most important transmission mechanisms of monetary policy involve consumer expenditure. Describe how at least two of these mechanisms work.

There are three mechanisms involving consumer expenditure. First, an expansionary monetary policy that lowers interest rates and reduces the cost of financing purchases of consumer durables, and consumer durable expenditure rises. Second, an expansionary monetary policy that causes stock prices and wealth to rise, leading to greater lifetime resources for consumers and causing them to increase their consumption. Third, an expansionary monetary policy that causes stock prices and the value of financial assets to rise and also lowers people’s probability of financial distress, so they spend more on consumer durables.

12. In the late 1990s, the stock market was rising rapidly, the economy was growing, and the Federal Reserve kept interest rates relatively low. Comment on how this policy stance would affect the economy as it relates to the Tobin’s q transmission mechanisms.

This situation is consistent with Tobin’s q and the wealth effects of expansionary monetary policy. With lower interest rates, stock prices rise. Tobin’s q predicts that investment will increase, stimulating aggregate demand. In addition, with the higher stock prices, this will raise wealth, and lead to higher consumption and increased aggregate demand.

13. During and after the global financial crisis, the Fed reduced the fed funds rate to nearly zero. At the same time, the stock market fell dramatically and housing market values declined sharply. Comment on the effectiveness of monetary policy during this period with regard to the wealth channel.

The wealth channel suggests that this type of monetary policy would raise stock prices and increase house prices, which would raise homeowners’ equity, and hence wealth through housing and stock markets. However, even though real interest rates

were low, stock values and housing wealth declined sharply, which ultimately decreased consumption and aggregate demand, suggesting monetary policy effects through the wealth channel were ineffective during the global financial crisis.

14. From August 2014 to August 2017, the Fed continued to reiterate that monetary policy was ‟accommodative.‖ And during this time, excess reserves by banks decreased from around $2.67 trillion to around $2 trillion, a decline of about 25%.

What does this say about the bank lending channel?

With accommodative monetary policy and plenty of reserves in the banking system, the reduction in excess reserves can be interpreted as an increase in lending by banks.

Through the bank lending channel of the monetary transmission mechanism, the increased lending should result in greater investment by firms and in new residential construction investment.

15. Why does the credit view imply that monetary policy has a greater effect on small businesses than on large firms?

Since small businesses are more dependent on bank loans than large firms, monetary policy changes that impact the availability of credit will disproportionately affect small businesses more than large firms.

16. Why might the bank lending channel be less effective today than it once was?

There are a couple reasons why this might be true. First, bank regulations in the United States have eased, making it easier for banks to raise funds through various sources that were cumbersome under Regulation Q. The implication is that the Fed has less control over the behavior of banks in response to policy changes because of the change in regulations. In addition, there has been a worldwide decline in the traditional bank lending business, meaning the sheer size of bank lending is lower, making this channel less potent.

17. If adverse selection and moral hazard increase, how does this affect the ability of monetary policy to address economic downturns?

It would make it more difficult for the central bank to stimulate the economy. The credit view indicates that adverse selection and moral hazard play an important part in affecting investment behavior and ultimately the economy. However, during downturns, asymmetric information problems increase, meaning that monetary policy must be more powerful to offset the contractionary effects of increases in adverse selection and moral hazard.

18. How does the Great Depression demonstrate the unanticipated price level channel?

During the Great Depression, the fall in the price level led to a significant decrease in consumer wealth and a sharp decline in consumption. The decline in prices led to an increase in real debt of more than 20%, and overall, the effect on consumers was to reduce expenditure more than 50%, and housing expenditures fell 80%.

19. How are the wealth effect and the household liquidity effect similar? How are they different?

The two channels are similar in that increases in real interest rates lead to lower asset

prices, which lead to lower spending on consumption and housing. The difference is in how changes in asset prices lead to lower spending. Under the wealth effect, people are simply less willing to spend when wealth is lower (due to lower overall lifetime resources), leading to a reduction in spending. The household liquidity effect instead indicates a substitution effect between more liquid assets (such as cash or stocks) and less liquid assets (such as consumer durables or housing). Thus, with lower asset values, households use their resources to purchase safer, more liquid assets rather than consumption or housing, leading to lower aggregate demand.

20. After the coronavirus pandemic hit the economy, mortgage rates reached record-low levels in 2020. a. What effect should this have had on the economy, according to the household liquidity effect channel?

Lower mortgage rates should lead to higher housing prices and raise the value of housing wealth. This should lead to a lower probability of financial distress and raise consumer durable and housing expenditure. b. During the same time, most banks raised their credit standards significantly, making it much more difficult to qualify for home loans and to refinance existing loans. How does this information alter your answer to part (a)?

Even though interest rates were extremely low, if nobody could qualify for the low mortgage rates it would not have an appreciable effect on raising the value of household’s financial assets (i.e., housing wealth). Thus, the likelihood of financial distress would remain elevated and not improve consumer durable and housing expenditure.

21. “If the fed funds rate is at zero, the Fed can no longer implement effective accommodative policy.” Is this statement true, false, or uncertain? Explain.

False. Even though conventional monetary policy tools may be ineffective, the Fed can implement a number of nonconventional monetary policy tools to help provide accommodation if needed. The recent financial crisis of 2009 is a good case in point where the Fed was able to effectively implement large-scale asset purchase programs, liquidity provision to key credit markets, and use forward guidance all to effectively (if not slowly) generate a sustained recovery away from the effective lower bound.

22. In December 2015, the Fed raised the fed funds rate for the first time in nearly a decade, and gradually increased interest rates over a prolonged period of time after that. However, the Fed continued to reiterate in its policy statements during this time that ―the stance of monetary policy remains accommodative.‖ Explain this seeming contradiction.

Even though the Fed was raising its conventional policy interest rate, the fact that inflation was higher than the fed funds rate indicates that real policy rates were still negative, and therefor accommodative. In addition, during this time the Fed still held a sizeable amount of assets from its previous large-scale asset purchase programs, which also had accommodative impacts on mortgage rates and longer-term interest rates. Altogether, this reflects the fact that movements in the nominal policy rate are not necessarily indicative of the overall stance of monetary policy.

23. In general, if stock prices are rising, consumption growth is strong, house price appreciation is high, and unemployment is low, would you classify monetary policy as likely to be tight or easy?

In this case, it is likely that whatever the short-term nominal policy rate is, monetary policy is very easy.

24. How does the experience of Japan during the ―two lost decades‖ lend support to the four lessons for monetary policy outlined in this chapter?

The experience of Japan directly supports the four lessons of monetary policy discussed in this chapter. First, short-term interest rates in Japan were near zero; however, due to deflation, real interest rates remained elevated, suggesting a contractionary monetary policy stance. Second, if Japanese policymakers would have paid more attention to the collapse of stock and housing markets, this could have led to earlier and swifter action to shore up the economy. Third, Japan took no steps to stimulate the economy other than pushing short-term rates to zero. However, they could have done more to push longer-term rates down through asset purchases and raising inflation expectations. Finally, Japan allowed the economy to go into a deflationary period, leading to unanticipated and undesirable fluctuations in the price level.

ANSWERS TO APPLIED PROBLEMS 25. Suppose the economy is in recession and the monetary policymakers lower interest rates in an effort to stabilize the economy. Use an aggregate supply and demand diagram to demonstrate the effects of a monetary easing when the transmission mechanisms are functioning normally and when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

When the transmission mechanisms are functioning normally (and predictably), policymakers can ease monetary policy with reasonable precision, so that the aggregate demand curve shifts to the right from AD1 to AD3 and eliminates the output gap. Under periods in which the monetary transmission mechanisms are not functioning normally, such as during a financial crisis, some channels may not work as effectively, or at all. As a result, for a given monetary policy prescription, the effects on aggregate demand may be muted or nonexistent. In this case, aggregate demand may only shift to the right to AD2 and an output gap may still remain at Y2. This illustrates the limitations of monetary policy to stabilize the output gap in such situations.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. A ―rate cycle‖ is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), real business fixed investment (PNFIC1), real residential investment (PRFIC1), and consumer durable expenditures (PCDGCC96). Use the frequency setting to convert the federal funds rate data to ―quarterly,‖ and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy. b. Calculate the percentage change in business fixed investment, residential (housing) investment, and consumer durable expenditures over this rate cycle.

Over this period, business fixed investment decreased by 9.2%, residential investment decreased by 6.3%, and consumer durable spending decreased by 2.9%. c. Based on your answers to parts (a) and (b), how effective was the traditional interest rate channel of monetary policy over this rate cycle?

Based on the expansionary nature of the rate cycle, and the declines in all three components of the traditional interest rate channel, this transmission mechanism was not very effective in having the impact the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

2. As defined in Exercise 1, a ―rate cycle‖ is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), bank reserves (TOTRESNS), bank deposits (TCDSL), commercial and industrial loans (BUSLOANS), real estate loans (REALLN), real business fixed investment (PNFIC1), and real residential investment (PRFIC1). Use the frequency setting to convert the federal funds rate, bank reserves, bank deposits, commercial and industrial loans, and real estate loans data to ―quarterly,‖ and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy.

b. Calculate the percentage change in bank deposits, bank lending, real business fixed investment, and real residential (housing) investment over this rate cycle.

Over this period, bank reserves increased by 97.3%, bank deposits increased by 45.5%. As a result, business fixed investment decreased by 9.2%, C&I loans increased by 25.4%, while real estate loans increased by 3.4% and residential investment decreased by 6.3%, c. Based on your answers to parts (a) and (b), how effective was the bank lending channel of monetary policy over this rate cycle?

The results are somewhat mixed with the data. Based on the expansionary nature of the rate cycle, we would expect all of these variables to increase when the policy rate decreases, according to the bank lending transmission mechanism.

However, with the exception of business fixed investment and residential investment, all of the variables increased. Thus, it appears that this transmission mechanism was modestly effective in having some impacts the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

Web Chapter 2 ANSWERS TO QUESTIONS 1. Why do people choose to buy insurance even if their expected loss is less than the payments they will make to the insurance company?

People carry insurance because they are risk-averse and prefer to know their wealth with certainty.

2. How do insurance companies protect themselves against losses due to adverse selection and moral hazard?

Insurance companies protect themselves by requiring inspections and medical examinations, insuring groups rather than individuals, and insisting on a deductible.

3. What is the difference between term life insurance and whole life insurance?

Term life insurance pays a death benefit if the policyholder dies; no other benefit is paid. Whole life policies pay a death benefit but also include a savings program that pays out if the policyholder lives.

4. What is the purpose behind reinsurance?

Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium.

5. Why do property and casualty insurance companies have large holdings of municipal bonds, whereas life insurance companies do not?

Property and casualty insurance companies are taxed on their interest income, so they hold municipal bonds that are tax exempt. This tax-exempt feature is of no benefit to life insurance companies, who are not taxed on their interest income, so they do not hold municipal bonds.

6. Why did the Federal Reserve and the government intervene to bail out AIG? As a result of AIG’s dealings in credit default swaps, the global financial crisis led to a sharp decrease in AIG’s net worth and its access to credit. But because AIG was one of the largest companies in the world and integrally tied to the financial system, the government believed letting AIG fail would be catastrophic. In particular, banks and mutual funds held a large portion of AIG debt, so letting AIG fail would also pressure these companies, who were already severely liquidity-constrained due to the crisis. As a result, the U.S. government along with the Federal Reserve created a credit facility to provide $85 billion in liquidity to keep AIG from failing.

7. ―In contrast to private pension plans, government pension plans are rarely underfunded.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Government pension plans are often underfunded. Many pension plans for both federal and state employees are not fully funded.

8. Why is Social Security in danger of eventually going bankrupt?

The demographics suggest that more people will be retiring than will be entering the workforce in the future. With fewer people paying into the plan and more taking out,

it could go bankrupt.

9. What are the three main proposals for privatizing Social Security? What are their advantages and disadvantages?

The three main proposals to privatize Social Security are (a) to invest the current assets in corporate securities. The advantage is that it would improve the trust fund’s overall return and minimize transaction costs. The disadvantage is that it could lead to more government intervention in the private sector. (b) To shift trust fund assets into individual accounts. This has the advantage of increasing returns on assets and doesn’t involve government ownership of assets. The disadvantage is that it could expose individuals to greater risk and higher transaction costs. (c) To provide individual accounts in addition to those in the trust fund. The advantages and disadvantages are similar to (b) above.

10. What is ERISA, and why was it established?

The Employee Retirement Income Security Act establishes minimum standards for reporting and disclosure, sets rules for vesting and the degree of underfunding, places restrictions on investment practices, and assigns oversight responsibility to the Labor Department. In addition, the Pension Benefit Guarantee Corporation was created, similar to the role that the FDIC plays for banks. ERISA was established to safeguard pension systems by protecting them from mismanagement, underfunding, fraudulent practices, and other abuses.

11. If you needed to take out a loan, why might you first go to your local bank rather than a finance company?

Because interest rates on loans are typically lower at banks than at finance companies.

12. How are securities brokers/dealers, investment banks, and organized exchanges different from financial intermediaries?

They are different from financial intermediaries in that they do not perform the intermediation function of acquiring funds by issuing liabilities and then using the funds to acquire assets.

13. What problems or concerns do sovereign wealth funds present? Are they valid?

There are several concerns that have been raised. For one, they have grown in size, and so changes in the asset positions of these funds can mean large movements of capital, which could cause market instability. There have also been concerns that sovereign wealth funds may use their investments and assets for political purposes.

Finally, most sovereign wealth funds provide little public information about their holdings or investment practices. To some extent, these concerns may be valid, but many believe they are overblown and that the concerns stem primarily from xenophobia and fear of the unknown.

14. Why can a money market mutual fund allow its shareholders to redeem shares at a fixed price while other mutual funds cannot?

Because a money market mutual fund holds high-quality, short-term debt instruments

that do not fluctuate much in value, it can allow shareholders to redeem shares at a fixed price. In contrast, other mutual funds hold assets that have large fluctuations in value, so their share values must also fluctuate.

15. What features of mutual funds and the investment environment have led to mutual funds’ rapid growth in the last three decades?

Liquidity intermediation, denomination intermediation, ease of diversification, cost advantages, and the growth of defined contribution pension plans have led to rapid growth in mutual funds.

16. Is investment banking a good career for someone who is afraid of taking risks? Why or why not?

No. Investment banking is a risky business, because if the investment bank cannot sell a security it is underwriting for the price it promised to pay the issuing firm, the investment bank can suffer substantial losses.

17. How do hedge funds differ from mutual funds?

In contrast to mutual funds, hedge funds have a minimum investment requirement of $100,000 and must have no more than 99 investors (limited partners) who have steady annual incomes of more than $200,000 or a net worth of at least $1 million, excluding their homes. They are also set up as partnerships rather than with shareholders as in mutual funds.

18. ―Hedge funds are not risky because, as their name indicates, they hedge risks.‖ Is this statement true, false, or uncertain? Explain.

False. Despite their name, hedge funds do not hedge risks. Indeed because they frequently have a lot of leverage and invest in very risky assets, they can be far riskier than investing in many other institutions.

19. What are the four advantages of private equity funds? How do they help alleviate the free-rider problem?

First, as private companies they are not subject to the controversial and costly regulations included in the Sarbanes-Oxley Act. Second, managers of private companies do not feel under pressure to produce immediate profits, as do those at publicly traded companies, and thus can manage their company with their eyes on longer-term profitability. Third, because private equity funds give managers of these companies larger stakes in the firm than is usually the case in publicly traded corporations, they have greater incentives to work hard to maximize the value of the firm. Fourth, private equity overcomes the free-rider problem. In contrast to publicly traded companies, which have a diverse set of owners who are happy to free-ride off of each other, venture capital and capital buyout funds are able to garner almost all the benefits of monitoring the firm and therefore have the incentives to make sure the firm is run properly.

20. How have GSEs exposed taxpayers to large losses?

The implicit government backing of GSE debt leads to the same moral hazard problem that led to the S&L and banking crises in the 1980s and early 1990s

discussed in Chapter 11. Because GSE debt is in effect guaranteed by the government, market discipline to limit excessive risk-taking by GSEs is quite weak.

The GSEs, therefore, have incentives to take on excessive risk, and this is exactly what they have done, with the taxpayer exposed to large losses.

ANSWERS TO APPLIED PROBLEMS 21. Your rich uncle dies, leaving you a life insurance policy worth $100,000. The insurance company offers you the option of receiving $8,225 per year for 20 years, with the first payment due today, or a lump sum. Which option should you choose?

It depends on the interest rate, as well as many other factors. Since the options are either $100,000 immediately or $8,225/year, you can calculate the present value of the yearly payment as: $8225  [1 + 1/(1 + r) + 1/(1 + r)2 + . . . + 1/(1 + r)19], where r is the rate of return (or interest rate). If the present value of the yearly payments is less than $100,000, you should take the $100,000 up front. The interest rate that equates the two is about 6%, so if the interest rate is greater than 6%, the present value of the yearly payments will be less than the $100,000 immediately, so the upfront payment would be more desirable (and vice versa). With this information, the answer for each individual depends on many factors. Do you ―need‖ the $100,000 today? Can you personally invest the $100,000 at a higher rate with the same level of risk? Is there any risk that the insurance company will not pay in the future?

22. Kio Outfitters estimated the following probabilities of loss from past experience: Loss

Probability (%)

$30,000

0.25

$15,000

0.75

$10,000

1.50

$5,000

2.50

$1,000

5.00

$250

15.00

$0

75.00

What is the probability that Kio will experience a loss of $5,000 or greater? If an insurance company offers a loss policy with a $1,500 deductible, what is the most that Kio will pay if it files a claim?

Losses of less than $5,000 occur 95% of the time. So, 5% of the time, losses will be $5,000 or greater.

With a $1,500 deductible, Kio’s expected losses are: Loss $28,500

Probability (%) 0.25

$13,500 $ 8,500 $ 3,500 $ 1,000 $ 250 $ 0

0.75 1.50 2.50 5.00 15.00 75.00

The expected (mean) loss is $475, which is the fair price of insurance.

23. Paul’s car slid off an icy road, causing $2,500 of damage to his car. He was also treated for minor injuries that cost $1,300. His car insurance has a $500 deductible, after which the full loss is paid. His health insurance has a $100 deductible and covers 75% of medical costs (total). What were Paul’s out-of- pocket costs from the incident?

The car will cost Paul $500. The remaining $2,000 is covered. Paul will pay $400 of the medical expenses—the $100 deductible plus 25% of the remaining $1,200 of expense. Thus, the total out-of-pocket expenses for Paul are $900.

24. An employee contributes $200 a year (at the end of the year) to her pension plan.

What will be the total value of the account after five years? Assume the plan earns 15% per year over the period.

The total contributions are $200  5 = $1,000. The future value of the plan at the end of five years is equal to 200  [1 + 1.152 + 1.153 + 1.154] = $1348.48.

25. Suppose that you contribute $20,000 at the beginning of each year into your defined benefit pension plan, and the interest rate is 10%. a. After 8 years, what will be the total value of the account?

The total contributions will be worth $20,000  8 = $160,000. The account will be worth $20,000  [1.10 + 1.102 + . . . + 1.108] = $251,589.54. b. Suppose that after eight years you are eligible to receive benefits of $250,000. Is the pension plan underfunded or fully funded?

It is fully funded, since the amount of benefits you are eligible for are less than the account’s value. c. Suppose the pension plan takes a 2% management fee at the time each contribution is made. How does this change your answer to parts (a) and (b), if at all?

If the pension plan takes a 2% management fee right off the top of gross contributions, then the net contribution each year will be 0.98  $20,000 = $19,600. In this case, total contributions will then be $19,600  8 = $156,800; the account will be worth $19,600  [1.10 + 1.102 + . . . + 1.108] = $246, 557.75.

Now the pension plan will be slightly underfunded, since the eligible benefits are larger than the account value.

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database and find data on the amount of mutual fund shares held by households and nonprofit organizations (HNOMFAQ027S) and the amount of mutual fund shares held by financial businesses (FBMFT-TQ027S). Which of the two categories currently holds the most assets?

Which of the two categories has grown the most in percentage terms over the past five years? (Use the most recent five years of data available.)

As of 2014:Q1, households and nonprofits held the most mutual fund assets at $7,058,871.1 million, more than twice as much as financial businesses at $3,389,318.9 million. Over the last five years from 2009:Q1 to 2014:Q1, household and nonprofit mutual fund assets held grew by 123.6%, slightly more than the 121.7% growth by mutual fund assets held by financial businesses.

2. Go to the St. Louis Federal Reserve FRED database and find data on the amount of mortgages held by Ginnie Mae (MDOTHFRAGNMA), Fannie Mae (MDOTHFRAFNMA), and Freddie Mac (MDOTHFRAFHLMC). Which of the three companies currently holds the largest dollar amount of mortgages? Which holds the smallest? How do the current volumes of mortgages held by Fannie Mae and Freddie Mac compare to the volumes before 2010?

As of 2014:Q1, Fannie Mae held the largest amount of mortgages, at $3,028,727.0 million, and Ginnie Mae held the smallest amount at $5,996.7 million. Fannie Mae and Freddie Mac as of 2014Q1 hold a combined $4,714,034 million in mortgages.

However, there is a significant dropoff in mortgages held by the two prior to 2010.

For instance, in 2009:Q4, they held a combined $555,359 million in mortgages, which was fairly consistent to this amount for much of the time prior to 2010.

Web Chapter 3 ANSWERS TO QUESTIONS 1. What are the advantages and disadvantages of using forward contracts to hedge?

The big advantage of forward contracts is their flexibility, as they can be designed in any way that the counterparties would like them to be. The two main disadvantages are first, that it may be difficult for one party to find a counterparty to enter into the forward contract, as they can be quite specific. Because of this, there may be a lack of liquidity in certain forwards markets, leading to less favorable terms on forward contracts to attract counterparties. The second main disadvantage is that forward contracts are subject to default risk, and the only recourse for a counterparty defaulting on its contract is to take legal action, which can be expensive and lengthy.

2. What advantages do futures contracts have over forward contracts?

There are several advantages of futures over forward contracts. For instance, quantities and delivery dates of futures are standardized to improve liquidity and limit the ability of someone to corner the market. Futures can be traded at any time up to the delivery date, which is not possible with forward contracts. And in contrast to forwards, futures contracts are cleared through a clearinghouse, limiting default risk.

Finally, in a futures contract, physical delivery of the underlying asset can be avoided, thus lowering the costs of trading in futures.

3. In the July 2017 FOMC meeting, governors and voting presidents of the Federal Reserve System agreed not to increase the federal funds rate target, but somewhat let the markets know that there could be a rise in the near future. How do you think that financial managers will react to this news? Which instruments can they use to hedge against a change in interest rates?

Financial managers should be prepared for an increase in interest rates somewhere in the near future. The fact that the FOMC announced a possible increase in interest rates as the economy recovers does not mean that interest rates will increase immediately, but they should be considering this scenario with higher probability.

The instruments used by each financial manager will depend on the characteristics of their business and the portfolio they manage. In essence, they should be prepared for a price decrease in securities (as the discount factor increases) and will have to find the specific instrument that better helps them to hedge this risk (forwards contracts, financial futures contracts, options, and so on).

4. What are the advantages and disadvantages of using an options contract rather than a futures contract?

The advantages of using options contracts are that the buyers of options are not obligated to take action (i.e., buy or sell the underlying asset) at a disadvantageous price when the option is ―out of the money‖ and that their potential losses are limited to the premium paid for the option. There is also no need to maintain a margin account and make daily settlement payments into or out of that account, as is the case with futures contracts. The disadvantage of an options contract is that you have to pay a premium that you would not have to pay with a futures contract.

5. Explain why greater volatility or a longer term to maturity leads to a higher premium on both call and put options.

Because an option has the feature that you win big if the price has a large change in one direction but don’t lose big if the price has a large change in the other direction.

More volatility of the price means that on average you will have a larger profit because you are more likely to win big with either a call or a put option and thus their premiums will be higher.

6. Why does a lower strike price imply that a call option will have a higher premium and a put option a lower premium?

Because for any given price at expiration, a lower strike price means a higher profit for a call option and a lower profit for a put option. A lower strike price makes a call option more desirable and raises its premium and makes a put option less desirable and lowers its premium.

7. What are the advantages and disadvantages of using interest rate swaps?

Advantages of interest rate swaps are that they allow institutions to convert fixed rate assets into rate-sensitive assets without affecting their balance sheets (which otherwise may be quite difficult), at relatively low cost. Another advantage of interest rate swaps is that they can be written over long horizons, whereas futures and options are typically of much shorter duration. The main disadvantages of interest rate swaps are that they may lack liquidity, and are subject to default risk similar to forward contracts.

8. If the finance company you manage has a gap of +$5 million (rate-sensitive assets greater than rate-sensitive liabilities by $5 million), describe an interest rate swap that would eliminate the company’s income gap.

You would swap interest on $5 million of variable rate assets for the interest on $5 million of fixed rate assets, thereby eliminating the income gap.

9. If the savings and loan you manage has a gap of −$42 million, describe an interest rate swap that would eliminate the S&L’s income risk from changes in interest rates.

You would swap the interest on $42 million of fixed rate assets for the interest on $42 million of variable rate assets, thereby eliminating the income gap.

10. How can financial derivatives create excessive risk in the financial system?

Derivatives allow financial institutions to increase their leverage, in essence making huge bets with a limited ability to pay up if they are on the wrong side of the bet, which can quickly and unexpectedly bring down large financial institutions. In addition, banks hold significant notional amounts of derivatives many times larger than their bank capital, exposing them to serious risk of failure. These factors present significant risk in the financial system, and the failure of one large institution that is systemically important can jeopardize the entire financial system.

ANSWERS TO APPLIED PROBLEMS 11. If the pension fund you manage expects to have an inflow of $120 million six months

from now, what forward contract would you seek to enter into to lock in current interest rates?

You would like to enter into a contract that specifies you will purchase $120 million of bonds with an interest rate equal to the current interest rate six months from now.

12. If the portfolio you manage is holding $25 million of 6s of 2035 Treasury bonds with a price of 110, what forward contract would you enter into to hedge the interest rate risk on these bonds over the coming year?

You would enter into a contract that specifies that you will sell the $25 million of 6s of 2035 at a price of 110 one year from now.

13. Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 105. If the price of the Treasury bond is 115 at expiration, is the option at the money, in the money, or out of the money? Determine the premium if the profit equals $8,000.

The call option is “in the money” because you would want to exercise the right to buy the Treasury bonds at $105 and then sell them at $115, for a profit. If the profit equaled $8,000 this means that the premium was (115 – 105) × 100,000 – 8,000 = $2,000.

14. Jason bought a put option on a $100,000 Treasury bond futures contract with an exercise price of 105 for a premium of $2,000. If on expiration the futures contract sells for 110, determine Jason’s profits and explain if he will exercise the right to sell the futures contract.

How would your answer change if the futures contract sells for 95 on expiration?

If price on expiration is 110: The option is “out of the money” and Jason does not exercise his right to sell the futures contract. His profit is: – $2,000. If price on expiration is 95: The option is “in the money” and Jason exercises his right to sell the futures contract. His profit is: (105 – 95) × 100,000 – $2,000 = $8,000.

15. If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125,000 euro futures contracts?

You would buy 200 million euro of futures contracts that mature one year from now.

With a contract size of 125,000 euros, you would buy 200 million/125,000 = 1,600 contracts.

16. If your company has to make a 10 million euro payment to a German company three months from now, how would you hedge the foreign exchange risk in this payment with 125,000 euro futures contract?

You would hedge the risk by buying 80 euro futures contracts that mature three months from now.

17. Suppose your company will be receiving 30 million euros six months from now, and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract should you enter into?

You would want to enter into a contract in which you agree to deliver 30 million euros six months from now in exchange for U.S. $30 million.

18. Suppose the pension fund you are managing is expecting an inflow of funds of $100 million next year, and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

You would buy $100 million worth, that is, 1,000 contracts, of long-term bond futures contracts with an expiration date of one year in the future. This means that you would be entitled to delivery of the long-term bond at today’s price so that the current rate would be locked in.

19. If you buy a put option on a $100,000 Treasury bond futures contract with an exercise price of 95 and the price of the Treasury bond is 120 at expiration, is the contract in the money, out of the money, or at the money? What is your profit or loss on the contract if the premium was $4,000?

The put option is out of the money because you would not want to take the option to sell the futures at 95 when the price at expiration is 120. Since the premium is $4,000 and you did not exercise the contract, your loss on the contract is $4,000.

20. Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 110 for a premium of $1,500. If, upon expiration, the futures contract has a price of 111, what is your profit or loss on the contract?

You have a profit of 1 point ($1,000) when you exercise the contract, but you have paid a premium of $1,500 for the call option, so your net profit is –$500, a loss of $500.

21. Chicago Bank and Trust has $100 million in assets and $83 million in liabilities. The duration of the assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures contracts does this bank need to fully hedge itself against interest rate risk? The available Treasury bond futures contracts have a duration of 10 years, have a face value of $1,000,000, and are selling for $979,000.

This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the duration of the liabilities, so the bank will take a short position, effectively increasing its liabilities. Assume that the dollar amount of the position is Y.

DURgap = 5  83100Y   8383Y 1.8  83YY 10  0 500 = 149.40 + 10Y, Y = 35.06, or a position in $35,060,000 futures. At the current price, this requires $35,060,000/979,000 = 35.812 contracts, or 36.

22. Futures are available on three-month T-bills with a contract size of $1 million. If you take a long position at 96.22 and later sell the contracts at 96.87, what is the total net gain or loss on this transaction?

Gain = (96.87 – 96.22)  10,000 = $6,500 per contract.

23. A bank customer will be going to London in June to purchase £100,000 in new inventory. The current spot and futures exchange rates are as follows: Exchange Rates (dollars/pound) Period

Rate

Spot

1.5342

March

1.6212

June

1.6901

September

1.7549

December

1.8416

The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

She paid an actual rate of $1.6901 per pound, or $169,010. Had she simply taken the spot rate at the time, the cost would have been $172,500. She saved $3,490.

24. Consider a put contract on a T-bond with an exercise price of 101 12/32. The contract represents $100,000 of bond principal and has a premium of $750. The actual T-bond price falls to 98 16/32 at the expiration. What is the gain or loss on the position?

The gain per contract is (101 12/32  98 16/32)  1,000 = $2,875. If you include the premium paid, the gain is $2,125 per contract.

25. A swap agreement calls for Durbin Industries to pay interest annually, based on a rate of 1.5% above the one-year T-bill rate, currently 6%. In return, Durbin receives interest at a rate of 6% on a fixed rate basis. The notional for the swap is $50,000.

What is Durbin’s net interest for the year after entering into the agreement?

Durbin pays 7.5%  $50,000 and receives 6%  $50,000, or net, pays 1.5%  $50,000 = $750.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the dollar/euro exchange rate (DEXUSEU). Suppose that one month ago you entered into a forward contract to sell 10 million euros at the forward rate equivalent to the spot rate one month ago. What exchange rate was specified on the forward contract? (Find the

most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 11, 2017, the spot exchange rate was $1.1811/€, and on July 11, 2017, when the forward contract was entered into, the exchange rate was $1.1430/€. Thus, locking in the forward contract exchange rate (assumed at the July 11 spot rate) would mean you receive €10,000,000  $1.1430/€ = $11,430,000 one month later on August 11.

Had the forward contract not been entered into, the €10,000,000 would be worth €10,000,000  $1.1811/€ = $11,811,000. In this case, since the dollar depreciated, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a risk-neutral world, you are worse off with utilizing the forward contract.

2. Go to the St. Louis Federal Reserve FRED database, and find data on crude oil prices (DCOILWTICO). Suppose that one month ago you entered into a forward contract to sell 1 million barrels of oil at the forward rate equivalent to the spot rate one month ago. What price was specified on the forward contract? (Find the most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 14, 2017, the spot price of WTI oil was $47.59/barrel, and on July 14, 2017, when the forward contract was entered into, the price was $46.53/barrel.

Thus, locking in the forward contract exchange rate (assumed at the July 14 spot rate) would mean you receive 1,000,000 barrels  $46.53/barrel = $46,530,000 one month later on August 14. Had the forward contract not been entered into, the 1,000,000 barrels would be worth 1,000,000 barrels  $47.59/barrel = $47,590,000. In this case, since the price of oil increased, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a risk-neutral world, you are worse off with utilizing the forward contract.

Web Chapter 4 ANSWERS TO QUESTIONS 1. How does the provision of several types of financial services by one firm lead to a lower cost of information production for the firm?

Because one information resource can be used in providing the several services, thus lowering the cost for each.

2. How does the provision of several types of financial services by one firm lead to conflicts of interest?

Conflicts of interest arise because higher profits might arise in providing one kind of service if the service provider misuses information, provides false information, or conceals information when providing another kind of service.

3. How can conflicts of interest make financial markets less efficient?

Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric information problems become worse, which prevent financial markets from channeling funds into productive investment opportunities. The result is that financial markets become less efficient.

4. How can conflicts of interest lead to unethical behavior?

Unethical behavior can arise because conflicts of interest generate incentives for service providers to lie or conceal information, thereby hurting the customers they work for.

5. Describe two conflicts of interest that occur when underwriting and research are provided by a single investment banking firm. 

Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business.



Investment banks might engage in spinning, a form of kickback in which they allocate hot but underpriced IPOs to executives in return for their companies’ future business.

6. How does spinning lead to a less efficient financial market?

Spinning makes financial markets less efficient because it might influence executives to not use the lowest-cost investment bank when issuing securities. The result would be a higher cost of capital and hence lower efficiency.

7. Describe three conflicts of interest that occur in accounting firms. 

Clients may be able to pressure auditors into skewing their opinions in order to get fees for other accounting services.



Auditors may be auditing information systems or structuring (tax and financial) advice put in place by their nonaudit counterparts within the firm, and thus may be reluctant to criticize this advice or systems.



Auditors may provide overly favorable opinions in order to solicit or retain

business.

8. Some commentators have attributed the demise of Arthur Andersen to the combination of auditing and consulting activities provided by the firm. Is this assessment correct?

The source of Arthur Andersen’s demise was not that the company combined its auditing and consulting activities, but rather that the Houston office succumbed to tremendous pressure to give favorable opinions about Enron because Enron was such a large client and the Houston office could not afford to lose Enron’s business.

9. Describe three conflicts of interest that occur in credit-rating agencies. 

Rating agencies might provide more favorable ratings to a firm in order to obtain its consulting business.



Rating agencies may bias their ratings because they are auditing their own work if they have been involved in advising the firm in their consulting business.



Rating agencies might provide more favorable ratings to firms to get firms to hire them to do their rating.

10. Describe two conflicts of interest that occur in universal banks.

The underwriting department may aggressively sell bad securities to the bank’s customers; the bank may use its underwriting department to sell bonds of a troubled firm so that the firm can pay off its loans to the bank; a bank may make loans at overly favorable terms to get the firm’s underwriting business; or a bank may lean on its customers to purchase insurance that they may not need from the bank.

11. ―Conflicts of interest always reduce the flow of reliable information.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Conflicts of interest only reduce the flow of reliable information if they are exploited. If the incentives to exploit the conflict are low, say because exploiting the conflict hurts the reputation of the firm and reduces its future business, then the conflict is unlikely to be exploited and the flow of reliable information will not be reduced.

12. Give two examples of conflicts of interest that do not seem to have been exploited and thus have not led to a reduction of reliable information in the financial markets. 

Credit-rating agencies seem to have given accurate appraisals of credit risk on plain vanilla corporate bonds even though they are paid by the firms that are issuing these securities.



Commercial banks that underwrote securities before the Glass-Steagall Act was enacted did not seem to push bad securities they had underwritten onto their customers.



The market can often figure out which research analysts not to trust if they are subject to strong conflicts of interest.



Clients of accounting firms limit the use of nonaudit services if the conflicts of

interest lead to a decrease in trust of the audit.

13. When is it more likely that conflicts of interest will be exploited?

When the market cannot get information about whether an exploitation of a conflict of interest is occurring, the reputation of firms exploiting conflicts of interest is not damaged and so they have incentives to exploit the conflicts of interest.

14. How can poorly designed compensation schemes in financial service firms lead to conflicts of interest?

If the compensation scheme for one activity is very high relative to the compensation scheme for another activity, then employees might conceal or misuse information when engaging in the lower-paying activity to get more business in the higher-paying activity.

15. What are ―reputational rents‖ and how are they significant?

Reputational rents refer to the value of a firm’s reputation, as reflected by customers’ purchases from the firm because it is trusted in the marketplace with high-quality, reliable products or services. They are significant here in that conflicts of interest can arise where individuals within an institution may have short-term incentives to produce results or meet goals which generate revenue for the company, but are not aligned with the principles or long-term strategies of the company, and may harm the reputation of the company in the long run.

16. ―Sarbanes-Oxley significantly raises compliance costs for firms. Since it dramatically decreases market efficiency, it should be abolished.‖ Do you agree with this statement? Why or why not?

Although many believe the standards set forth in the Sarbanes-Oxley legislation are onerous and make compliance costly, there are benefits to the laws which reduce conflicts of interest and help to avoid the accounting scandals illustrated by the Arthur Anderson and Enron cases. In this sense, it should probably not be abolished, but some might agree that an overhaul or streamlining of the legislation should occur.

17. Which provisions of the Sarbanes-Oxley Act do you think are beneficial and which do you think are not?

Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the firm and requires disclosure of off-balance-sheet transactions and relationships with special purpose entities. This mandatory disclosure improves the quality of information, but has the disadvantage of being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB that can help stop conflicts of interest in the accounting industry. Also by making the audit committee independent of management, audits are likely to be more reliable, an important benefit. However, Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them from providing auditing and consulting services to the same client.

18. Which provisions of the Global Legal Settlement do you think are beneficial and which do you think are not?

The Global Settlement has increased disclosure of analysts’ recommendations, which can help increase information in financial markets. Also, it required increased disclosure of potential conflicts of interest, which can help the market to constrain them. The Global Settlement bans spinning, which might otherwise encourage executives to choose high-cost investment banks to underwrite their securities: Banning spinning makes it more likely that lower-cost and more efficient underwriting will take place. The fines imposed by the Global Settlement also provide incentives for investment banks to avoid exploiting conflicts of interest in the future. The negative side of the Global Settlement is that it separates activities and so may mean that economies of scope in information production are lost. The Global Settlement also requires that part of the $1.4 billion fine be used to fund independent research, but it is not clear that the quality of this research will be high.

19. Why might the market be the best mechanism for minimizing conflicts of interest?

There are several reasons why a self-regulating market mechanism may work best.

First of all, it requires no explicit regulation by the government. In addition, markets can penalize offending firms in the form of higher funding costs, or lower demand for their services. This has the effect of impacting offending firms with lower profits and helps to avoid excessive reactionary responses, which can occur in the politicized regulatory process.

20. What are the advantages and disadvantages of mandatory disclosure when dealing with conflicts of interest?

Mandatory disclosure has the advantage of providing information to help markets assess whether a conflict of interest exists, thus enabling the markets to discipline firms that exploit conflicts of interest. It has the disadvantage that it might reveal proprietary information or have a high cost, thereby making it hard for the financial institution to make money from engaging in information production. Also it might not work if financial firms can get around the regulations and continue to hide information about conflicts of interest.

21. How can supervisory oversight help reduce conflicts of interest?

Supervisory oversight can reduce conflicts of interest because the supervisor might have better access to information about whether a conflict of interest exists and is being exploited and can then take actions to stop it.

22. What are the disadvantages of separating financial activities into different firms in an effort to avoid conflicts of interest?

Separating financial activities can reduce synergies, thereby preventing financial firms from taking advantage of economies of scope, thereby raising the cost of information production and reducing the flow of reliable information.

23. What are the advantages and disadvantages of governmental provision of information as a solution to the problems created by conflicts of interest?

The government agency is less likely to have the conflict of interest than the private sector. In addition, information may be a public good that is undersupplied, so government provision of this information might make the markets more efficient.

Conversely, the government may not have as good incentives as the private sector to

provide good-quality information. Also, government agencies have trouble paying high salaries to get the best people, so the quality of information they provide might not be very good.

24. Why is a conflict of interest present when compliance officers are involved in the production of credit ratings?

This represents a conflict of interest in that compliance officers are tasked with ensuring that an institution is conforming to all applicable laws and regulations, as well as internal firm protocols. In order for them to be credible and effective in this role, it is vital that they do not put themselves in a situation where conflicts of interest can arise. This can occur in particular when producing credit ratings, since the companies that are being rated can benefit tremendously from favorable ratings, and can lobby the raters to improve those ratings. Compliance officers involved in this process may then face a conflict between ensuring compliance with internal and formal regulations and improving client relations and better bonus checks.

25. In what ways is the Dodd-Frank legislation designed to reduce conflicts of interest?

The Dodd-Frank legislation helps reduce conflicts of interest by prohibiting compliance officers from working on producing credit ratings, and prohibits firms issuing asset-backed securities from shopping around for the highest ratings. It also authorizes investors to sue credit-rating agencies for reckless failure to produce accurate ratings.

PART FOUR

Chapter Outlines

Part 1 Introduction Chapter 1: Why Study Money, Banking, and Financial Markets?

Why Study Financial Markets?

Debt Markets and Interest Rates The Stock Market Why Study Financial Institutions and Banking?

Structure of the Financial System Banks and Other Financial Institutions Financial Innovation Financial Crises Why Study Money and Monetary Policy?

Money and Business Cycles Money and Inflation Money and Interest Rates Conduct of Monetary Policy Fiscal Policy and Monetary Policy Why Study International Finance?

The Foreign Exchange Market The International Financial System Money, Banking, Financial Markets and Your Career How We Will Study Money, Banking, and Financial Markets Concluding Remarks Summary Key Terms Questions Applied Problems Data Analysis Problems Appendix to Chapter 1: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate Aggregate Output and Income Real Versus Nominal Magnitudes Aggregate Price Level Growth Rates and the Inflation Rate

Chapter 2: An Overview of the Financial System Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets Financial Market Instruments Money Market Instruments Following the Financial News Money Market Rates Capital Market Instruments Following the Financial News Capital Market Interest Rates Internationalization of Financial Markets Global Are US Capital Markets Losing Their Edge?

International Bond Market, Eurobonds, and Eurocurrencies World Stock Markets Function of Financial Intermediaries: Indirect Finance Following the Financial News Foreign Stock Market Indexes Transaction Costs Global The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Economies of Scope and Conflicts of Interest Types of Financial Intermediaries Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroad Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 3: What Is Money?

Meaning of Money Functions of Money Medium of Exchange Unit of Account Store of Value Evolution of the Payments System Commodity Money Fiat Money Checks Electronic Payment E-Money FYI Are We Headed for a Cashless Society?

Application Will Bitcoin or Other Cryptocurrencies Become the Money of the Future?

Measuring Money The Federal Reserve’s Monetary Aggregates Following the Financial News The Monetary Aggregates FYI Where Are All the U.S. Dollars?

Summary Key Terms Questions Applied Problems Data Analysis Problems

Part 2 Financial Markets Chapter 4: The Meaning of Interest Rates Measuring Interest Rates Present Value Application Simple Present Value Application How Much Is That Jackpot Worth?

Four Types of Credit Market Instruments Yield to Maturity Application Yield to Maturity on a Simple Loan Application Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan Application Yield to Maturity and Bond Price for a Coupon Bond Application Yield to Maturity on a Perpetuity Application Yield to Maturity on a Discount Bond Global Negative Interest Rates? Japan First, Then the United States, Then Europe Maturity and the Volatility of Bond Returns: Interest-Rate Risk Summary The Distinction Between Interest Rates and Returns The Distinction Between Real and Nominal Interest Rates Application Calculating Real Interest Rates Summary Key Terms Questions Applied Problems Data Analysis Problems Appendix to Chapter 4: Measuring Interest-Rate Risk: Duration Application: Rate of Capital Gain Calculating Duration Application: Duration Duration and Interest-Rate Risk Application: Duration and Interest-Rate Risk Application: Duration and Interest-Rate Risk

Chapter 5: The Behavior of Interest Rates Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Theory of Portfolio Choice Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply and Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds Application Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect Application Changes in the Interest Rate Due to a Business Cycle Expansion Application Explaining Current Low Interest Rates in Europe, Japan, and the United States: Low Inflation and Secular Stagnation Supply and Demand in the Market for Money: The Liquidity Preference Framework Changes in Equilibrium Interest Rates in the Liquidity Preference Framework Shifts in the Demand for Money Shifts in the Supply of Money Application Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply Changes in Income Changes in the Price Level Changes in the Money Supply Money and Interest Rates Application Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?

Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix to Chapter 5: Loanable Funds Framework

Chapter 6: The Risk and Term Structure of Interest Rates Risk Structure of Interest Rates Default Risk FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis Application The Coronavirus Pandemic and the Baa-Treasury Spread Liquidity Income Tax Considerations Summary Application Effects of the Trump Tax Cuts on Bond Interest Rates Term Structure of Interest Rates Following the Financial News Yield Curves Expectations Theory Segmented Markets Theory Liquidity Premium and Preferred Habitat Theories Evidence on the Term Structure FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Summary Application Interpreting Yield Curves, 1980–2020 Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 7: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis Computing the Price of Common Stock The One-Period Valuation Model The Generalized Dividend Valuation Model The Gordon Growth Model How the Market Sets Stock Prices Application Monetary Policy and Stock Prices Application The Coronavirus Stock Market Crash of 2020 The Theory of Rational Expectations Formal Statement of the Theory Rationale Behind the Theory Implications of the Theory The Efficient Market Hypothesis: Rational Expectations in Financial Markets Rationale Behind the Hypothesis Random-Walk Behavior of Stock Prices Global Should Foreign Exchange Rates Follow a Random Walk?

Application Practical Guide to Investing in the Stock Market How Valuable Are Reports Published by Investment Advisers?

Should You Be Skeptical of Hot Tips?

FYI Should You Hire an Ape as Your Investment Adviser?

Do Stock Prices Always Rise When There Is Good News?

Efficient Market Prescription for the Investor Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are Efficient Application What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis and the Efficiency of Financial Markets?

Behavioral Finance Summary Key Terms Questions Applied Problems Data Analysis Problems

Part 3 Financial Institutions Chapter 8: An Economic Analysis of Financial Structure Basic Facts About Financial Structure Throughout the World Transaction Costs How Transaction Costs Influence Financial Structure How Financial Intermediaries Reduce Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons in the Stock and Bond Markets Tools to Help Solve Adverse Selection Problems FYI The Enron Implosion How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts: The Principal–Agent Problem Tools to Help Solve the Principal–Agent Problem How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Summary Application Financial Development and Economic Growth FYI The Tyranny of Collateral Application Is China a Counterexample to the Importance of Financial Development?

Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 9: Banking and the Management of Financial Institutions The Bank Balance Sheet Liabilities Assets Basic Banking General Principles of Bank Management Liquidity Management and the Role of Reserves Asset Management Liability Management Capital Adequacy Management Application Strategies for Managing Bank Capital Application How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Managing Credit Risk Screening and Monitoring Long-Term Customer Relationships Loan Commitments Collateral and Compensating Balances Credit Rationing Managing Interest-Rate Risk Gap and Duration Analysis Application Strategies for Managing Interest-Rate Risk Off-Balance-Sheet Activities Loan Sales Generation of Fee Income Trading Activities and Risk Management Techniques Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase: Rogue Traders and the Principal–Agent Problem Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix 1 to Chapter 9: Duration Gap Analysis Application Example 1: Duration Gap Analysis Application Example 2: Duration Gap Analysis Application Example 3: Duration Gap Analysis Example of a Nonbanking Financial Institution Some Problems with Income and Duration Gap Analysis Application Strategies for Managing Interest-Rate Risk Appendix 2 to Chapter 9: Measuring Bank Performance Bank’s Income Statement Operating Income Operating Expenses Income Measures of Bank Performance Recent Trends in Bank Performance Measures

Chapter 10: Economic Analysis of Financial Regulation Asymmetric Information as a Rationale for Financial Regulation Government Safety Net Global The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

Drawbacks of the Government Safety Net Types of Financial Regulation Restrictions on Asset Holdings Capital Requirements Global Where Is the Basel Accord Heading After the Global Financial Crisis?

Prompt Corrective Action Financial Supervision: Chartering and Examination Assessment of Risk Management Disclosure Requirements Consumer Protection Restrictions on Competition Summary Global International Financial Regulation Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix to Chapter 10: Banking Crises Throughout the World ―Déjà Vu All Over Again‖ Scandinavia Latin America Russia and Eastern Europe Japan China East Asia

Chapter 11: Banking Industry: Structure and Competition Historical Development of the Banking System Multiple Regulatory Agencies Financial Innovation and the Growth of the “Shadow Banking System” Responses to Changes in Demand Conditions: Interest-Rate Volatility Responses to Changes in Supply Conditions: Information Technology Securitization and the Shadow Banking System Avoidance of Existing Regulations FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 Financial Innovation and the Decline of Traditional Banking Structure of the U.S. Commercial Banking Industry Restrictions on Branching Response to Branching Restrictions Bank Consolidation and Nationwide Banking The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 What Will the Structure of the U.S. Banking Industry Look Like in the Future?

Global Comparison of Banking Structure in the United States and Abroad Are Bank Consolidation and Nationwide Banking Good Things?

Separation of Banking and Other Financial Service Industries Erosion of Glass-Steagall The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall Implications for Financial Consolidation Separation of Banking and Other Financial Services Industries Throughout the World FYI The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks Thrift Industry: Regulation and Structure Savings and Loan Associations Mutual Savings Banks Credit Unions International Banking Eurodollar Market Global Ironic Birth of the Eurodollar Market Structure of U.S. Banking Overseas Foreign Banks in the United States Summary Key Terms

Questions Data Analysis Problems

Chapter 12: Financial Crisis What Is a Financial Crisis?

Dynamics of Financial Crises Stage One: Initial Phase Stage Two: Banking Crisis Stage Three: Debt Deflation Application The Mother of All Financial Crises: The Great Depression Stock Market Crash Bank Panics Continuing Decline in Stock Prices Debt Deflation International Dimensions The Global Financial Crisis of 2007–2009 Causes of the 2007–2009 Financial Crisis FYI Collateralized Debt Obligations (CDOs) Effects of the 2007–2009 Financial Crisis Inside the Fed Was the Fed to Blame for the Housing Price Bubble?

Global The European Sovereign Debt Crisis Height of the 2007–2009 Financial Crisis Government Intervention and the Recovery Global Worldwide Government Bailouts During the 2007–2009 Financial Crisis Application Could the Coronavirus Pandemic Have Led to a Financial Crisis?

Response of Financial Regulation Macroprudential Versus Microprudential Supervision Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Too-Big-to-Fail and Future Regulation What Can Be Done About the Too-Big-to-Fail Problem?

Beyond Dodd-Frank: Where Might Regulation Head in the Future?

Summary Key Terms Questions Applied Problems Data Analysis Problems

Part 4 Central Banking and the Conduct of Monetary Policy Chapter 13: Central Banks and the Federal Reserve System Origins of the Federal Reserve System Inside the Fed The Political Genius of the Founders of the Federal Reserve System Structure of the Federal Reserve System Federal Reserve Banks Inside the Fed The Special Role of the Federal Reserve Bank of New York Member Banks Board of Governors of the Federal Reserve System Federal Open Market Committee (FOMC) Inside the Fed The Role of the Research Staff Inside the Fed The FOMC Meeting Inside the Fed Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? Why the Chair of the Board of Governors Really Runs the Show Inside the Fed Styles of Federal Reserve Chairs: Bernanke, Yellen and Powell Versus Greenspan How Independent Is the Fed? Inside the Fed Presidential Attacks on the Independence of the Fed Should the Fed Be Independent? The Case for Independence The Case Against Independence Central Bank Independence and Macroeconomic Performance Throughout the World Explaining Central Bank Behavior Inside the Fed The Evolution of the Fed’s Communication Strategy Structure and Independence of the European Central Bank Differences Between the European System of Central Banks and the Federal Reserve System Governing Council How Independent Is the ECB? Structure and Independence of Other Foreign Central Banks Bank of Canada Bank of England Bank of Japan The Trend Toward Greater Independence Summary Key Terms Questions Data Analysis Problems

Chapter 14: The Money Supply Process Three Players in the Money Supply Process The Fed’s Balance Sheet Liabilities Assets Control of the Monetary Base Federal Reserve Open Market Operations Shifts from Deposits into Currency Loans to Financial Institutions Other Factors That Affect the Monetary Base Overview of the Fed’s Ability to Control the Monetary Base Multiple Deposit Creation: A Simple Model Deposit Creation: The Single Bank Deposit Creation: The Banking System Deriving the Formula for Multiple Deposit Creation Critique of the Simple Model Factors that Determine the Money Supply Changes in the Nonborrowed Monetary Base, MBn Changes in Borrowed Reserves, BR, from the Fed Changes in the Required Reserve Ratio, rr Changes in Excess Reserves Changes in Currency Holdings Overview of the Money Supply Process The Money Multiplier Deriving the Money Multiplier Intuition behind the Money Multiplier Money Supply Response to Changes in the Factors Application Quantitative Easing During the Global Financial and Coronavirus Crises Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix 1 to Chapter 14: The Fed’s Balance Sheet and the Monetary Base Assets Liabilities Monetary Base Appendix 2 to Chapter 14: The M2 Money Multiplier Factors that Determine the M2 Money Multiplier Changes in rr, c, and e Response to Changes in t and mm Appendix 3 to Chapter 14: Explaining the Behavior of the Currency Ratio Effect of Changes in Wealth Effect of Changes in Expected Returns Interest Rates on Checkable Deposits Cost of Acquiring Currency Bank Panics Illegal Activity Foreign Holdings of Currency Application Explaining the Historical Record of c 1892–1917 1917–1919 1919–1921 1921–1929 1929–1933 1933–1941 1941–1945 1945–Early 1960 Early 1960s–1980 1980–1993 1994–2007 2007–2020 Application Predicting the Future of c Rise in Income Tax Rates to Balance the Budget Abolishment of Interest Payments on Checking Accounts Appendix 4 to Chapter 14: The Great Depression Bank Panics, 1930–1933, and the Money Supply

Chapter 15: Tools of Monetary Policy The Market for Reserves and the Federal Funds Rate Demand and Supply in the Market for Reserves How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate Application How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate Conventional Monetary Policy Tools Open Market Operations Inside the Fed A Day at the Trading Desk Discount Policy and the Lender of Last Resort Inside the Fed Using Discount Policy to Prevent a Financial Panic Reserve Requirements Interest on Reserves Relative Advantages of the Different Tools Nonconventional Monetary Policy Tools and Quantitative Easing in the Wake of the Global Financial Crisis and the Coronavirus Pandemic Liquidity Provision Large-Scale Asset Purchases Inside the Fed Fed Lending Facilities During the Global Financial and Coronavirus Crises Quantitative Easing Versus Credit Easing Forward Guidance Negative Interest Rates on Bank’s Deposits Monetary Policy Tools of the European Central Bank Open Market Operations Lending to Banks Interest on Reserves Reserve Requirements Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 16: The Conduct of Monetary Policy: Strategy and Tactics The Price Stability Goal and the Nominal Anchor The Role of a Nominal Anchor The Time-Inconsistency Problem Other Goals of Monetary Policy High Employment and Output Stability Economic Growth Stability of Financial Markets Interest-Rate Stability Stability in Foreign Exchange Markets Should Price Stability Be the Primary Goal of Monetary Policy?

Hierarchical Versus Dual Mandates Price Stability as the Primary, Long-Run Goal of Monetary Policy Inflation Targeting Inflation Targeting in New Zealand, Canada, and the United Kingdom Advantages of Inflation Targeting Disadvantages of Inflation Targeting The Evolution of the Federal Reserve’s Monetary Policy Strategy The Fed’s “Just Do It” Monetary Policy Strategy The Long Road to Inflation Targeting Inside the Fed Ben Bernanke’s Advocacy of Inflation Targeting Global The European Central Bank’s Monetary Policy Strategy Lessons for Monetary Policy Strategy from the Global Financial Crisis Implications for Inflation Targeting Inside the Fed Average Inflation Targeting Should Central Banks Try to Stop Asset-Price Bubbles?

Two Types of Asset-Price Bubbles The Debate Over Whether Central Banks Should Try to Pop Bubbles Tactics: Choosing the Policy Instrument Criteria for Choosing the Policy Instrument Tactics: The Taylor Rule Inside the Fed The Fed’s Use of the Taylor Rule Inside the Fed Fed Watchers Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix 1 to Chapter 16: Monetary Targeting Monetary Targeting in the United States, Japan, and Germany United States Japan Germany Advantages of Monetary Targeting Disadvantages of Monetary Targeting Appendix 2 to Chapter 16: A Brief History of Federal Reserve Policymaking The Early Years: Discount Policy as the Primary Tool Discovery of Open Market Operations The Great Depression Inside the Fed: Bank Panics of 1930–1933: Why Did the Fed Let Them Happen?

Reserve Requirements as a Policy Tool War Finance and the Pegging of Interest Rates: 1942–1951 Targeting Money Market Conditions: The 1950s and 1960s Targeting Monetary Aggregates: The 1970s New Fed Operating Procedures: October 1979–October 1982 De-Emphasis of Monetary Aggregates: October 1982–Early 1990s Federal Funds Targeting Again: Early 1990s and Beyond Preemptive Strikes against Inflation Preemptive Strikes against Economic Downturns and Financial Disruptions: LTCM, Enron, and the Global Financial Crisis International Considerations

Part 5 International Finance and Monetary Policy Chapter 17: The Foreign Exchange Market Foreign Exchange Market Following the Financial News Foreign Exchange Rates What Are Foreign Exchange Rates?

Why Are Exchange Rates Important?

How Is Foreign Exchange Traded?

Exchange Rates in the Long Run Theory of Purchasing Power Parity Application Burgernomics: Big Macs and PPP Factors That Affect Exchange Rates in the Long Run Exchange Rates in the Short Run: A Supply and Demand Analysis Supply Curve for Domestic Assets Demand Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Explaining Changes in Exchange Rates Shifts in the Demand for Domestic Assets Recap: Factors That Change the Exchange Rate Application Effects of Changes in Interest Rates on the Equilibrium Exchange Rate Application The Global Financial Crisis and the Dollar Application Brexit and the British Pound Summary Key Terms Questions Applied Problems Data Analysis Problems Appendix to Chapter 17: The Interest Parity Condition Comparing Expected Returns on Domestic and Foreign Asset Interest Parity Condition

Chapter 18: The International Financial System Intervention in the Foreign Exchange Market Foreign Exchange Intervention and the Money Supply Inside the Fed A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk Unsterilized Intervention Sterilized Intervention Balance of Payments Current Account Financial Account Global Should We Worry About the Large U.S. Current Account Deficit?

Exchange Rate Regimes in the International Financial System Gold Standard The Bretton Woods System How a Fixed Exchange Rate Regime Works Speculative Attacks Application The Foreign Exchange Crisis of September 1992 The Policy Trilemma Application How Did China Accumulate $4 Trillion of International Reserves?

Monetary Unions Managed Float Global Will the Euro Survive?

Capital Controls Controls on Capital Outflows Controls on Capital Inflows The Role of the IMF Should the IMF Act as an International Lender of Last Resort?

International Considerations and Monetary Policy Direct Effects of the Foreign Exchange Market on Monetary Policy Exchange Rate Considerations To Peg or Not to Peg: Exchange-Rate Targeting as an Alternative Monetary Policy Strategy Advantages of Exchange-Rate Targeting Disadvantages of Exchange-Rate Targeting When Is Exchange-Rate Targeting Desirable for Industrialized Countries?

When Is Exchange-Rate Targeting Desirable for Emerging Market Countries?

Currency Boards Global Argentina’s Currency Board Dollarization Summary Key Terms Questions Applied Problems

Data Analysis Problems

Part 6 Monetary Theory Chapter 19: Quantity Theory, Inflation, and the Demand for Money Quantity Theory of Money Velocity of Money and Equation of Exchange From the Equation of Exchange to the Quantity Theory of Money Quantity Theory and the Price Level Quantity Theory and Inflation Application Testing the Quantity Theory of Money Budget Deficits and Inflation Government Budget Constraint FYI Modern Monetary Theory Hyperinflation Application The Zimbabwean Hyperinflation Keynesian Theories of Money Demand Transactions Motive Precautionary Motive Speculative Motive Putting the Three Motives Together Portfolio Theories of Money Demand Theory of Portfolio Choice and Keynesian Liquidity Preference Other Factors That Affect the Demand for Money Summary Empirical Evidence for the Demand for Money Interest Rates and Money Demand Stability of Money Demand Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 20: The IS Curve Planned Expenditure and Aggregate Demand The Components of Aggregate Demand Consumption Expenditure FYI: Meaning of the Word Investment Planned Investment Spending Government Purchases and Taxes Net Exports Goods Market Equilibrium Solving for Goods Market Equilibrium Deriving the IS Curve Understanding the IS Curve What the IS Curve Tells Us: Intuition What the IS Curve Tells Us: Numerical Example Why the Economy Heads Toward Equilibrium Factors That Shift the IS Curve Changes in Government Purchases Application The Vietnam War Buildup, 1964–1969 Changes in Taxes Application The Fiscal Stimulus Package of 2009 Changes in Autonomous Spending Changes in Financial Frictions Summary of Factors That Shift the IS Curve Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 21: The Monetary Policy and Aggregate Demand Curves The Federal Reserve and Monetary Policy The Monetary Policy Curve The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope Shifts in the MP Curve Movements Along Versus Shifts In the MP Curve Application Movement Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 and 20015–2019 Application Shift in the MP Curve: Autonomous Monetary Easing at the Onset of the Global Financial and Coronavirus Crises The Aggregate Demand Curve Deriving the Aggregate Demand Curve Graphically Factors That Shift the Aggregate Demand Curve FYI Deriving the Aggregate Demand Curve Algebraically Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 22: Aggregate Demand and Supply Analysis Business Cycles and Inflation Business Cycles Inflation Aggregate Demand Following the Financial News: Aggregate Output, Unemployment, and Inflation Deriving the Aggregate Demand Curve Factors That Shift the Aggregate Demand Curve FYI What Does Autonomous Mean?

Aggregate Supply Long-Run Aggregate Supply Curve Short-Run Aggregate Supply Curve Price Stickiness and the Short-Run Aggregate Supply Curve Shifts in the Aggregate Supply Curves Shifts in the Long-Run Aggregate Supply Curve Shifts in the Short-Run Aggregate Supply Curve Equilibrium in Aggregate Demand and Supply Analysis Short-Run Equilibrium Aggregate Demand and Supply Analysis Using an Aggregate Output Index How the Short-Run Equilibrium Moves to the Long-Run Equilibrium over Time Self-Correcting Mechanism Changes in Equilibrium: Aggregate Demand Shocks Application The Volcker Disinflation, 1980–1986 Changes in Equilibrium: Aggregate Supply (Inflation) Shocks Temporary Supply Shocks Application Negative Supply Shocks, 1973–1975 and 1978–1980 Conclusions from Aggregate Demand and Supply Analysis Application AD/AS Analysis of the Great Recession of 2007– 2009 Application An AD/AS Analysis of the Covid-19 Recession Summary Key Terms Questions Applied Problems Data Analysis Problems

Appendix to Chapter 22: The Phillips Curve and the Short-Run Aggregate Supply Curve The Phillips Curve Phillips Curve Analysis in the 1960s FYI The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s The Friedman-Phelps Phillips Curve Analysis The Phillips Curve After the 1960s The Modern Phillips Curve The Modern Phillips Curve with Adaptive (BackwardLooking) Expectations The Short-Run Aggregate Supply Curve Appendix 1 to Chapter 22: The Effects of Macroeconomic Shocks on Asset Prices Impact of Demand Shocks on Real Interest Rates, Inflation, and Output Monetary Policy Shocks Spending Shocks Impact of Supply Shocks on Real Interest Rates, Inflation, and Output Temporary Supply Shocks Permanent Supply Shocks Impact of Shocks on the Stock Market Monetary Policy Shocks Spending Shocks Temporary Supply Shocks Permanent Supply Shocks Appendix 2 to Chapter 22: Aggregate Demand and Supply: An Algebraic Example Determination of Equilibrium Output and the Inflation Rate Response to a Shift in the Aggregate Demand Curve

Chapter 23: Monetary Policy Theory Response of Monetary Policy to Shocks Response to an Aggregate Demand Shock Response to a Permanent Supply Shock Response to a Temporary Supply Shock The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity How Actively Should Policymakers Try to Stabilize Economic Activity?

Lags and Policy Implementation Inflation: Always and Everywhere a Monetary Phenomenon FYI The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package Causes of Inflationary Monetary Policy High Employment Targets and Inflation Application The Great Inflation Monetary Policy at the Zero Lower Bound Deriving the Aggregate Demand Curve at the Zero Lower Bound The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound Application Nonconventional Monetary Policy and Quantitative Easing Liquidity Provision Asset Purchases and Quantitative Easing Management of Expectations Application Abenomics and the Shift in Japanese Monetary Policy in 2013 Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 24: The Role of Expectations in Monetary Policy Lucas Critique of Policy Evaluation Econometric Policy Evaluation Application The Term Structure of Interest Rates Policy Conduct: Rules or Discretion?

Discretion and the Time-Inconsistency Problem Types of Rules The Case for Rules FYI The Political Business Cycle and Richard Nixon The Case for Discretion Constrained Discretion Global The Demise of Monetary Targeting in Switzerland The Role of Credibility and a Nominal Anchor Benefits of a Credible Nominal Anchor Credibility and Aggregate Demand Shocks Credibility and Aggregate Supply Shocks Application A Tale of Three Oil Price Shocks Credibility and Anti-Inflation Policy Global Ending the Bolivian Hyperinflation: A Successful Anti-Inflation Program Application Credibility and the Reagan Budget Deficits Approaches to Establishing Central Bank Credibility Nominal GDP Targeting Inside the Fed The Appointment of Paul Volcker, AntiInflation Hawk Appoint “Conservative” Central Bankers Summary Key Terms Questions Applied Problems Data Analysis Problems

Chapter 25: Transmission Mechanisms of Monetary Policy Transmission Mechanisms of Monetary Policy Traditional Interest-Rate Channels Other Asset Price Channels Credit View FYI Consumers’ Balance Sheets and the Great Depression Why Are Credit Channels Likely to Be Important?

Application The Great Recession Lessons for Monetary Policy Application Applying the Monetary Policy Lessons to Japan’s Two Lost Decades Summary Key Terms Questions Applied Problems Data Analysis Problems Appendix to Chapter 25: Evaluating Empirical Evidence: The Debate Over the Importance of Money in Economic Fluctuations Framework for Evaluating Empirical Evidence Structural Model Evidence Reduced-Form Evidence Advantages and Disadvantages of Structural Model Evidence Advantages and Disadvantages of Reduced-Form Evidence FYI The Perils of Reverse Causation: A Russian Folk Tale Conclusions FYI The Perils of Ignoring an Outside Driving Factor: How to Lose a Presidential Election Application The Debate Over the Importance of Monetary Policy to Economic Fluctuations Early Keynesian Evidence on the Importance of Money Objections to Early Keynesian Evidence Early Monetarist Evidence on the Importance of Money Timing Evidence Statistical Evidence Historical Evidence Overview of the Monetarist Evidence FYI Real Business Cycle Theory and the Debate on Money and Economic Activity

Web Chapter 1: Financial Crises in Emerging Market Economies Dynamics of Financial Crises in Emerging Market Economies Stage One: Initial Phase Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis Application Crisis in South Korea, 1997–1998 Financial Liberalization/Globalization Mismanaged Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Stock Market Decline and Failure of Firms Increase Uncertainty Adverse Selection and Moral Hazard Problems Worsen and the Economy Contracts Currency Crisis Ensues Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Commences Application The Argentine Financial Crisis, 2001–2002 Severe Fiscal Imbalances Adverse Selection and Moral Hazard Problems Worsen Bank Panic Begins Currency Crisis Ensues Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Begins Global When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 Preventing Emerging Market Financial Crises Beef Up Prudential Regulation and Supervision of Banks Encourage Disclosure and Market-Based Discipline Limit Currency Mismatch Sequence Financial Liberalization Summary Key Terms Questions

Web Chapter 2: Nonbank Finance Insurance Life Insurance Property and Casualty Insurance The Competitive Threat from the Banking Industry Credit Insurance FYI The AIG Blowup FYI The Global Financial Crisis and the Monoline Insurers Application Insurance Management Screening Risk-Based Premiums Restrictive Provisions Prevention of Fraud Cancellation of Insurance Deductibles Coinsurance Limits on the Amount of Insurance Summary Pension Funds Private Pension Plans Public Pension Plans FYI Should Social Security Be Privatized?

Finance Companies Securities Market Operations Investment Banking Securities Brokers and Dealers Organized Exchanges Mutual Funds FYI Sovereign Wealth Funds: Are They a Danger?

Money Market Mutual Funds Hedge Funds Private Equity and Venture Capital Funds Government Financial Intermediation Federal Credit Agencies FYI The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Summary Key Terms Questions Applied Problems Data Analysis Problems

Web Chapter 3: Financial Derivatives Hedging Interest-Rate Forward Contracts Application Hedging with Interest-Rate Forward Contracts Pros and Cons of Forward Contracts Financial Futures Contracts and Markets Application Hedging with Financial Futures Organization of Trading in Financial Futures Markets The Globalization of Financial Futures Markets Explaining the Success of Futures Markets Application Hedging Foreign Exchange Risk Hedging Foreign Exchange Risk with Forward Contracts Hedging Foreign Exchange Risk with Futures Contracts Options Options Contracts Profits and Losses on Option and Futures Contracts Application Hedging with Future Options Factors Affecting Option Premiums Summary Swaps Interest-Rate Swap Contracts Application Hedging with Interest-Rate Swaps Advantages of Interest-Rate Swaps Disadvantages of Interest-Rate Swaps Financial Intermediaries in Interest-Rate Swaps Credit Derivatives Credit Options Credit Swaps Credit-Linked Notes Application Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb?

Summary Key Terms Questions Applied Problems Data Analysis Problems Web Exercises

Web Chapter 4: Conflicts of Interest in the Financial Services Industry What Are Conflicts of Interest, and Why Are They Important?

Why Do We Care About Conflicts of Interest?

Ethics and Conflicts of Interest Types of Conflicts of Interest Underwriting and Research in Investment Banking Auditing and Consulting in Accounting Firms Credit Assessment and Consulting in Credit-Rating Agencies FYI The Collapse of Arthur Andersen Universal Banking FYI Why Do Issuers of Securities Pay to Have Their Securities Rated?

FYI Banksters Can the Market Limit Exploitations of Conflicts of Interest?

What Has Been Done to Remedy Conflicts of Interest?

Sarbanes-Oxley Act of 2002 Global Legal Settlement of 2002 Dodd-Frank Bill of 2010 A Framework for Evaluating Policies to Remedy Conflicts of Interest Approaches to Remedying Conflicts of Interest Application Evaluating Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill Summary Key Terms Questions