Instructor’s Manual for Money, Banking, and the Financial System 4th Edition. R. Glenn Hubbard, Anth

Contents Preface

.....................................................................................................................................

Part 1:

Foundations

Chapter 1

Introducing Money and the Financial System.............................................................

1

Chapter 2

Money and the Payments System................................................................................

11

Chapter 3

Interest Rates and Rates of Return ..............................................................................

25

Chapter 4

Determining Interest Rates ..........................................................................................

40

Part 2:

Financial Markets

Chapter 5

The Risk Structure and Term Structure of Interest Rates ...........................................

61

Chapter 6

The Stock Market, Information, and Financial Market Efficiency .............................

72

Chapter 7

Derivatives and Derivatives Markets ..........................................................................

88

Chapter 8

The Market for Foreign Exchange ..............................................................................

101

Part 3:

Financial Institutions

Chapter 9

Transactions Costs, Asymmetric Information, and the Structure of the Financial System ...................................................................

117

Chapter 10

The Economics of Banking .........................................................................................

127

Chapter 11

Beyond Commercial Banks: Shadow Banks and Nonbank Financial Institutions......

144

Chapter 12

Financial Crises and Financial Regulation ..................................................................

158

Part 4:

Monetary Policy

Chapter 13

The Federal Reserve and Central Banking ..................................................................

178

Chapter 14

The Federal Reserve’s Balance Sheet and the Money Supply Process .......................

191

Chapter 15

Monetary Policy ..........................................................................................................

207

Chapter 16

The International Financial System and Monetary Policy ..........................................

230

Part 5:

The Financial system and the Macroeconomy

Chapter 17

Monetary Theory I: The Aggregate Demand and Aggregate Supply Model ..............

247

Chapter 18

Monetary Theory II: The IS–MP Model .....................................................................

266

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Preface Revisions to the Main Textbook If you used Hubbard/O’Brien MONEY, BANKING, AND THE FINANCIAL SYSTEM, Third Edition, here is a summary of the changes the authors made to the main text. Knowing about these changes will help you revise your teaching notes and class presentations.

We’ve added coverage of new topics and revised and updated our coverage of other topics. Examples include: • • • • • • • • • •

The effects of the Covid-19 pandemic on the financial system The Fed’s policy response to the pandemic The continuing debate over the Fed’s independence and its structure The issues raised by the Fed’s collaboration with the Treasury during the pandemic and the Fed’s expansion into lending to nonfinancial businesses The continuing evolution of the Fed’s policy tools The expanding role of the Fed in providing liquidity to foreign central banks The effects on the financial system of historically low interest rates The policy and regulatory implications of new developments in the shadow banking system The evolution of the U.S. dollar’s role in the international financial system New developments in the U.S. payment system and in digital banking

We’ve also made the following changes: • • • • • • •

Replaced many chapter-opening cases and updated the cases we retained.

Added new Apply the Concept features (formerly titled Making the Connection), including several that are relevant to students’ personal lives and decisions (titled Apply the Concept: In Your Interest), and updated the retained Apply the Concepts.

Added new Solved Problem features and updated retained Solved Problems. Some Solved Problems involve subjects that are relevant to students’ personal lives and financial decisions.

Added new figures and updated the remaining figures and tables with the latest available data.

Replaced or updated many of the end-of-chapter Review Questions and Problems and Applications, which students can complete on MyLab Economics.

Revised the 55 end-of-chapter real-time data exercises. Students can complete these exercises on MyLab Economics, where they can also view the very latest data from FRED, the online macroeconomic data bank of the Federal Reserve Bank of St. Louis.

Cut Apply the Concepts that had become less relevant.

These changes were made in all chapters 1.

2.

3.

4.

5.

6.

Updated graphs and tables with the latest data available.

Replaced or updated all Chapter-Opening business vignettes.

Changed the feature title of Making the Connection to Apply the Concept Added several new Apply the Concepts and updated those retained from previous edition.

Replaced or updated several Solved Problems.

Added several new end-of-chapter problems, updated others, and cut out-of-date problems.

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Assessment located in eText and MyLab Economics MyLab Economics is a powerful assessment and tutorial system that works hand-in-hand with Money, Banking, and the Financial System. MyLab Economics includes comprehensive homework, quiz, test, and tutorial options, allowing instructors to manage all assessment needs in one program. Key innovations in the MyLab include the following: • •

• •

Students can complete exercises in each chapter’s Problems and Applications section and many other exercises online; get tutorial help; and receive instant feedback and assistance on exercises they answer incorrectly.

Fifty-five Real-time Data Analysis Exercises allow students and instructors to use the very latest data from FRED, the online macroeconomic data bank from the Federal Reserve Bank of St. Louis. By completing the exercises, students become familiar with a key data source, learn how to locate data, and develop skills to interpret data.

In the Multimedia Library available in MyLab Economics, select figures labeled MyLab Economics Real-time data allow students to display a popup graph updated with real-time data from FRED. Current News Exercises provide a turnkey way to assign gradable news-based exercises in MyLab Economics. Every week, Pearson locates a current news article, creates an exercise around the article, and adds it to MyLab Economics.

Chapter-by-chapter changes Chapter 1: Introducing Money and the Financial System Chapter 1 opens with a new discussion of how the Covid-19 pandemic affected financial markets. That topic continues in Section 1.2, “The Crises of 2007–2009 and 2020” and also in a new section titled “The Financial Crisis Caused by the Covid-19 Pandemic.” The two retained Apply the Concept features, “The Rise of Peer-to-Peer Lending and Fintech” and “What Do People Do with Their Savings?” contain recent examples and data.

Chapter 2: Money and the Payments System Chapter 2 opens with a discussion of the Federal Reserve, the 2020 presidential campaign, and Covid-19.

The chapter includes a new Apply the Concept, “Why Is the U.S. Payments System So Slow?” Section 2.3 has new coverage of real-time payments systems. The section “Should Central Banks be Independent?” has been extensively updated based on recent events.

Chapter 3: Interest Rates and Rates of Return Chapter 3 opens with a discussion of evaluating the risk of investing in Treasury bonds during the 2020 pandemic. The Apply the Concepts “Interest Rates and Student Loans” and “How to Follow the Bond Market: Reading the Bond Tables” have been extensively updated and revised. In Section 3.5, the section “How Much Interest-Rate Risk Do Investors in Treasury Bonds Face?” has been updated with a discussion of the state of the financial system during the 2020 Covid-19 pandemic.

Chapter 4: Determining Interest Rates Chapter 4 begins with an updated discussion of the persistence of historically low interest rates. A new Solved Problem feature, “Investing in Bonds When a Change in Policy Leads to Higher Inflation,” covers the 2020 presidential race and “modern monetary theory (MMT)”. The chapter’s Apply the Concepts have all been updated with recent data and take into account recent events.

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Chapter 5: The Risk Structure and Term Structure of Interest Rates Chapter 5 opens with a discussion of whether the term structure of interest rates can help predict recessions. A new Solved Problem feature, “Political Uncertainty and Bond Yields,” discusses the U.S.– China trade war and the Covid-19 pandemic. The new section “Using the Term Structure to Evaluate Market Expectations” discusses how investors, managers at firms, and policymakers can use information from the term structure of interest rates to forecast economic variables. This section includes a new Apply the Concept, “What Happened to the Recession of 2019?”

Chapter 6: The Stock Market, Information, and Financial Market Efficiency Chapter 6 opens with a discussion of investing in the stock market featuring Tesla. Section 6.1 includes new coverage of the ways that artificial intelligence and robo-advisors are disrupting the financial services industry. Section 6.4 includes a new Apply the Concept, “Do the Stock Market Fluctuations During the Covid-19 Pandemic Disprove the Efficient Markets Hypothesis?” The Apply the Concepts and Solved Problems in the chapter have been updated with the latest data and include recent economic events.

Chapter 7: Derivatives and Derivatives Markets Chapter 7 opens with a discussion of day trading oil futures and the incident from Spring 2020 when the price of oil was briefly negative. Sections 7.3, 7.4, and 7.5 have been extensively updated to include recent data and important developments in the markets for derivatives.

Chapter 8: The Market for Foreign Exchange Chapter 8 opens with a new discussion of the effect of the Covid-19 pandemic on the exchange rate of the U.S. dollar and on U.S.-based multinational firms like Coca-Cola. The Apply the Concepts “Brexit, Covid19, Exchange Rates, and the Profitability of British Firms,” and “What Explains Movements in the Dollar Exchange Rate?” have been updated to take into account recent events, including the Covid19 pandemic. Solved Problem 8.2 on the Big Mac index has been updated with new data.

Chapter 9: Transactions Costs, Asymmetric Information, and the Structure of the Financial System Chapter 9 opens with an updated discussion of fintech and crowdsourcing. New Solved Problem 9.2 examines why banks ration credit. There are two new Apply the Concepts: “Moral Hazard, Adverse Selection, and Covid-19 in the Mortgage Market” and “When Stocks Are Risky, Should You Buy Bonds Instead?” Section 9.2 includes expanded coverage of the problems facing small investors and new coverage of the effects of the Covid-19 pandemic on the financial system.

Chapter 10: The Economics of Banking Chapter 10 opens with a new discussion of the importance to small businesses of banks, particularly community banks, during the Covid-19 pandemic. Section 10.4 includes new coverage of the effects of the Covid-19 pandemic on trends in the commercial banking industry as well as a new Apply the Concept, “Would You Want a Bank Account at the Fed or the Post Office?”

Chapter 11: Beyond Commercial Banks: Shadow Banks and Nonbank Financial Institutions Chapter 11 opens with updated discussions of shadow banks other than investment banks. Section 11.1 includes an updated discussion of investment banking and the role of repo financing. The section also has two updated Apply the Concepts: “Should Congress Bring Back Glass–Steagall?” and “So, You Want to Be an Investment Banker?” The remaining sections include updated discussions of other shadow banks and of how shadow banks fared during the Covid-19 pandemic.

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Chapter 12: Financial Crises and Financial Regulation Chapter 12 includes a new discussion on the role of shadow banks during the 2007–2009 and 2020 financial crises. The chapter includes the new sections “The Covid-19 Pandemic and the Financial Crisis of 2020” (in Section 12.3) and “The 2020 Financial Crisis: Is the Debate over the Too-Big-to-Fail Policy Still Relevant?” (in Section 12.4). The Making the Connection on the Dodd-Frank Act is cut.

Chapter 13: The Federal Reserve and Central Banking Chapter 13 opens with a revised and updated discussion about the debate over the structure of the Federal Reserve System. A new Apply the Concept, “Should Congress Change the Structure of the Fed?” reviews this debate in light of the political reaction to recent Fed policy. The chapter also covers the issues raised by the Fed’s close collaboration with the Treasury in formulating the policy response to the Covid-19 pandemic.

Chapter 14: The Federal Reserve’s Balance Sheet and the Money Supply Process Chapter 14 opens with an updated discussion of gold as a hedge against economic chaos in light of investors driving up the price of gold to record highs during the Covid-19 pandemic. The discussion of the money supply process has been extensively revised to take into account the Fed’s decision to eliminate reserve requirements and the new normal of banks holding very large reserve deposits. The figures and features have been revised to reflect the effects of the Covid-19 pandemic on the Fed’s balance sheet and on the movements in monetary aggregates.

Chapter 15: Monetary Policy Chapter 15 begins with a new chapter opener that discusses how the Fed’s approach to monetary policy has changed in an era of very large bank reserves and chronically low rates of inflation. A new Apply the Concept discusses whether the Fed has done enough to reduce Black unemployment. The chapter has been thoroughly revised and updated to reflect the new reality that during recessions, the Fed typically faces a zero lower bound to the federal funds rate. The discussion of the Fed’s monetary policy tools shifts the emphasis away from open market operations to quantitative easing and forward guidance. Similarly, we have given increased emphasis to the Fed’s use of the interest rate on reserves and the rate on its reverse repo operations to manage the federal funds rate. The Apply the Concept “Are Negative Interest Rates an Effective Monetary Policy Tool?” has been updated to reflect the Fed’s stance during the 2020 recession.

We have also updated our discussion of international comparisons of monetary policy to reflect the policies pursued by foreign central banks during the 2020 recession. The Making the Connection on asset bubbles is cut.

Chapter 16: The International Financial System and Monetary Policy Chapter 16 opens with an updated and revised discussion about countries using a single currency. Solved Problem 16.2 now examines the Swiss National Bank’s response to the rising value of the Swiss franc.

The chapter has been updated to include recent developments in the international financial system, including the strain resulting from the Covid-19 pandemic.

Chapter 17: Monetary Theory I: The Aggregate Demand and Aggregate Supply Model Chapter 17 opens with a new discussion about recent college graduates struggling in the labor market. A new section applies the aggregate demand and aggregate supply model to the recession of 2020. A new Apply the Concept discusses whether the Covid-19 pandemic will result in an end to the fracking revolution in U.S. oil production. A revised section assesses the effectiveness of monetary policy during the years since the 2007–2009 recession, including the effects of labor market scarring and the argument that Fed policy was insufficiently expansionary.

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Chapter 18: Monetary Theory II: The IS–MP Model Chapter 18 has a new chapter opener on the importance of economic forecasts to the Fed. A revised Apply the Concept assesses the recent performance of Okun’s law and the stability of the relationship between the output gap and the cyclical unemployment rate. The chapter also includes a new discussion of the problems the Fed faced in dealing with the economic consequences of the Covid-19 pandemic. A revised Apply the Concept discusses the steps taken during 2020 to begin the process of privatizing Fannie Mae and Freddie Mac. A new Apply the Concept, “Modern Monetary Theory: A Controversial New Approach,” discusses the debate among economists and policymakers over “modern monetary theory (MMT).”

Features of this Instructor’s Manual Each chapter of this Instructor’s Manual contains the following elements: Chapter Summary and Learning Objectives: An overview of the main concepts covered, organized by learning objectives.

Key Terms and Concepts: Key terms and definitions.

Chapter Outline, organized by learning objectives: Detailed descriptions of the concepts in the book and teaching tips.

Solutions to Review Questions and Problems and Applications, organized by learning objectives: Each chapter of this Instructor’s Manual includes solutions to the following end-of-chapter materials: • • •

Review Questions Problems and Applications Data Exercises

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Supplements Supplements Available to Instructors Download at www.pearsonhighered.com Instructor’s Resource Manual

Test Bank

TestGen

PowerPoint Lecture Presentation

Features of the Supplement • Chapter-by-chapter summaries • Learning objectives • Extended examples and class exercises • Teaching outlines incorporating key terms and definitions • Teaching tips, topics for class discussion, and additional applications.

• Solutions to the end-of-chapters problems • More than 1,500 multiple-choice and short-answer questions.

• Test questions are annotated with the following information: o Difficulty: 1 for straight recall, 2 for some analysis, and 3 for complex analysis o Type: Multiple-choice, short-answer, and essay o Topic: The term or concept that the question supports o Learning objective o Page number o Special features in the main book: Chapter-opening story, Key Issue and o Question, Solved Problems, and Apply the Concepts. o Advanced Collegiate Schools of Business (AACSB) Assurance of Learning o Standards: Communication; Ethical Reasoning Analytic Skills; Use of Information Technology; Multicultural and Diversity; Reflective Thinking • Allows instructors to easily create and administer tests on paper, electronically, or online.

• Instructors can select test items from the publisher-supplied test bank, which is organized by chapter and based on the associated textbook material, or create their own questions from scratch. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.

• The slides include all the graphs, tables, and equations from the textbook.

• Student versions of the PowerPoint slides are available as PDF files.

These files allow students to print the slides and bring them to class for note taking.

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Chapter 1 Introducing Money and the Financial System 

Brief Chapter Summary and Learning Objectives

1.1

Key Components of the Financial System (pages 2–15) Identify the key components of the financial system.

• Financial assets, financial institutions, the Federal Reserve, and financial regulators are the key components of the financial system.

• There are many different types of financial assets with distinctive characteristics.

• Financial institutions are distinguished by how they transfer funds from savers or lenders to borrowers.

• There are various regulators that provide oversight to different sectors of the financial system.

1.2

The Crises of 2007–2009 and 2020 (pages 15–19) Provide an overview of the financial crises of 2007–2009 and 2020.

• The financial crisis of 2007-2009 provides an opportunity to explore the role and significance of the financial system in the economy.

• The crisis of 2020 again shows the uses of Fed tools in supporting the economy.

1.3

Key Issues and Questions About Money, Banking, and the Financial System (pages 19–21) Explain the key issues and questions concerning the financial system.

• Beginning with Chapter 2, the start of each chapter highlights one key issue and a related question. Answers to the questions appear at the end of the chapters, using analysis from the chapters.



Key Terms

Asset, p. 2. Anything of value owned by a person or a firm.

Bond, p. 3. A financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money.

Bubble, p. 16. An unsustainable increase in the price of a class of assets.

Commercial bank, p. 6. A financial firm that serves as a financial intermediary by taking in deposits and using them to make loans.

Diversification, p. 13. Splitting wealth among many different assets to reduce risk.

Interest rate, p. 3. The cost of borrowing funds (or the payment for lending funds), usually expressed as a percentage of the amount borrowed.

Liquidity, p. 13. The ease with which an asset can be exchanged for money.

Monetary policy, p. 11. The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives.

Money, p. 3. Anything that is generally accepted in payment for goods and services or to pay off debts.

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Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

Dividend, p. 3. A payment that a corporation makes to its shareholders.

Money supply, p. 3. The total quantity of money in the economy.

Federal funds rate, p. 12. The interest rate that banks charge each other on short-term loans.

Federal Reserve, p. 11. The central bank of the United States; usually referred to as “the Fed.”

Portfolio, p. 8. A collection of assets, such as

Financial asset, p. 2. An asset that represents a claim on someone else for a payment.

Financial crisis, p. 16. A significant disruption in the flow of funds from lender to borrowers.

Financial intermediary, p. 4. A financial firm, such as a bank, that borrows funds from savers and lends them to borrowers.

Financial liability, p. 4. A financial claim owed by a person or a firm.

Financial market, p. 2. A place or channel for buying or selling stocks, bonds, and other securities.

Foreign exchange, p. 4. Units of foreign currency.

stocks and bonds.

Primary market, p. 9. A financial market in which stocks, bonds, and other securities are sold for the first time.

Risk sharing, p. 13. A service the financial system provides that allows savers to spread and transfer risk.

Secondary market, p. 9. A financial market in which investors buy and sell existing securities.

Securitization, p. 4. The process of converting loans and other financial assets that are not tradable into securities.

Security, p. 2. A financial asset that can be bought and sold in a financial market.

Stock, p. 3. A financial security that represents partial ownership of a firm; also called an equity.

Information, p. 14. Facts about borrowers and expectations of returns on financial assets.



Chapter Outline

The Coronavirus, Financial Markets, and the Flow of Funds March 16, 2020 was “one of the worst days the financial markets have seen,” according to an article in the Wall Street Journal, due to the effects of the Covid-19 pandemic. As it became clear that the pandemic would cause a significant recession, many investors stopped buying financial assets. Corporations, cities, and school districts all found it difficult to use financial markets to borrow money and so had difficulty paying their bills, including the salaries and wages of their employees. The Federal Reserve took steps to stabilize the financial system and restore the flow of credit to borrowers. A well-functioning financial system is a crucial determinant of economic prosperity. Without an efficient financial system, there will be little borrowing or lending, and so people will be stuck earning low incomes and the country will make very little economic progress.

To see the importance of borrowing and lending to an economy, suppose that you come up with an idea for a company: You design a smartphone application (“app”) that will deliver a textbook chapter to a student’s phone for a limited time for a low price. You have a lot of work to do to get your company off the ground— perfecting the software, designing the page in the app store where you will sell it, negotiating with textbook publishers to gain access to their books, and marketing your idea to students. You will have to spend a lot of money before you receive any revenue from sales. Where will you get this money?

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We can demonstrate the importance of borrowing and lending to an economy by considering the process a company uses to develop a new product. The company will have to spend a lot of money before it receives any revenue from sales of the new product. Nearly every entrepreneur faces the same challenge. The role of the financial system is to channel funds from savers to businesses. During the economic crisis that began in 2007, the financial system was disrupted and large sections of the U.S. economy were cut off from the flow of funds they needed to thrive. The result was the worst recession the world had experienced since the Great Depression. Officials of the U.S. Treasury Department and the Federal Reserve took strong actions to restore financial markets. Although some of these actions were controversial, most economists believe that some government intervention was necessary to pull the economy out of a deep recession.

Teaching Tips This chapter contains two innovations worth noting: (1) An overview of the Federal Reserve System and (2) an overview of the financial crises of 2007-2009 and 2020. Federal Reserve policy plays an important role in most money and banking courses. Because of the variety of new policies the Fed implemented during the financial crisis, many instructors have begun discussing the Fed earlier in their courses. In their own teaching, the authors found that they couldn’t always rely on students recalling the basics of how the Fed operates from their principles courses. So the authors included an overview in this first chapter.

Many students have become more interested in the financial system due to the financial crises of 2007–2009 and 2020. The Covid-19 pandemic will be fresh in the minds of undergraduates and many of their families still bear financial scars from the deep recession of 2007–2009. Some students have formed their opinions of what happened during these episodes based on incomplete or erroneous information.

Discussion of the two financial crises at the beginning of the semester can help to motivate the study of money, banking, and financial markets while also highlighting why students need to grasp the fundamental concepts underlying the financial system, including how financial assets are traded in financial markets, how financial institutions operate, and the role of regulatory agencies (including the Fed).

Instructors who prefer to leave discussion of the Federal Reserve and the financial crises for later in the course should feel free to do so by omitting these sections of the chapter. None of the discussion in later chapters directly requires knowledge of these topics.

1.1

Key Components of the Financial System (pages 2–15) Learning Objective: Identify the key components of the financial system.

There are three major components of the financial system: Financial assets, financial institutions, and the Federal Reserve and other financial regulators.

A. Financial Assets Financial assets can be divided among five categories: money, stocks, bonds, foreign exchange, and securitized loans. Money is anything that people are willing to accept in payment for goods and services or to pay off debts. Stocks, also called equities, are financial securities that represent partial ownership of a firm. When you buy a bond issued by a corporation or a government, you are lending the corporation or the government a fixed amount of money.

Foreign exchange refers to units of foreign currency. Loans that banks could sell on financial markets become securities, so the process of converting loans into securities is known as securitization.

B. Financial Institutions The financial system is made up of two types of financial institutions: (1) banks and other financial intermediaries and (2) financial markets. Funds flow from lenders to borrowers

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Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

indirectly through financial intermediaries, such as banks, or directly through financial markets.

Commercial banks are the most important financial intermediaries. Some financial intermediaries, such as savings-and-loans, savings banks, and credit unions, are legally distinct from banks, although these “nonbanks” operate in a very similar way by taking in deposits and making loans. Other financial intermediaries include investment banks, insurance companies, pension funds, mutual funds and exchange-traded funds (ETFs), and hedge funds. Financial markets are places or channels for buying and selling stocks, bonds, and other securities.

C. The Federal Reserve and Other Financial Regulators The federal government of the United States has several agencies that are devoted to regulating the financial system, including: • The Securities and Exchange Commission, which regulates financial markets • The Federal Deposit Insurance Corporation, which insures deposits in banks • The Office of the Comptroller of the Currency, which regulates federally chartered banks • The Federal Reserve System, which is the central bank of the United States • The Consumer Finance Protection Bureau, which was created by Congress to protect consumers from fraud and deceptive practices in financial markets.

Two of the major roles of the Fed are serving as the lender of last resort and conducting monetary policy. Monetary policy is the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives such as high levels of employment, low rates of inflation, high rates of growth, and stability of the financial system.

Figure 1.2 shows the location of the 12 districts of the Federal Reserve System.

D. What Does the Financial System Do? The financial system provides three key financial services: risk sharing, liquidity, and information. Risk sharing gives savers and borrowers ways to reduce the uncertainty to which they are exposed. Liquidity is a measure of how easily an asset can be converted to cash. The financial system gathers and communicates information about borrowers’ circumstances.

Teaching Tips Solved Problem 1.1, “The Services That Securitized Loans Provide,” shows students how to solve an economic problem by breaking it down step by step. Encourage students to read the Solved Problems in each chapter because this feature can help them solve homework problems on their own and develop the skills they’ll need to perform well on exams.

1.2

The Crises of 2007–2009 and 2020 (pages 15–19) Learning Objective: Provide an overview of the financial crises of 2007–2009 and 2020.

The only episode comparable to the financial crises and recessions of 2007–2009 and 2020 during the past 100 years was the Great Depression of the 1930s.

A. Origins of the 2007-2009 Financial Crisis The origins of the financial crisis lie in large part in the housing bubble of 2000–2005. Many economists believe that changes in the market for mortgages played a key role in the housing bubble. By the 2000s, significant changes had taken place in the mortgage market. First, investment banks became significant participants in the secondary market for mortgages.

Second, by the height of the housing bubble in 2005 and early 2006, lenders had greatly loosened the standards for obtaining a mortgage loan. The decline in housing prices that began

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in 2006 led to rising defaults among subprime and Alt-A borrowers, borrowers with adjustablerate mortgages, and borrowers who had made only small down payments. By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury. Banks began to restrict credit to all but the safest borrowers. The flow of funds from savers to borrowers, on which the economy depends, began to be greatly reduced.

B. The Deepening Crisis and the Response of the Fed and Treasury Some economists and policymakers criticized the Fed and the Treasury for arranging the sale of the investment bank Bear Stearns to JP Morgan Chase in March 2008. The main concern was with moral hazard, which is the possibility that managers of other financial firms would make risky investments if they believed that the government would also save them from bankruptcy.

In September 2008, the Fed and Treasury allowed another investment bank, Lehman Brothers, to go bankrupt. The fallout from the Lehman Brothers bankruptcy had widespread repercussions, including a sharp decline in most types of lending. In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury provided funds to commercial banks in exchange for stock in those banks. These actions by the Fed and the Treasury were meant to restore the flow of funds from savers to borrowers.

C. The Financial Crisis Caused by the COVID-19 Pandemic The financial system suffered an immediate shock from the effects of the Covid-19. By midMarch 2020, many non-essential businesses were closed, reducing revenues and leading firms to lay off workers. Savers and investors became reluctant to lend because they worried that both household and business borrowers might have difficulty repaying loans. The Fed revived some of the lending programs used during the 2007–2009 financial crisis and set up new facilities with the goal of maintaining the flow of funds. The federal government also passed several aid packages. The main aid package was the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a more than $2 trillion spending bill—the largest fiscal policy action in U.S. history. Many economists and policymakers believed the severity of the financial crisis resulting from the Covid-19 pandemic justified the Fed’s use of innovative policies, but some worried that the Fed’s actions in working closely with the U.S. Treasury during the crisis might reduce the Fed’s independence.

1.3

Key Issues and Questions About Money, Banking, and the Financial System (pages 19-21) Learning Objective: Explain the key issues and questions the concerning the financial system.

This section lists the issues and questions that are addressed in the main text, beginning with Chapter 2.

Teaching Tip The “Issues and Questions” in Section 1.3 serve as a roadmap for the topics the book will explore in the remaining chapters.

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 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 1.1 Key Components of the Financial System Learning Objective: Identify the key components of the financial system.

Review Questions 1.1

a. Money: Anything that people are willing to accept in payment for goods and services or to pay off debts. b. Stocks: Financial securities that represent partial ownership of a firm. c. Bonds: Financial securities issued by a corporation or government to borrow money, in exchange for the rights to interest and principal payments. d. Foreign Exchange: Units of foreign currency. e. Securitized Loans: Loans that are tradable–that can be bought and sold in financial markets.

Not every financial asset is a financial security. Only a financial asset that can be bought and sold in a financial market is a financial security.

It is possible that a saver’s asset could be a borrower’s liability. For example, a bond issued by a corporation is a liability to the corporation because it represents a loan that corporation is legally obliged to pay back. From the point of view of the saver who buys the bond, however, the bond is an asset because it represents a financial claim on the corporation that issued the bond.

1.2

With direct finance, one party lends directly to the other party. Buying the stock of a firm’s initial public offering (IPO) is direct financing. Direct financing requires financial markets.

Indirect finance involves three parties: the borrower, the lender, and a financial intermediary who accepts the savings of the first party and independently lends those savings to the other party. A bank is an example of indirect finance because banks accept deposits from savers and lend the funds to borrowers. Indirect finance involves financial intermediaries.

1.3

The financial system is highly regulated because when left largely alone the financial system has experienced periods of instability that have led to economic recessions.

1.4

The Federal Reserve is the central bank of the United States. The president appoints the members of the Board of Governors with the consent of the Senate. The Federal Reserve’s initial responsibility was to act as a lender of last resort. As the financial system and banking system have evolved, the Fed’s role has expanded from being a lender of last resort to include the conduct of monetary policy to manage inflation, unemployment, and the stability of the financial system.

1.5

The financial system provides these services to savers: i. Risk sharing, which allows savers to spread and transfer risk. ii. Liquidity, which is the ease with which an asset can be exchanged for money. iii. Collection and communication of information about borrowers and expectations of returns on financial assets.

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Problems and Applications 1.6

Disagree. Insurance companies specialize in contracts to protect their policyholders from the risk of financial loss. These companies invest the insurance premiums they collect in stocks, bonds, and mortgages. Insurance companies channel funds from savers to borrowers, which makes them financial intermediaries.

1.7

a. A systemic problem is one that is inherent in the system, a problem of the system itself rather than specific firms or institutions. b. While many industries are very important to the economy, banks are critical because of their important role as financial intermediaries in the economy, providing credit to households and businesses. Without bank loans to pay for inventories, help meet payrolls, and fund long-term capital projects, many businesses would have to cut back on operations or shut down.

1.8

a. Affirm is a financial intermediary in the sense that it channels funds from savers (from bank loans, so originally from savers) to borrowers. Borrowers on a peer-to-peer lending site can get a loan that they could not qualify for from a bank and at an interest rate lower than the interest rate charged on credit cards. Savers on a peer-to-peer lending site can get a higher interest rate than they would receive on bank savings accounts, many bonds, and other financial assets. b. Affirm’s borrowers may not meet bank lending standards, or the size of the loans offered by Affirm may be too small to be considered worthwhile by banks.

1.9

An IRA is an individual retirement account, and a 401(k) is a retirement savings plan sponsored by an employer. IRAs and 401(k) accounts allow households to invest in stocks and bonds which have a higher rate of return in the long run than bank deposits, and the income deposited in IRAs and 401(k) accounts is not taxed until the funds are withdrawn during retirement.

1.10

Directly lending your funds to an individual or a business decreases your liquidity (your money would be tied up in the loans); increases your risk (the loans may default); and increases your cost of determining whether the loans would be paid off because you would need to investigate the financial situation of the individual or business you are making a loan to. Depositing your funds in a bank allows you to withdraw your money when needed, transfers the risk of default to the bank, and eliminates your need to evaluate the loan.

1.11

Direct finance would make the process of an individual buying a car or a house much more difficult.

The car or house buyer would either have to accumulate the savings to pay for the car or house or find someone willing to lend them the funds. Direct finance, as opposed to indirect finance through financial intermediaries, incurs more risk, less liquidity, and greater information costs. These drawbacks would increase the interest rate that the lender charges and reduce the quantity of loans.

1.12

Lenders win because borrowers would be more likely to make their mortgage payments.

Borrowers win because they would be better able to afford their mortgage payments.

Securitization slices the mortgages into numerous pieces because the mortgages are bundled together with similar mortgages in mortgaged-backed securities. Securitization makes renegotiating the loan more difficult because the bank does not own the loan; investors who purchased mortgage-backed securities generally own the loan. Moreover, the cost of negotiation with every investor holding the security may be very high. These difficulties substantially reduce the liquidity of mortgaged-backed securities and the amount of risk-sharing they provided during the 2007–2009 financial crisis was much less than expected. Also, the originators of some of the mortgage loans did a poor job of gathering information about the borrowers, particularly borrowers with poor credit histories.

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1.2 The Crises of 2007–2009 and 2020 Learning objective: Provide an overview of the financial crises of 2007–2009 and 2020.

Review Questions 2.1

A bubble is an unsustainable increase in the price of a class of assets. Many economists believe that there was a housing bubble in the United States between 2000 and 2005 because, among other things, housing prices rose rapidly from 2000 to the beginning of 2006 and then fell more than 30% from 2006 to 2009.

2.2

Investment banks became significant participants in the secondary market for mortgages.

Investment banks began buying mortgages, bundling large numbers of them together as mortgage-backed securities, and reselling them to investors. Also, lenders greatly loosened their standards for granting a mortgage loan. A subprime borrower is a borrower with a flawed credit history. Alt-A borrowers are borrowers who simply state their incomes but do not document their incomes.

2.3

The decline in housing prices led to rising defaults among subprime and Alt-A borrowers, borrowers with adjustable rate mortgages, and borrowers who had made only small down payments. As a result, mortgage-backed securities declined in value, causing losses for the investment institutions that owned them.

2.4

The Federal Reserve made loans to commercial banks and to investment banks. Congress passed the Troubled Asset Relief Program (TARP) under which the U.S. Treasury provided funds to commercial banks in exchange for stock in those banks. The Fed and U.S. Treasury also worked together to find a buyout partner for the investment bank Bear Stearns, and the Fed provided an $85 billion loan to American International Group (AIG). Likewise, the Fed and the Treasury worked together in 2020 to create lending facilities and make loans to businesses and governments affected by the Covid-19 pandemic. The interaction between the Treasury and the Fed has caused some concern about the independence of the Fed.

Problems and Applications 2.5

There can be no bubble in automobiles and refrigerators because those products do not gain value over time. If an increase in demand causes the prices of automobiles or refrigerators to rise, manufacturers can easily increase production, which should cause prices to quickly fall to their previous levels. Increasing the supply of houses is more time consuming and can be difficult to achieve in some urban areas or in places where zoning restrictions make new construction difficult.

2.6

The primary issue involved in measuring housing prices is that houses are not homogeneous goods. Because no two houses are exactly the same, the price of an “average” house can be difficult to determine. In addition, in constructing an index of housing prices, economists need to decide whether to use the sale price as the value of the house, or the appraised value. Even if the housing index is based solely on selling prices, it may not account for quality improvements (renovations to the home) or declines (the quality of neighborhood schools has deteriorated).

There are many other features of a home or a neighborhood that are not easily identifiable from an index number.

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Introducing Money and the Financial System

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2.7

The secondary mortgage market allows banks to transfer the risk of holding mortgage loans to investors who buy mortgage-backed securities. Access to the funds from these investors allows banks to offer a lower interest rate than if the banks held the loans themselves. The Federal government has intervened in the housing market to promote ownership by creating Fannie Mae and Freddie Mac. The federal government believes that there are positive externalities to home ownership. Neighborhoods become more stable with less litter, vandalism, and crime when more of the people who live there own their homes rather than rent them. Because individual homebuyers don’t take this externality into account when deciding whether to purchase a home, an inefficiently small number of homes may be purchased. Government intervention may result in a more efficient quantity of homes being purchased. Economists and policymakers debate how large the positive externality associated with homeownership may be and whether establishing Fannie Mae and Freddie Mac was the best way to deal with the externality.

2.8

During the financial crisis of 2007–2009, the federal government’s role was largely in helping the Fed to purchase troubled assets and in restoring the flow of funds from savers to borrowers.

The disruption in the flow of funds during this period was the worst since the Great Depression of the 1930s. During the Covid-19 crisis, the federal government was faced with the unusual situation of many businesses being closed or operating at reduced capacity because of orders from mayors and governors or because consumers were reluctant to dine in restaurants, go to movies or plays, or attend sporting events for fear of contracting the virus. As a result, the federal government took a far more active role than it had during the 2007–2009 financial crisis, particularly in supplementing unemployment benefits and sending checks to most families, as well as acting with the Fed to facilitate lending to a number of sectors of the economy.

Data Exercises D1.1

The first graph that follows shows the annual percentage change in real GDP (in chained 2009 dollars) for 2000–2020. The second graph that follows and the data from Figure 1.3(b) is updated and changed to a quarterly frequency and percentages change from a year ago.

Movements in real GDP correspond well, but not perfectly, to movements in the Case-Shiller price index of houses from 2000 through 2012. From 2000 through 2005, the Case-Shiller price index of houses increased, as did real GDP. The decline in housing prices, which started in 2006, preceded the decline in real GDP, which began in 2008. Both housing prices and real GDP declined in 2008 and 2009. Real GDP rose through the 2010 to 2019 period, but housing prices did not begin to rise until 2012. In early 2020, the growth rate of real GDP plummeted, but housing prices did not fall, fueled by low mortgage rates and a persistent shortage of housing in some areas.

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Chapter 2 Money and the Payments System 

Brief Chapter Summary and Learning Objectives

2.1

Do We Need Money? (pages 25–28) Analyze the inefficiencies of a barter system.

• Money reduces the transactions costs of exchange as well as other inefficiencies of a barter system.

2.2

The Key Functions of Money (pages 28–32) List and describe the four key functions of money.

• Money serves four key functions in the economy: It acts as a medium of exchange, a unit of account, and a store of value, and it offers a standard of deferred payment.

2.3

The Payments System (pages 32–39) Explain the role of the payments system in the economy.

• The efficiency of the payments system has increased over time as new instruments have reduced the cost of settling transactions.

2.4

Measuring the Money Supply (pages 40–42) Explain how the U.S. money supply is measured.

• There are currently two measures of the money supply in the United States, M1 and M2.

• M1 includes liquid assets that can directly be used as a medium of exchange, while M2 includes short-term assets that are less liquid but can readily be converted to currency and used as a medium of exchange.

2.5

The Quantity Theory of Money: A First Look at the Link Between Money and Prices (pages 42–48) Use the quantity theory of money to analyze the relationship between money and prices in the long run.

• The quantity theory of money helps to explain the long-run relationship between the growth of the money supply and inflation.



Key Terms

Barter, p. 26. A system of exchange in which individuals trade goods and services directly for other goods and services.

Money, p. 25. Anything that is generally accepted as payment for goods and services or in the settlement of debts.

Checks, p. 33. A promise to pay on demand money deposited with a bank or other financial institution.

Payments system, p. 32. The mechanism for conducting transactions in the economy.

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Commodity money, p. 27. A good used as money that has value independent of its use as money.

E-money, p. 36. Digital cash people use to buy goods and services over the Internet; short for electronic money.

Fiat money, 30. Money, such as paper currency, that has no value apart from its use as money.

Hyperinflation, p. 46. Extremely high rates of inflation, exceeding 50% per month.

Legal tender, p. 30. The government designation that currency is accepted as payment of taxes and must be accepted by individuals and firms in payment of debts.

M1, p. 40. A narrower definition of the money supply: The sum of currency in circulation and checking account and savings account deposits.

[In January 2021, the Fed began including savings account deposits in M1.]

M2, p. 40. A broader definition of the money supply: All the assets that are included in M1, as well as time deposits with a value of less than $100,000, savings accounts—including money market deposit accounts—and noninstitutional money market mutual fund shares.

Medium of exchange, p. 28. Something that is generally accepted as payment for goods and services; a function of money.

Monetary aggregate, p. 40. A measure of the quantity of money that is broader than currency; M1 and M2 are monetary aggregates.



Quantity theory of money, p. 43. A theory about the connection between money and prices that assumes that the velocity of money is determined mainly by institutional factors and so is roughly constant in the short run.

Real-time payments system, p. 35. A system that makes checks and other payments available within a few minutes and which operates 24 hours per day, 365 days per year.

Specialization, p. 27. A system in which individuals produce the goods or services for which they have the best ability relative to others.

Standard of deferred payment, p. 29. The characteristic of money by which it facilitates exchange over time; a function of money.

Store of value, p. 28. The accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future—in effect moving your purchasing power forward in time; a function of money.

Transactions cost, p. 26. The costs in time or other resources that parties incur in the process of agreeing and carrying out an exchange of goods and services.

Unit of account, p. 28. A way of measuring value in an economy in terms of money; a function of money.

Wealth, p. 29. The sum of the value of a person’s assets minus the value of the person’s liabilities.

Chapter Outline

The Federal Reserve: Good for Main Street or Wall Street – or Both?

During the 2020 presidential election, President Donald Trump criticized Federal Reserve Chair Jerome Powell for not doing more to lower interest rates and spur the economy. Senators Elizabeth Warren of Massachusetts and Bernie Sanders of Vermont also criticized the Fed, arguing that the Fed focused too much on the interests of financial firms and not enough on the needs of the average person. Many members of Congress and the public also had an unfavorable view of the Fed. And then the Covid-19 pandemic hit. The Fed and the U.S. Treasury offered trillions of dollars of direct and indirect support to businesses and households. The Fed and the Treasury had taken similar actions during the 2007–2009 financial crisis and recession, and many economists credit those actions with saving the financial system from further disruption. It remains to be seen how effective the Fed and the Treasury’s actions will be during the current crisis.

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The source of dissatisfaction among some economists and policymakers with the Fed actions during both periods has to do more with the belief that the Fed had acted contrary to the basic idea embodied in the Federal Reserve Act of 1913, which granted the Fed substantial independence from Congress and the president, but in exchange, the Fed was only to engage in narrowly defined monetary policy. Senators Warren and Sanders, among others, argued that over the years, the Fed has used its independence to pursue policies that favored “Wall Street”—large financial firms—rather than “Main Street”—households and small businesses.

A key reason many countries have granted their central banks considerable independence is that changes in the money supply have effects on the inflation rate. When a central bank is under direct control of the government, the money supply often increases rapidly, and so does the inflation rate. In Zimbabwe, the government ordered the country’s central bank to rapidly increase the money supply to help pay for the government’s spending. The result was an inflation rate that reached an almost unimaginable 15 billion percent in 2008. The extraordinary inflation rates in Zimbabwe contributed to disastrous declines in production and employment. In 2009, in an attempt to rein in inflation, the Zimbabwean government decided to abandon its own currency entirely in favor of the U.S. dollar. More recently, the government of Venezuela also financed much of its government spending by requiring the central bank to print money at a rapid rate. The result was an estimated inflation rate of 10 million percent in 2019.

Teaching Tips For most students, Sections 2.1, 2.2, and 2.4 on the functions and definitions of money should be a review of material they learned in their principles class. You can cover this material briefly with well-prepared students. Section 2.3 discusses the payments system—a term that may be unfamiliar to many students— including electronic funds and blockchain payment technology, which are topics not often covered in principles classes.

Section 2.5 contains material on the quantity theory that is likely to be less familiar to students. Given the debate over the likely outcome of monetary policies that have resulted in large increases in the money supply, students are often interested in this material. For this reason, the authors cover it early in their classes. The material on hyperinflation is interesting to most students and may help to reinforce the discussion of the quantity theory. Nevertheless, if you are pressed for time, you can omit the material.

Similarly, the background on the quantity theory and hyperinflation helps motivate the last section on central bank independence, although discussion of this material can be postponed to later in the course.

2.1

Do We Need Money? (pages 25–28) Learning Objective: Analyze the inefficiencies of a barter system.

A. Barter Barter is a system of exchange in which individuals trade goods and services directly for other goods and services. Sources of inefficiency for barter include (1) the time and effort spent looking for trading partners; (2) each good having many prices (in terms of all other goods with which it can be exchanged); (3) a lack of standardization of the products being traded; and (4) difficulty in accumulating wealth (people need to store various products).

B. The Invention of Money Money reduces transactions costs as well as other inefficiencies of barter. Money allows for specialization, a system in which individuals produce the goods or services for which they have relatively the best ability.

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2.2

The Key Functions of Money (pages 28–32) Learning Objective: List and describe the four key functions of money.

A. Medium of Exchange Medium of exchange describes the role of money as a generally accepted payment for goods and services.

B. Unit of Account Unit of account is the function of money in which money can be used to measure value in an economy.

C. Store of Value Money is a store of value in that it allows for the accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future.

D. Standard of Deferred Payment Money is considered a standard of deferred payment in that it facilitates exchange over time.

E. Remember That Money, Income, and Wealth Measure Different Things Money, like other assets, is a component of wealth, which is the sum of the value of a person’s assets minus the value of the person’s liabilities. A person’s income is equal to his or her earnings over a period of time.

F. What Can Serve as Money?

An asset is suitable to use as money if it is (1) acceptable to (that is, usable by) most people; (2) standardized in terms of quality, so that any two units are identical; (3) durable, so that it does not quickly become too worn out to be usable; (4) valuable relative to its weight, so that amounts large enough to be useful in trade can be easily transported; and (5) divisible, because prices of goods and services vary.

G. The Mystery of Fiat Money Money, such as paper currency, that has no value apart from its use as money is called fiat money. The most important reason paper currency circulates as a medium of exchange is the confidence consumers and firms have that if they accept paper currency they will be able to pass it along when they need to buy goods and services.

2.3

The Payments System (pages 32–39) Learning Objective: Explain the role of the payments system in the economy.

A. The Transition from Commodity Money to Fiat Money Centuries ago, people had difficulty transporting large quantities of gold coins to settle transactions and also ran the risk of being robbed. To get around this problem, beginning around the year A.D. 1500 in Europe, governments and private firms—early banks—began to store gold coins in safe places and issue paper certificates. In modern economies, central banks issue fiat money.

B. The Importance of Checks It can be expensive to transport paper money to settle large commercial or financial transactions.

Checks are promises to pay on demand money deposited with a bank or other financial institution.

C. New Technology and the Payments System Breakthroughs in electronic telecommunication have improved the efficiency of the payments system, reducing the time needed for clearing checks and for transferring funds. Examples of computerized payment-clearing devices include debit cards and payment apps, Automated Clearing House (ACH) transactions, and automated teller machines (ATMs).

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D. The Real-Time Payments Systems A real-time payments system would allow checks and other payments to be cleared electronically so the funds could be available within minutes. The United States has been slow to adopt this technology, compared to Japan and the countries of Western Europe, although the Fed plans to implement FedNow—its real-time payments system—within five years. although the Fed plans to implement a version within five years.

E. E-money, Bitcoin and Blockchain E-money is digital cash used to buy goods and services over the Internet. The use of e-money has increased in recent years. The Fed does not control e-money, so it is essentially a private payments system. One type of e-money is bitcoin, which is a product of a decentralized system of linked computers. To produce bitcoin, people perform calculations necessary to ensure that purchases made with bitcoin are legitimate. Bitcoins can be bought with dollars and other currencies and stored in “digital wallets” on smartphones. Unlike credit card purchases, no record is made of transactions that use bitcoins. Some retailers prefer bitcoin to credit card transactions because bitcoin purchases have lower processing costs. However, some firms question whether bitcoin software can handle large numbers of transactions. Some policymakers fear that investors might manipulate the prices of bitcoins and other virtual currencies. Despite these problems the technology underlying bitcoin, known as blockchain, has the potential to increase the speed, efficiency and security of the payments system. Blockchain and other new payments technologies have led some commentators to predict a coming “cashless society.” But an entirely cashless society may be difficult to achieve. One problem is the high cost of the infrastructure needed for an e-payments system. Another problem is the concern many households and firms have about the potential for computer hackers to violate the privacy of an electronic system.

Teaching Tips Ask students if they have bought items on eBay using PayPal. Next, ask how many of those students would have bought those items if they could not have used PayPal. The discussion that follows should help them to understand how money evolves over time and how increased efficiency of the payments systems allows for increased economic activity.

2.4

Measuring the Money Supply (pages 40-42) Learning Objective: Explain how the U.S. money supply is measured.

Teaching Tips For the upcoming section, Section 2.4 part A, note that in January 2021, the Fed began including savings account deposits in M1. Since the 4th edition of the main book was published in December 2020, that change is not reflected in the definitions of M1 and M2. We will try to adjust definitions in the second printing of the main book.

A. Measuring Monetary Aggregates M1 is a narrow definition of money that includes traditional mediums of exchange: currency in circulation and checking deposits. M2 is a broader definition of money that includes all the assets in M1 as well as short-term investments that can be easily converted to currency including time deposits valued under $100,000, savings deposits, money market deposits held at banks, and noninstitutional money market shares.

B. Does it Matter which Definition of the Money Supply We Use?

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M2 has grown more over time as people increase their holdings of money market mutual fund shares and CDs. M1 has been more volatile, soaring during the recession years of 1990–1991, 2001, 2007–2009, and 2020 as investors desired the safety of liquid assets. The strengths and weaknesses of each measure will be discussed in later chapters.

Teaching Tips There has been much discussion about how the Fed “printed money” and greatly increased the size of the money supply during the financial crises of 2007–2009 and 2020. As a result, some commentators have predicted that the United States will eventually experience much higher rates of inflation. Have students look at Figure 2.2 (both panel (a) and panel (b)) to see how much the money supply grew during the financial crises of 2007–2009 and 2020 (pay particular attention to M2). You can use this figure to reinforce the definitions of the money supply. However, you should save the discussion of the difference between the monetary base and the money supply for a future chapter. Although M1 displays periods of rapid growth, these high growth rates tend not to be sustained. The growth rates of M2 don’t differ as much from their historical behavior.

2.5

The Quantity Theory of Money: A First Look at the Link between Money and Prices (pages 42–48) Learning Objective: Use the quantity theory of money to analyze the relationship between money

and prices in the long run.

A. Irving Fisher and the Equation of Exchange The velocity of money is defined as the number of times a dollar is used to purchase a good or service that’s included in GDP, or V = PY/M, where V is the velocity of money; Y is real GDP, P is the price level (so P × Y is nominal GDP), and M is the money supply. Rearranging terms, we obtain the equation of exchange, M × V = P × Y (which is true by definition). Irving Fisher assumed that the velocity of money is constant to develop the quantity theory of money.

Therefore, if the money supply (M) increases faster than real GDP (Y), an economy will experience inflation (the increase in P).

B. The Quantity Theory Explanation of Inflation We can rewrite the equation of exchange in percentage terms as: the percentage change in M plus the percentage change in V equals the percentage change in P plus the percentage change in Y. Because V is assumed to be constant, the percentage change in V is 0. Therefore, if the money supply (M) increases faster than real GDP (Y), there will be an increase in the percentage change of the price level, which is inflation.

C. How Accurate Are Forecasts of Inflation Based on the Quantity Theory?

Because velocity can move erratically in the short run, we would not expect the quantity equation to provide good forecasts of inflation in the short run. Over the long run, however, there is a strong link between changes in the money supply and inflation.

D. The Hazards of Hyperinflation When there is hyperinflation, prices rise so rapidly that a given amount of money can purchase fewer and fewer goods and services each day. Eventually, households and firms may refuse to accept money at all, in which case money no longer functions as a medium of exchange. When an economy does not use money, the degree of specialization necessary to maintain high rates of productivity breaks down and the economy will fall into a severe recession.

E. What Causes Hyperinflation?

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The quantity theory indicates that hyperinflation is caused by the money supply increasing far more rapidly than the real output of goods and services. The ultimate cause of hyperinflation is usually governments spending more than they collect in taxes, which results in government budget deficits. If private investors are not willing to purchase government bonds and the government controls the central bank, the government will sell the bonds to the central bank.

The central bank increases the money supply to buy the bonds, resulting in monetizing the debt.

F. Should Central Banks Be Independent?

Research has shown that countries with highly independent central banks have lower inflation rates than countries whose central banks have little independence. The more independent a central bank is of the rest of the government, the more it can resist political pressures to increase the money supply, and the lower the country’s inflation rate is likely to be. Policymakers continue to debate whether Congress and the president should change the law to reduce the Fed’s independence, although historically, curtailing the independence of a central bank has resulted in higher inflation rates.

Teaching Tips Have students consider the implications of Figure 2.4 regarding the independence of the Federal Reserve.

For example, ask them to consider what would likely happen to inflation in the United States if Congress reduced the independence of the Fed.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 2.1 Do We Need Money?

Learning objectives: Analyze the inefficiencies of a barter system.

Review Questions 1.1

Barter is a system of exchange in which individuals trade goods and services directly for other goods and services. The costs of a barter system include the transactions cost of searching for trading partners (as a result of the need for a double coincidence of wants); the many prices for each good in terms of every other good it might be exchanged for; a lack of standardization of goods being exchanged; and the difficulty of accumulating wealth by storing goods.

1.2

Commodity money is a good used as money that has value independent of its use as money.

Cigarettes and gold are two examples of commodity money.

1.3

Specialization is a system in which individuals produce the goods or services for which they have relatively the best ability. Specialization increases productivity. By specializing, people as a whole are far more productive than they would be if they tried to produce all the goods and services they consume themselves.

Problems and Applications 1.4

Yes. The invention of money greatly increases the ease of exchange and moves away from the inefficiency of barter transactions and the requirement of double coincidence of wants. Money therefore facilitates economic activity and has the ability to greatly increase the volume of transactions, allowing markets and economic activity to grow.

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1.5

The primary difference would be that using a deerskin as money incurs a much larger transaction cost because it is bigger/heavier than paper money. In addition, deerskins are not of uniform quality, which is a drawback to using them as money.

1.6

The packs of cigarettes should be considered money because they had displaced the official currency (rubles) as the money used by Moscow taxi drivers and possibly other merchants.

1.7

Cigarettes must have been acceptable to most people (because so many people smoked cigarettes in the World War II period); they have a fairly standard quality (although there would have been some differences across brands); they are relatively durable, they are light (although bulky compared to paper currency); and they are divisible by individual cigarette. Until people were willing to put their faith in a new currency to replace the existing Reichsmark, commodity goods with universal value (cigarettes) were a logical replacement as money. Anyone would have been willing to use cigarettes as money, not just people who smoked, as long as they knew they could use cigarettes to buy other goods and services.

2.2 The Key Functions of Money Learning objective: List and describe the four key functions of money.

Review Questions 2.1

To serve as money, dollar bills and personal checks must generally be accepted as means of payment. Various circumstances might cause you or a business to be reluctant to accept a dollar bill as money. For instance, if prices were rising very fast, you might fear that a dollar bill would lose a significant amount of its value before you could spend it. Or, if you were running a business such as a convenience store, you might prefer that customers pay with a credit card in order to speed up transactions and reduce the risk of robbery. You or a business may not want to accept personal checks if you do not want to bear the cost of receiving bad checks.

2.2

The four main functions of money are to serve as a medium of exchange (generally accepted means of payment); unit of account (all prices expressed in monetary terms); store of value (transferring purchasing power over time); and standard of deferred payment (unit of account for exchange over time).

2.3

No, the store-of-value function is not unique to money. Houses, bonds, and stocks are other examples of stores of value. Money must be a reasonable store of value to function as a medium of exchange. People will not accept money for long if it loses value rapidly.

2.4

Commodity money has value beyond its use as currency; fiat money has no intrinsic value.

Problems and Applications 2.5

a. Milk can be difficult to transport, milk containers can break or leak, and milk can sour if

not properly refrigerated. b. Each good could be listed in terms of the amount of milk required to exchange for a particular good. However, the value of milk would vary depending on the supply and demand for milk.

These fluctuations would make prices in terms of milk unstable. c. Storing milk is difficult, and it can sour. This attribute would make milk a poor store of value.

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d. Future milk can be promised in exchange for present goods and services. However, changes in the value of milk due to changes in the supply and demand would mean that its future value would be unpredictable.

2.6

a. Wealth increases b. Income increases c. The form you are holding your wealth in changes from cash to an iPhone, but the value of your wealth does not change.

2.7

People who hold a lot of cash and those who wanted to be anonymous when they buy products would gain. As would people who don’t have a credit card or don’t have a bank checking account. Firms such as some convenience stores and other businesses that would prefer not to accept cash because it slows down transactions or exposes them to robbery will lose. Other firms—for instance, automobile dealers—that sell products that have high prices would also lose because their transactions costs would rise from having to handle so much currency.

2.8

a. The $100 bill derives its popularity from making it easier to conduct large cash transactions, which is particularly valuable for illegal activities. Unlike using checks or credit cards, cash transactions don’t leave records that governments can consult when investigating a crime. b. Answers will vary, but some choices might be: the value of criminal transactions, the percentage of these transactions that involve cash, the type of cash used, and the alternative payment methods for criminals and terrorists. Because these activities are illegal, it is difficult to collect data on them.

2.9

a. The demand for $100 bills exceeds the demand for lower-denomination bills because $100 bills make it easier to conduct large cash transactions that involve illegal activities. b. People in emerging markets might use U.S. currencies rather than the currencies issued by their governments because of soaring inflation rates in their domestic economies, which dramatically decrease the purchasing power of their currencies. People in emerging markets may also be using U.S. currencies to conduct illegal activities across country borders.

2.3 The Payments Systems Learning objective: Explain the role of the payments system in the economy.

Review Questions 3.1

The Fed cares about payments systems in part because these payments are facilitated by FedWire and in part because the efficiency of the payments system determines the speed and security of interbank transactions. A real-time payments system makes checks and other payments available within a few minutes and operates 24 hours a day. The primary advantage of a real-time payments system is the speed of access to funds.

3.2

It was expensive to transport gold and silver coins. Paper currency lowered the cost of transactions. Paper currency also allowed governments to put money in circulation beyond the governments’ holdings of gold and silver.

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Blockchain is technically a distributed ledger, or an online network that registers ownership of funds, securities, or any other good, including movies and songs. Blockchain allows individuals and businesses around the world to settle transactions instantly and securely on encrypted sites.

It is likely that more transactions in the United States will be cashless in the future, but it is unlikely that cash will be eliminated. First, the infrastructure for an e-payments system is expensive to build, and second, many people want the option to use cash for privacy purposes.

Finally, lower-income people may lack the means to carry out electronic transactions and may have to continue to use cash.

Problems and Applications 3.4

As the stones were destroyed, the value of each remaining stone would increase because there would be fewer stones relative to goods and services. As a result, prices would fall and the economy would experience deflation. If someone found a quantity of new stones, the value of stones would fall because there would be more of them relative to goods and services. As a result, prices would rise and the economy would experience inflation.

3.5

a. Coinage becomes debased when amounts of less valuable metals are mixed in with gold and silver coins. b. Money is only as good as the confidence a person has in its value. Citizens need to trust that money the government creates has exchange value and will be accepted by others. c. “In kind” means to pay for a service or a good with another service or good. Paying in kind would increase the cost of trade and other economic activity, and thereby decrease specialization and the level of real income in the empire.

3.6

Blockchain technology refers to an online network that can register ownership of funds, securities, and other goods, including movies and songs. Blockchain allows individuals and businesses around the world to settle transactions instantly and securely on encrypted sites. The ability to direct transactions through blockchain could eliminate banks and other intermediaries, potentially greatly reducing transactions costs.

3.7

Competitors to PayPal would need to have enough merchants and households using their electronic payments system to make the system work and would need enough transactions to spread the overhead costs of setting up the competing electronic payments system. Economists use the phrase “network externalities” when referring to the lower costs that a firm like PayPal has relative to potential entrants to its market. The more merchants and households that use PayPal, the more desirable using the system becomes for other merchants and households, the lower PayPal’s costs are, and the more difficult it becomes for new entrants to compete with it.

3.8

a. These are a real-time payments systems. b. Without a real-time payments system, after being deposited in a bank, a check may take several days to clear. If the delay leaves someone, particularly someone with a lower income, short of funds, the person may have to pay an overdraft fee to a bank or pay the fees charged by check cashing or payday loan firms. Lower-income people who cannot maintain higher bank balances are harmed most by the lack of a real-time payments system, as they may need immediate access to funds.

3.9

a. The benefits to the bank would be the reduction in cost from eliminating ATMs and cash withdrawals and deposits and the reduced likelihood of a bank robbery. The costs would be the loss of customers who prefer using cash, such as older people, people with vision problems, lowincome people, and people with privacy concerns. The bank could gain new customers if the reduction in costs allowed it to handle other transactions more quickly and cheaply.

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b. The bank could measure the benefits from eliminating ATMs and cash withdrawals and deposits by calculating the cost savings from purchasing and maintaining less capital equipment and from hiring fewer workers. The bank could measure the costs by estimating how many customers who prefer using cash they would lose. The bank could also examine the demographics of its customers and determine how many are older people, people with vision problems, or have low incomes, and make a forecast of how many of these customers would switch to other banks.

2.4 Measuring the Money Supply Learning objective: Explain how the U.S. money supply is measured.

Review Questions 4.1

The assets in M1 are more liquid. M1 is the narrow definition of the money supply and includes currency in circulation and checking account deposits, all assets that are highly liquid. M2 is a broader measure of the money supply and includes M1, time deposits with a value of less than $100,000 each, savings accounts, money market deposit accounts, and non-institutional money market mutual fund shares.

4.2

M2 has grown more rapidly. Certificates of deposit, money market mutual fund shares, and other assets that are included only in M2 have grown faster than currency in circulation or checking accounts. The growth of M2 has been more stable than the growth of M1, although as Figure 2.2, panel (b) shows, there have been substantial swings in the growth rates of both measures of the money supply.

Problems and Applications 4.3

Liquidity indicates the ease with which an asset can be converted to money. Ranking from most to least liquid: dollar bill, checking account, savings account, money market mutual fund, corporate stock, gold bar, and house.

4.4

The M1 measure of the money supply includes the assets that are easily used as a medium of exchange and households and firms can easily use checking accounts to buy goods and services.

4.5

a. b. c. d.

Only M2 Only M2 Only M2 Both M1 and M2

4.6

Gold is not used as money in the United States today, so it is not included in either the M1 or M2 definition of the money supply.

4.7

M1 will decrease and M2 will stay the same. M2 includes both the checking account deposit (because M2 includes M1) and the certificate of deposit.

4.8

Credit cards are not a form of money, because they are a debt that is owed to the issuer of the card. A transaction using a credit card is completed only when the credit card debt is paid off— typically using a check.

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The rate of M1 growth could increase rapidly while the rate of M2 growth decreases if people transfer funds from certificates of deposit, savings accounts, money market deposit accounts, and noninstitutional money market mutual funds into checking account deposits (which would increase M1) and into other assets, such as stocks and bonds not included in the measures of the money supply (which would decrease M2). [A note to students and professors: In January 2021, the Fed began including savings account deposits in M1, not M2.]

2.5 The Quantity Theory of Money: A First Look at the Link Between Money and Prices Learning objective: Use the quantity theory of money to analyze the relationship between money and prices in the long run.

Review Questions 5.1

The equation of exchange relates the quantity of money, M, the velocity of money, V, the price level, P, and the level of real GDP, Y as M × V = P × Y. With the velocity of money defined as (P × Y)/M, the equation of exchange is an identity, not a theory. A theory is a statement about the world that might possibly be false.

5.2

The quantity theory of money is a theory about the relationship between money and prices that assumes that the velocity of money is constant (or at least stable). The theory is based on the equation of exchange identity: M × V = P × Y. Assuming that velocity (V) is constant, increases in the money supply that exceed increases in real GDP lead to inflation.

Large increases in the money supply cause hyperinflation. Historically, the large increases in the money supply resulting in hyperinflation were ultimately caused by large government budget deficits, which were paid for by the central bank buying government bonds, thereby increasing the money supply.

5.3

5.4

Pro: The central bank will be independent from direct political influence. For example, in the United States, the independence of the Federal Reserve means that Congress has no direct control over monetary policy. Typically, inflation is lower when a central bank is independent.

Cons: A central bank may have too much power without the checks and balances that come from being overseen by elected members of the government. In addition, the independence of the central bank may make it more difficult for the government to coordinate monetary and fiscal policy.

Problems and Applications 5.5

Rearranging the quantity equation in terms of percentage changes: % ΔV = (%ΔP + %ΔY ) − % ΔM or 1 = (2 + 3) − 4. The value of velocity in 2022 would have increased by 1%.

5.6

Rearranging the quantity equation in terms of percentage changes: % ΔY = (%ΔM + %ΔV ) − % ΔP or 3.8 = (4.5 + 1.1) − 1.8. The value of real GDP in 2018 would have increased by 3.8%.

5.7

Disagree. An increase in the money supply will raise prices, which increases the nominal value of GDP, but real GDP will not necessarily increase (if the economy was already at full employment), although it may increase.

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5.8

The money supply falling, the velocity of money falling, or the money supply increasing more slowly than real GDP—with velocity remaining constant—can all cause a deflation. It is not necessary for the quantity of money to decline for a deflation to occur. Although there is a strong link between money supply and prices, prices can fall without the money supply falling.

For example, if velocity is constant while real GDP increases by 4%, then a 3% increase in the money supply would result in a 1% decline in the price level. During the late nineteenth century in the United States, the money supply increased most years, although the rate of increase was small.

5.9

Inflation reduces the value of money. Fewer transactions using money will occur if inflation is high. At very high rates of inflation, households and firms tend to use barter to exchange goods and services because they fear that holding money even for brief periods will cause them to suffer losses as the purchasing power of the money rapidly declines.

5.10

In order to say this with certainty, you would have to have information on the growth rate of real GDP and on the velocity of money. While the rise in the price level is at least consistent with the quantity theory of money, the rise in the money supply is far larger than the increase in inflation, so changes in velocity or real GDP may account for this (or may not!). Also, prices take time to adjust, so one year of data is not a good representation of a long-run relationship.

5.11 a. The inflation rate is very high because the growth rate of the money supply is very high, which in turn can also cause the velocity of money to increase, further fueling inflation. b. The central bank is controlled by the government and so does not have an independent choice about its monetary policy decisions. The government requires the printing of money to pay for its spending. c. Beating hyperinflation means protecting the real value of your assets. No one can beat hyperinflation because with the rate of inflation so high, money loses value before you can spend it on food or real assets, such as a home or a car, whose prices are constantly and rapidly rising.

5.12

After World War I, reparations left Germany with unrealistic debt obligations. To meet these debt obligations, Germany printed money. Printing large amounts of money caused hyperinflation, which resulted in a collapse in the purchasing power of money and created economic turmoil. As we have seen in this chapter, when money is no longer used as a medium of exchange, an economy reverts to barter, with a resulting decline in specialization and income.

In addition, people with savings accounts, bonds, and other financial assets payable in currency will have some, perhaps all, of their wealth wiped out. It is in the context of this economic turmoil and discontent that the Nazi party eventually gained power. Had there not been economic turmoil in post-WWI Germany, it could be argued Adolf Hitler might not have come to power in 1933.

5.13 a. The Federal Reserve was designed to be independent of Congress and the president in order for the Federal Reserve to make monetary policy decisions in an apolitical way. The more independent a central bank is of the rest of government, the more it can resist political pressures to increase the money supply, and the lower the country’s inflation rate is likely to be. The Fed is much more independent than, say, the Department of Agriculture, which relies on the government for funding and whose officials can be fired at the will of the President. b. The President or a member of Congress might want to influence Fed decisions to achieve political goals, particularly because a better-performing economy can increase a politician’s reelection chances.

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c. There is significant evidence that the degree of independence of central banks is negatively correlated with inflation rates. That is, more independent central banks have been shown to be better at controlling inflation.

Data Exercises

Teaching Tips Note that in January 2021 the Fed began including savings account deposits in M1. Since the 4th edition of the main book was published in December 2020, that change is not reflected in the solutions below.

D2.1

At end of November, 2020: M1 Money Stock = $6,542.7 billion, Currency Component of M1 = $1,962.9 billion, Total Checkable Deposits = $4,579.7 billion. Total Checkable Deposits are the largest component of M1 and Currency is the smallest.

D2.2 a.

Date

M1

M2

M1/M2

2020-11

$6,542.7 billion

$18.997.5 billion

0.344

2015-11

$3,084.4 billion

$12,280.8 billion

0.251

2010-11

$1,836.1 billion

$8,774.0 billion

0.209

b. M1 as a proportion of M2 increased from November 2010 to November 2020. The rise in M1 as a proportion of M2 may be due to the historically low interest rates on short-term financial assets such as savings accounts, money market deposit accounts, small time deposits, and money market mutual funds.

D2.3 a. Using the equation of exchange (M × V = P × Y), M = (P × Y)/V. P × Y equals nominal GDP. See the table below for the data and the calculations of M1 and M2.

Nominal GDP Year/Quarter (billions)

Velocity of M1

Velocity of M2

M1 (billions)

M2 (billions)

2020/3rd

$21,157.1

3.912

1.146

$5,408.3

$18,461.2

1985/3rd

$4,394.6

7.371

1.799

$596.2

$ 2,442.8

b. Both the velocity of M1 and the velocity of M2 declined from 1985 to 2020.

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25

The compound annual rate of change of M2 and the percentage change in the CPI tend to move together, except during recession periods. However, M2 was considerably more volatile.

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Chapter 3 Interest Rates and Rates of Return 

Brief Chapter Summary and Learning Objectives

3.1

The Interest Rate, Present Value, and Future Value (pages 55–63) Use the interest rate to calculate present values and future values.

• People value funds in the future less than they do funds in the present, so funds that will be received in the future need to be discounted to determine their present value.

3.2

Debt Instruments and Their Prices (pages 63–67) Distinguish among different debt instruments and understand how their prices are determined.

• Debt instruments take different forms because lenders and borrowers have different needs. There are four basic categories of debt instruments: simple loans, discount bonds, coupon bonds, and fixedpayment loans.

3.3

Bond Prices and Yield to Maturity (pages 68–72) Explain the relationship between the yield to maturity on a bond and its price.

• The yield to maturity equates the present value of the payments from an asset with the asset’s price today.

3.4

The Inverse Relationship Between Bond Prices and Bond Yields (pages 72–78) Understand the inverse relationship between bond prices and bond yields.

• The reasoning behind the inverse relationship between bond prices and yields to maturity is that if interest rates rise, existing bonds issued when interest rates were lower become less desirable to investors and the prices of those bonds will fall.

3.5

Interest Rates and Rates of Return (pages 79–81) Explain the difference between interest rates and rates of return.

• The rate of return is the return on a security as a percentage of the initial price. The rate of return on a bond includes the coupon payment received and the change in the price of the bond.

3.6

Nominal Interest Rates Versus Real Interest Rates (pages 81-84) Explain the difference between nominal interest rates and real interest rates.

• The real interest rate is the nominal interest rate adjusted for inflation.



Key Terms

Capital Gain, p. 74. An increase in the market price of an asset.

Capital loss, p. 74. A decrease in the market price of an asset.

Compounding, p. 57. The process of earning interest on the principal of an investment and on

Future value, p. 57. The value at some future date of an investment made today.

Interest-rate risk, p. 80. The risk that the price of a financial asset will increase or decrease in response to changes in market interest rates.

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the interest earned, as savings accumulate over time.

Coupon bond, p. 64. A debt instrument that requires multiple payments of interest on a regular basis, such as semiannually or annually, and a payment of the face value at maturity.

Debt instruments (also known as credit market instruments or fixed-income assets), p. 63.

Methods of financing debt, including simple loans, discount bonds, coupon bonds, and fixed payment loans.

Deflation, p. 82. A sustained decline in the price level.

Discount bond, p. 64. A debt instrument in which the borrower repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially.

Discounting, p. 59. The process of determining the present value of funds that will be paid or received in the future.

Equity, p. 63. A claim to part ownership of a firm; stock issued by a corporation.

Financial arbitrage, p. 76. The process of buying and selling securities to profit from price changes over a brief period of time.

Fixed-payment loan, p. 65. A debt instrument that requires the borrower to make regular periodic payments of principal and interest to the lender.



Nominal interest rate, p. 81. An interest rate that is not adjusted for changes in purchasing power caused by changes in the price level.

Present value, p. 59. The value in today’s dollars of funds to be paid or received in the future.

Rate of return, R, p. 79. The return on a security as a percentage of the initial price; for a bond during a holding period of one year, the coupon payment plus the change in the price of a bond divided by the initial price.

Real interest rate, p. 81. An interest rate that is adjusted for changes in purchasing power caused by changes in the price level.

Return, p. 79. The total earnings from a security; for a bond during a holding period of one year, the coupon payment plus the change in the price of the bond.

Simple loan, p. 64. A debt instrument in which the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures.

Time value of money, p. 59. The way that the value of a payment changes depending on when the payment is received.

Yield to maturity, p. 69. The interest rate that makes the present value of the payments from an asset equal to the asset’s price today.

Chapter Outline

Are Treasury Bonds a Risky Investment?

The Treasury sells bonds with a face value of $100 when it needs to borrow money to pay the federal government’s bills. The U.S. government is almost certain to make the payments on these bonds, or in other words, the default risk is effectively zero. Investors generally view these bonds as very safe investments. But in 2020, with the arrival in the United States of the Covid-19 pandemic, some investors and financial advisers believed Treasury bonds were too risky and therefore warned investors not to buy them. Why? In mid-2020, 30-year Treasury bonds—bonds that would mature and pay the owner $100 in 30 years—had an interest rate of less than 1.5%, which was an historic low. In 2020, many investors expected that the inflation rate would remain 2% or less for years into the future. If this expectation proves to be accurate, low interest rates on long-term bonds might be the “new normal.”

Even after the policy actions taken by the Fed and Congress in response to the pandemic. Federal Reserve Chair Jerome Powell and other members of the Federal Open Market Committee still expected that the inflation rate would be 2%, even in the long run. But if Fed policymakers were wrong and inflation increased faster than expected, the Treasury would have to pay higher interest rates on newly issued bonds.

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Suppose you buy a Treasury bond with an interest rate of 1.5%, but the Treasury then begins selling newly issued bonds with interest rates of 5%. You will still receive the same return if you hold the bond to maturity. But if you decide to sell the bond before it matures, it will sell at a lower price because it has a lower interest rate than the one investors would receive by buying newly issued Treasury bonds. The interest rate on the newly issued bonds becomes the market interest rate. You do not face default risk in your investment in the Treasury bond because the Treasury is certain to make the payments due on the bond. But you do face interest-rate risk, which is the risk that the price of your bond will fluctuate in response to changes in market interest rates.

Teaching Tips This chapter may be the most important in the book. Interest rates can be mysterious to some students.

Students who fail at the beginning of the semester to understand the basics of calculating interest rates experience considerable difficulty understanding the subsequent material. So carefully going over this material should pay large dividends to you and your students later in the semester.

The concept of present value is fundamental to interest rate calculations, but many students find it difficult to grasp when first presented. Working through several examples—such as those presented in the text—can be a worthwhile use of class time. You may want to direct students’ attention to Table 3.1 of the text. This table summarizes the relationship between present value, time to maturity, and the interest rate. Students also often have difficulty grasping the difference between the yield to maturity and the rate of return on a financial asset for a given holding period (one year, in the examples in the text). This distinction is important in understanding several important points the authors make later in the text.

Students often find the interpretation of the bond price and bond yield listings to be one of the more interesting and useful exercises in the course. So, it may be worth spending time on the material discussed in the Apply the Concept, “How to Follow the Bond Market: Reading the Bond Tables,” in Section 3.4 of the text. Finally, the distinction between nominal and real interest rates is also worth stressing. A worthwhile class discussion can be centered on the question of how to decide whether a nominal interest rate of, say, 10% is high or low.

You can use the chapter opener, “Are Treasury Bonds a Risky Investment?,” to show how changing interest rates affect the prices of bonds. Begin by stating that a person purchased for $1,000 a bond that pays 2% interest per year. Suppose that newly issued bonds pay an interest rate of 6%. Ask students how much interest they would receive each year if they held the original bond to maturity. Next, ask students whether they would be willing to sell their bonds for $1,000 and use the $1,000 to purchase a new bond yielding 6% interest.

Follow up by asking whether someone would be willing to purchase their bonds for $1,000. If not, would any of your students be willing to accept less than $1,000? Have students explain the reasoning behind their answers. Discuss what would happen to the price of a bond as a result of higher interest rates. Also, discuss how an increase in interest rates affects existing bondholders.

3.1

The Interest Rate, Present Value, and Future Value (pages 55–63) Learning Objective: Use the interest rate to calculate present values and future values.

A. Why Do Lenders Charge Interest on Loans?

Interest on loans compensates lenders for inflation, default risk, and the opportunity cost of waiting to spend money.

B. Most Financial Transactions Involve Payments in the Future Most loans involve future payments to pay off the loans. Interest rates are an important factor in comparing different financial transactions.

C. Compounding and Discounting Economists call the process of earning interest on the principal of an investment and on the interest earned as savings accumulate over time compounding. Funds in the future are worth less than funds Copyright © 2022 Pearson Education, Inc.

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in the present, so the value today of funds received in the future has to be reduced, or discounted, to find their present value. Funds in the future are worth less than funds in the present because: (1) Dollars in the future will usually buy less than dollars can today; (2) dollars that are promised to be paid in the future may not actually be received; and (3) there is an opportunity cost in waiting to receive a payment because you cannot get the benefits of the goods and services you could have bought if you had the money today.

D. Discounting and the Prices of Financial Assets By adding up the present values of all the payments, we have the dollar amount that a buyer will pay for the asset; in other words, we have determined the asset’s price.

3.2

Debt Instruments and Their Prices (pages 63–67) Learning Objective: Distinguish among different debt instruments and understand how their prices are determined.

A. Loans, Bonds, and the Timing of Payments Debt instruments include (1) loans granted by banks and (2) bonds issued by corporations and governments. Debt instruments take different forms because lenders and borrowers have different needs. There are four basic categories of debt instruments: 1. Simple loans: The borrower receives from the lender an amount of funds called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures.

2. Discount bonds: The borrower pays the lender an amount called the face value at maturity but receives less than the face value initially. The interest paid on the loan is the difference between the amount repaid and the amount borrowed.

3. Coupon bonds: The borrower makes interest payments to the lender in the form of coupons at regular intervals, typically semi-annually or annually, and repays the face value at maturity.

4. Fixed-payment loans: The borrower makes periodic payments to the lender. The payments are of equal amounts and include both interest and principal.

3.3

Bond Prices and Yield to Maturity (pages 68-72)

Learning Objective: Explain the relationship between the yield to maturity on a bond and its price.

A.

B.

C.

Bond Prices The price of a coupon bond is equal to the present value of all future payments including coupons and its face value.

Yield to Maturity The yield to maturity equates the present value of the payments from an asset with the asset’s price today. Calculating yields to maturity for alternative investments allows savers to compare different types of debt instruments.

Yields to Maturity on Other Debt Instruments For both simple loans and discount bonds, the yield to maturity is the interest rate that makes the lender indifferent between having the amount of the loan today or the final payment at maturity.

Calculating the yield to maturity for a fixed-payment loan is similar to calculating the yield to maturity for a coupon bond. The yield-to-maturity is the interest rate that ensures that the amount of the loan today equals the present value of the loan payments.

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Teachings Tips Refer students to Solved Problem 3.3, “Finding the Yield to Maturity for Different Types of Debt Instruments,”, which provides a nice summary of how to solve for the yield to maturity for a simple business loan; a government discount bond; a corporate bond, and a student loan.

3.4

The Inverse Relationship Between Bond Prices and Bond Yields (pages 72-78) Learning Objective: Understand the inverse relationship between bond prices and bond yields.

A. What Happens to Bond Prices When Interest Rates Change?

Because the coupon is fixed once a bond is issued, a change in market interest rates affects the present value of future payments and, therefore, affects the price of the bond. Higher market interest rates reduce the price of existing bonds, while lower market interest rates increase the prices of existing bonds.

B. Bond Prices and Yields to Maturity Move in Opposite Directions If a bond’s yield to maturity increases, then the present value of the coupon payments and the face value payment of the bond must decline, causing the price of the bond to decline. The economic reasoning behind the inverse relationship between bond prices and yields to maturity is that if interest rates rise, existing bonds issued when interest rates were lower become less desirable to investors and the prices of those bonds will fall.

C. Secondary Markets, Arbitrage, and the Law of One Price If yields to maturity on comparable securities differ, traders on secondary markets will engage in financial arbitrage, the process of buying and selling securities to profit from price changes over a brief period of time. Prices of securities adjust very rapidly—often within seconds—to eliminate arbitrage profits because of the very large number of traders participating in financial markets and the speed of electronic trading. This description of how prices of financial securities adjust is an example of a general economic principle called the law of one price, which states that identical products should sell for the same price everywhere.

Teaching Tips Encourage students to read the Apply the Concept: “How to Follow the Bond Market: Reading the Bond Tables” because this feature will help them learn how to obtain and interpret real-world information about bonds rather than just understanding theoretical concepts. Also have a brief class discussion of bid and ask prices to reinforce how bond prices are determined by the interaction of buyers and sellers in the bond market.

3.5

Interest Rates and Rates of Return (pages 79–81) Learning Objective: Explain the difference between interest rates and rates of return.

A. A General Equation for the Rate of Return on a Bond The rate of return is the return on a security as a percentage of the initial price; for a bond, this is equal to the coupon payment plus the change in the price of a bond divided by the initial price. In general, the rate of return is the current yield (coupon divided by the initial price) plus the rate of capital gain.

B. Interest-Rate Risk and Maturity Economists refer to the risk that the price of a financial asset will fluctuate in response to changes in market interest rates as interest-rate risk. Bonds with fewer years to maturity will be less affected by a change in market interest rates than would bonds with more years to maturity.

C. How Much Interest-Rate Risk Do Investors in Treasury Bonds Face?

Although Treasury bonds have no default risk, they have significant interest-rate risk.

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Teaching Tips Consider discussing in class a three-year coupon bond that sells for $1,000 with an initial coupon rate of 5%.

Solve for the price of the bond (present value), assuming the yield to maturity is equal to the coupon rate (the answer is $1,000). Now have students determine the new price if the interest rate rises to 6%. Have students note how much the bond price changes (the new price is $973.27). Next, consider what happens to the price if one year passes (the new price is $981.67). Point out to students that the three-year coupon bond now behaves as a two-year bond. Also, point out that the price of the bond doesn’t decline as much as it did when it was a three-year bond (an example of interest-rate risk). This example shows students how the interest-rate risk on bonds rises as the time-to-maturity increases.

3.6

Nominal Interest Rates Versus Real Interest Rates (pages 81-84) Learning Objective: Explain the difference between nominal interest rates and real interest rates.

A nominal interest rate is an interest rate that is unadjusted for changes in purchasing power. The real interest rate is the interest rate adjusted for changes in purchasing power. Because lenders and borrowers don’t know what the actual real interest rate will be during the period of a loan, they must make saving or investing decisions on the basis of what they expect the real interest rate to be. The expected real interest rate is the nominal interest rate minus the expected inflation rate.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 3.1 The Interest Rate, Present Value, and Future Value Learning objective: Use the interest rate to calculate present values and future values.

Review Questions 1.1

Interest provides lenders with an incentive to supply credit. Interest also compensates lenders for inflation, default risk, and the opportunity cost of not being able to spend their money while it is lent.

1.2

After two years, you would have: $1,000 × (1 + 1.02)2 = $1,040.40

1.3

Present value (PV) = $1,200/(1 + 0.05) = $1,142.86

1.4

The price of a financial asset is related to the payments to be received through the present value formula. The price of a financial asset equals the present value of the future payments to be received.

Problems and Applications 1.5

By describing money as “barren,” Aristotle meant that money does not produce anything by itself.

Lenders should not charge interest on loans, according to Aristotle, because money does not produce value by being used as houses and fields do. Aristotle failed to understand the role of credit—that money loaned to another person allows for production of goods and services in the future. For example, with a loan, a small start-up company can invest in new software to improve medical record keeping and an established company can invest in upgrading its computer systems, thereby raising the productivity of its workers.

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1.6

a. CD 1: $1,000 × (1 + 0.05)3 = $1,157.63 CD 2: $1,000 × (1 + 0.08) × (1 + 0.05) × (1 + 0.03) = $1,168.02 You should choose CD 2 because it gives you the largest amount (or highest future value) after three years. b. CD 2: $1,000 × (1 + 0.01) × (1 + 0.01) × (1 + 0.10) = $1,122.11. CD 1 has the higher future value, so you should choose CD 1 rather than CD 2. c. CD 3: $1,000 × (1 + 1.03) × (1 + 1.03) × (1 + 1.07) = $1,135.16. CD 3 has a lower future value than the other two CDs. CD 1 yields the highest future value and is the best investment.

1.7

a. The total value of 25 years of monthly payments is $1,000 × 12 × 25 = $300,000. The present value of the future pension payments would depend on the discount rate used and would be far less than that amount. b. Recall that the lower the interest rate, the higher the present value of a series of payments. Low interest rates would increase the present value of the future stream of pension payments and would therefore increase the value of a lump-sum payment.

1.8

a. No. The one-time payment of $32,088 would occur now, but the reporter’s future pension payments would not start until 14 years have passed. The present value of the future pension payments would depend on the discount rate used and would be far less than $101,520. b. The lower Treasury bond interest rates would increase the present value of the future stream of pension payments. With lower interest rates, the company would need more funds today to be able to invest and generate the future fixed stream of pension benefit payments.

1.9

a. The $145 million is $29 million per year multiplied by 5. The actual value to Chris Sale would be the present value of the future stream of payments, which is less than $145 million. b. PV = $20/(1 + .07) + $20/(1 + .07)2 + $20/(1 + .07)3 = $ 52.49 million.

3.2 Debt Instruments and Their Prices Learning objective: Distinguish among different debt instruments and understand how their prices are determined.

Review Questions 2.1

Debt instruments may be loans granted by banks or bonds issued by corporations and governments.

Equities represent partial ownership of the firm that issues them.

2.2

The four basic categories of debt instruments are simple loans, discount bonds, coupon bonds, and fixed-payment loans. Coupon bonds and fixed-payment loans pay interest before the instrument matures. Fixed-payment loans pay back principal before the instrument matures.

Problems and Applications 2.3

a. b. c. d.

Fixed-payment loan Coupon bond Discount bond Fixed-payment loan

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2.4

Fixed-payment loans are popular with households because as long as the household makes all the required payments, the loan will be completely paid off. There will be no large final payment for the household to worry about as with a simple loan where the whole principal is due, along with the interest, in a lump-sum payment when the loan matures. Given the high prices of cars and houses, most consumers prefer to avoid making single lump-sum payments to pay off loans they take out to buy these goods.

2.5

At time period zero, Ford receives the $1,000 price of the bond. With a 5% coupon rate, Ford pays $50 at the end of each year (assuming annual coupon payments) for 20 years and the par value of $1,000 at the end of the twentieth year.

2.6

Disagree. The payments on a fixed-payment loan, like the student loan, include both interest and principal, so the $104 monthly payments include paying down the principal of the loan as well paying interest on the principal.

2.7

a. The interest payments will “capitalize” means that the interest payments will be added to the principal of the loan. b. Making the interest payments while in college keeps them from being added to your principal, which would increase your monthly payments and the total amount of interest paid on the loan. The financial circumstances of students vary, so postponing making interest payments may be appealing to some students.

3.3 Bond Prices and Yield to Maturity Learning objective: Explain the relationship between the yield to maturity on a bond and its price.

Review Questions 3.1

The yield to maturity is the interest rate that equates the present value of future payments of a debt instrument to its current price. The yield to maturity is a better measure of the interest rate than the coupon rate because the coupon rate does not take into account that the purchase price of a bond may differ from the face value of the bond. An investor buying a bond with a price greater than its par value will be earning an interest rate, as measured by the yield to maturity that is lower than the coupon rate on the bond. An investor buying a bond with a price lower than its par value will be earning an interest rate, as measured by the yield to maturity that is greater than the coupon rate on the bond. = P

3.2

a.

C C C C FV . + + + ... + + 2 3 n (1 + i ) (1 + i ) (1 + i ) (1 + i ) (1 + i )n

b.

Principal = Required loan payment / (1 + i)

c.

F−P . i= P

FP FP FP + + ... + .

2 (1 + i )n d. Loan value = (1 + i ) (1 + i )

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Problems and Applications 3.3

At the 10% interest rate: The present value of $75 one year from now is: $75/(1 + 0.10) = $68.18.

The present value of $85 two years from now is: $85/(1 + 0.10)2 = $70.25.

The present value of $90 three years from now is: $90/(1 + 0.10)3 = $67.62.

Because the present value is highest if you receive $85 in two years, you would prefer to receive that payment.

The 20% interest rate compared to the 10% interest rate puts a higher premium on funds received sooner. At the 20% interest rate: The present value of $75 one year from now is: $75/(1 + 0.20) = $62.50.

The present value of $85 two years from now is: $85/(1 + 0.20)2 = $59.03.

The present value of $90 three years from now is: $85/(1 + 0.20)3 = $52.08.

With an interest rate of 20%, you would prefer to receive a payment of $75 in one year because it has the highest present value.

3.4

The present value of two one-year subscriptions is $60 + $60/(1 + 0.10) = $114.55. The present value of a two-year subscription is the $115 you pay for the subscription. So, you can save a small amount in present value terms if you take out two one-year subscriptions rather than a two-year subscription.

3.5

The following must be true for this bond: $870 = $1,000/(1 + i)2. So, we need to solve for the yield to maturity, i. $870(1 + i)2 = $1,000 (1 + i)2 = $1,000/$870 i = (($1,000/$870)1/2 – 1) × 100 = 7.21%

3.6

a. b. c. d.

$350,000 = $475,000/(1+i)5 $720 = $1,000/(1+i)5 $950 = $80/(1+i) + $80/(1+i)2 + $80/(1+i)3 + $80/(1+i)4 + $80/(1+i)5 + $80/(1+i)6 + $1,000/(1+i)6 $4,000 = $275/(1+i)3 +$275/(1+i)4 +… + $275/(1+i)22

3.7

$450 = $62.5/(1+i)11 + $62.5/(1+i)12 + $62.5/(1+i)13 + ….+ $62.5/(1+i)30 + $1000/(1+i)30

3.8

a. A consol is a bond that pays a fixed coupon payment forever, so it has no maturity date. b. The present value of a consol equals the annual coupon payment divided by the interest rate: PV = C/i. With a 2.5% interest rate, the present value of £40 every year forever equals 40/0.025 = £1,600.

3.9

a. $100,000 = $10,000/(1 + i) + $10,000/(1 + i)2 + … + $10,000/(1 + i)20 b. Thinking in terms of the arithmetic, if Chris dies after 40 years instead of 20 years, we have to add another 20 terms to the right side of the equation in part (a). The only way for the value of those 40 terms to still equal $100,000 is if the interest rate were higher than in part (a).

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3.4 The Inverse Relationship Between Bond Prices and Bond Yields Learning objective: Understand the inverse relationship between bond prices and bond yields.

Review Questions 4.1

A newly issued bond is purchased in a primary market. If an owner of an existing bond decides to sell the bond to another investor, that transaction takes place in a secondary market.

4.2

A capital gain is an increase in the price of an asset. If market interest rates increase, bond prices fall, so you will experience a capital loss.

4.3

The equation for bond prices at the start of Section 3.3 of the text shows that the higher the purchase price of a bond the lower the yield to maturity, and the lower the purchase price of a bond, the higher the yield to maturity. The price of a bond equals the present value of the payments an investor will receive from owning the bond. Because the present value of these payments increases (decreases) when the yield to maturity decreases (increases), the price of the bond and the yield to maturity move in opposite directions.

4.4

Investors hold a stock, bond, or other security for a long period of time in order to collect the payments (dividends for a stock or coupons for a bond) received from owning the security. A trader buys and sells securities hoping to take advantage of price arbitrage over a brief period. Financial arbitrage is the process of buying and selling securities to profit from price changes over brief periods of time.

Problems and Applications 4.5

The price of a bond will be below its face value of $1,000 only if the bond has a coupon rate below the coupon rates on newly issued bonds. For example, a bond with a coupon rate of 3% will see its price fall below $1,000 if similar, newly issued bonds have coupon rates of 5%. Although the owner of the bond with the 3% coupon rate will still receive a payment of the bond’s $1,000 face value if he or she holds the bond to maturity, it may be a number of years before the bond matures. During the years before the bond matures, the owner will be receiving $20 less per year than he or she would receive from owning a newly issued bond. As a result, should the owner of the bond decide to sell the bond, he or she would be willing to accept a price below $1,000.

4.6

Disagree. Interest rates and bond prices are not determined independently, but one determines the other. Interest rates rise because bond prices fall. A drop in bond prices raises the yield on the bond (on the fixed stream of future payments). Conversely, if interest rates rise the present value of the fixed stream of future payments falls, lowering bond prices.

4.7

4.8

a. A fixed income security pays periodic amounts of interest until maturity and then returns the principal at maturity. b. The statement means that if interest rates change, the value of the security (for resale) may rise or fall.

Apple might have to pay a higher coupon rate in the future for a number of reasons, but primarily either because inflation rates have increased or the perceived riskiness of the Apple bonds has increased. If Apple offers higher-coupon bonds in 2024, the price of existing 2020 bonds would fall, since their return is lower.

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4.9

a. A coupon rate of 5% means that the bond pays a $50 annual coupon. A bond’s current yield equals its coupon divided by its current price. So this bond’s current yield is: ($50/$955.11) × 100 = 5.24%. b. The bond’s price is lower than its face value, which raises the yield to maturity above the coupon rate. The yield to maturity on the bond reflects the current market interest rate, while the coupon rate reflects the (lower) market interest rate at the time the bond was first issued.

4.10

Either conditions in the bond market changed with long-term market interest rates rising, or investors became more reluctant to buy Ford’s bonds, perhaps because they believed that Ford’s risk of defaulting on its bonds had increased. In either case, investors were requiring a higher interest rate to invest in Ford’s bonds, so Ford would not have been able to sell bonds with a 7.4% coupon rate.

4.11 a. Banks wanted these mortgage-backed securities because they believed that the return would be higher than similar investments with the same default risk. b. The word “safe” is in quotation marks because ultimately, these mortgage-backed securities proved not to be such safe investments. c. By early 2009, U.S. commercial banks had suffered losses on their holdings of mortgage-backed securities of about $1 trillion.

4.12

Because both bonds were issued by the U.S. Treasury and have the same maturity date, investors will consider the two bonds to be comparable. In these circumstances, financial arbitrage will result in the two bonds having the same yield to maturity. The only way for Bond A, which has a lower coupon rate, to have the same yield to maturity as Bond B, which has a higher coupon rate, is for Bond A to have a lower price than Bond B. Note that even though the two bonds have the same maturity date, we can infer from the fact that they have different coupon rates that they originally had different maturities. For example, Bond B might be a seven-year Treasury note while Bond A is a five-year Treasury note with the same maturity date.

4.13

The analysis is partially correct. There is an inverse relationship between bond prices and bond yields, and the rate of return on the coupon payment is higher if the purchase price is lower.

However, the analysis incorrectly refers to the current yield (the value of the coupon expressed as a percentage of the current price) as the yield to maturity.

3.5 Interest Rates and Rates of Return Learning objective: Explain the difference between interest rates and rates of return.

Review Questions 5.1

Yield to maturity is the return on a bond assuming the bondholder holds the bond for the full maturity. Rate of return is the return over a specific holding period that takes into account the coupon received during the period and any change in the price of the bond during the period.

5.2

Interest-rate risk is the risk that the price of a financial asset will increase or decrease in response to changes in market interest rates. A given change in interest rates has a larger effect on the present value, and therefore the price, of a long-term bond than a short-term bond. Suppose market interest rates rise. The more years until a bond matures, the more years the buyer of the bond will potentially be receiving a coupon rate below the new market rate and, therefore, the lower the price a buyer would be willing to pay.

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Problems and Applications 5.3

To calculate the rate of return (R), we need to add the coupon received to the capital gain and divide by the purchase price of the bond. With a 4% coupon rate, you received a $40 coupon. You also earned a capital gain of: $1,150 − $950 = $200. So, your rate of return during this one-year holding period was: R = (($40 + $200)/$950) × 100 = 25.26%.

5.4

a. By a “stupidly high price,” the columnist likely means a price that is much more likely to fall— causing capital losses for investors holding these bonds—than to rise. For the prices to remain as high as they were when the column appeared, interest rates would have to remain very low, which seems unlikely over periods as long as 50 to 100 years. b. If the bonds sell for very high prices, then any increase in interest rates will lower the present value of the bonds and their prices, resulting in capital losses for investors who own these bonds. c. Because they are government bonds, investors would perceive the default risk as low. Investors may also believe that the U.S. and European economies have entered a period of permanently low interest rates.

5.5

With a coupon rate of 8 3/8 (or 8.375%), you would receive a coupon payment of $83.75. We can calculate the purchase price because we know that the current yield equals the coupon divided by the purchase price: 0.075 = $83.75/P, or P = $83.75/0.075 = $1,116.67. So, you suffered a capital loss of $850 − $1,116.67 = −$266.67. Your rate of return on the bond for the year was: (($83.75 + (− $266.67))/$1,116.67) × 100 = −16.38%.

5.6

Because the coupon rate and the market interest rate are the same, the price you paid equals the face value of $1,000. The fall in the market interest rate one year later to 4% increases the present value of the remaining payments, raising the price of the bond to: $60/(1 + 0.04) + $60/(1 + 0.04)2 + $60/(1 + 0.04)3 + $1,000/(1 + 0.04)3 = $1,055.50. The rate of return you earned on the bond for the year is: (($60 + ($1,055.50 − $1,000))/$1,000) × 100 = 11.55%.

5.7

a. The present value of the bond is $1,000, so the price is $1,000 and current yield is 6%. When the market interest rate equals the coupon rate, the price of the bond will equal its face value and the current yield of the bond will equal the coupon rate. b. The decrease in the market interest rate to 5% increases the present value of the payments received from owning the bond, raising the price of the bond to: $60/(1 + 0.05) + $60/(1 + 0.05)2 + $60/(1 + 0.05)3 + $60/(1 + 0.05)4 + $1,000/(1 + 0.05)4 = $1,035.46. The current yield falls from 6% (recall that when market interest rates are equal to coupon rate, the current yield equals the coupon rate) to: ($60/$1,035.46) × 100 = 5.79%. c. Investors would be willing to pay a price equal to the present value of the $60 coupon payments for three years and the face value of $1,000 at the end of three years. With a market interest rate of 5%, that price equals: $60/(1 + 0.05) + $60/(1 + 0.05)2 + $60/(1 + 0.05)3 + $1,000/(1 + 0.05)3 = $1,027.23. Your total return on the bond equals the $60 coupon you received plus the $27.23 capital gain divided by your purchase price of $1,000: (($60 + $27.23)/$1,000) × 100 = 8.72%. If another investor had bought the bond for a price of $1,035.46 (as calculated in part (b), the investor’s return would have been: (($60 + ($1,027.23 − $1,035.46))/$1,035.46) × 100 = 5.00%. d. Investors would be willing to pay a price equal to the present value of the $60 coupon payments for two years and the face value of $1,000 at the end of two years. With a market interest rate of 10%, that price equals: $60/(1 + 0.10) + $60/(1 + 0.10)2 + $1,000/(1 + 0.10)2 = $930.58. The current yield would equal: ($60/$930.58) × 100 = 6.44%. The investor’s rate of return over the year would be: (($60 + ($930.58 − $1,027.23))/$1,027.23) × 100 = −3.57%.

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3.6 Nominal Interest Rates Versus Real Interest Rates Learning objective: Explain the difference between nominal interest rates and real interest rates.

Review Questions 6.1

Nominal interest rates are not adjusted for inflation. Real interest rates are adjusted for inflation.

6.2

The expected real interest rate equals the nominal interest rate minus the expected inflation rate.

The real interest rate (sometimes called the actual real interest rate) equals the nominal interest rate minus the actual inflation rate.

6.3

TIPS, which stands for Treasury Inflation Protection Securities, are indexed bonds, which means that the Treasury increases the bonds’ principal as the price level rises. Because the principal increases with inflation, so does the interest rate on the bond. An investor would buy TIPS rather than conventional Treasury bonds to protect against increases in inflation.

Problems and Applications 6.4

You would prefer situation i. The interest rate of 10% with an expected inflation rate of 8% would be preferred because the expected real interest rate is lower (2% vs. 4% with situation ii.)

6.5

The difference between the real interest rate and the expected real interest rate exists because the future inflation rate is unknown, which can cause the actual inflation rate to differ from the expected inflation rate. The difference would be more of a concern for a 10-year loan than for a 1-year loan because the actual inflation rate could differ more from the expected inflation rate for a 10-year period than a 1-year period. In particular, if the inflation rate were to be persistently higher over the 10-year period than you had expected when you made the loan, you would be receiving a lower than expected real interest rate during the 10-year period.

6.6

The decline in prices hurt farmers in the late nineteenth century. Deflation was bad for farmers because they would be paying off their loans with dollars that were increasing in purchasing power.

The answer does depend on whether deflation was expected. The expected real interest rate equals the nominal interest minus the expected inflation rate. If the farmers and the bankers lending to them had anticipated deflation, they would have adjusted the nominal interest rate charged on the loans so that farmers would not have ended up paying an unexpectedly high real interest rate. In practice, borrowers and lenders did not fully anticipate the deflation, so farmers and other borrowers ended up paying higher real interest rates than they had expected.

6.7

Nominal interest rate (yield to maturity): (($1,000 − $970.87)/$970.87) × 100 = 3.00% Expected real interest rate: Nominal interest rate − expected inflation rate: 3.00% − 2% = 1.00% Real interest rate: Nominal interest rate − actual inflation rate: 3.00% − 1.00% = 2.00%

6.8

With lower inflation, investors require a lower nominal interest rate. Since the inflation rate is lower, the purchasing power of future bonds payments will decline less (in other words, the present value of the future payments will be higher). So, bond yields will fall as the nominal rate falls.

Data Exercises D3.1

The gap between the 30-year Treasury bond and the 10-year Treasury note is the greatest during late 2009 through early 2014, although it has widened again recently. From 1990 to May 2015, the only time the gap exceeds 1 percentage point is during 2010 through 2013. Prior to 2010, the gap between the 10-year Treasury note and the 3-month Treasury bill was the greatest during May 1992 (3.76 percentage points) and exceeds 3.5 percentage points during 1992, 1993, 2004, 2009, and 2010.

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Since 2010, the gap stayed very large until 2016, when the 3 month began to rise again, but both the 10 year and the 3 month have fallen since the beginning of the pandemic.

D3.2

The gap between the nominal and real 1-year Treasury bill rate equals the inflation rate (percentage change from year ago in the CPI) and was the greatest in the early 1990s, exceeding 6 percentage points during the 1992 recession. Note in the following graph that the 1-year Treasury bill rate does not exist for September 2001 through May 2008 because the U.S. Treasury didn’t issue these securities during this period. Since 2008, the real return on the 1-year has largely been negative, with brief rises into positive territory in early 2015 (when real and nominal rates briefly converged) and in early 2019. Real rates briefly spiked in May of 2020, but since then, both real and nominal rates have fallen.

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TIPS, Treasury Inflation-Protection Securities, are indexed bonds. The interest rate on the 10-year Treasury TIPS is a real interest rate, while the interest rate on the 10-year Treasury note is a nominal interest rate. The difference between the two interest rates provides a measure of the average annual expected inflation rate over the upcoming 10 years. The gap was the greatest in March 2005 at 2.71 percentage points and was generally higher in 2004 through 2006 than in other periods.

D3.4 a. For December 2020: Real 30-year Conventional Mortgage Rate = 2.72% – 2.6% = 0.12% Real BofA Merrill Lynch US Corporate AAA Effective Yield = 2.29% – 2.6% = −0.31% Real 3-Month Treasury Bill = 0.09% – 2.6% = −2.51% Real 10-Year Treasury Constant Maturity Rate = 0.87% – 2.6% = −1.73% b. Lenders will be worse off if the actual inflation rate exceeds the expected inflation rate because the actual real interest rate will be below the expected real interest rate.

D3.5 a. The 1-year Treasury bill rate was 0.12% for November 2020, 1.53% for November 2019, and 2.60% for November 2018. The price of a 1-year $1,000 Treasury bill equals 1000/(1 + i), where i is the interest rate. Using this equation, the price for the 1-year $1,000 Treasury bill for November 2020 is $998.80, for November 2019 is $984.93, and for November 2018 is $974.66. b. As the interest rate on the Treasury bill increases, the price decreases. There is an inverse relationship between the price and bond yields.

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Chapter 4 Determining Interest Rates 

Brief Chapter Summary and Learning Objectives

4.1

How to Build an Investment Portfolio (pages 94–102) Discuss the most important factors in building an investment portfolio.

• The determinants of portfolio choice include: (1) wealth; (2) an asset’s expected rate of return compared with the expected returns on other assets; (3) an asset’s degree of risk compared with the risk from investing in other assets; (4) an asset’s liquidity compared with the liquidity of other assets; and (5) the cost of acquiring information about the asset relative to the cost of acquiring information about other assets.

• To reduce risk, investors typically buy multiple assets, such as shares of stock issued by different companies.

4.2

Market Interest Rates and the Demand and Supply for Bonds (pages 102–112) Use a demand and supply model to determine market interest rates for bonds.

• The demand and supply for bonds determines the prices of bonds and, therefore, their interest rates.

• Changes in the following factors will cause the demand curve for bonds to shift: wealth, expected returns on bonds, risk, liquidity, and costs of information.

• Changes in the following factors will cause the supply curve for bonds to shift: the expected pretax profitability of physical capital investment, business taxes, expected inflation, and government borrowing.

4.3

Explaining Changes in Interest Rates (pages 112-119) Use the bond market model to explain changes in interest rates.

• Any factor that affects the demand or supply of bonds affects bond prices and, therefore, interest rates.

4.4

Interest Rates and the Money Market Model (pages 120–123) Use the money market model to explain how interest rates are determined. ● The money market model shows how the interaction of the demand and supply for money determines the short-term nominal interest rate. ● The money market model assumes that the Federal Reserve is able to set the supply of money at any level it wishes. ● Equilibrium in the money market occurs where the money demand curve crosses the money supply curve.

The Loanable Funds Model and the International Capital Market (pages 129-137) Analyze the determination of interest rates in the international capital market using the loanable funds model.

• In a small open economy, the international capital market determines the domestic real interest rate because the domestic demand and supply for funds is too small to affect the world real interest rate.

4.5

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• A large open economy is an economy that is large enough to affect the world real interest rate. ● Factors that cause the demand and supply of funds to shift in a large open economy will affect the

world interest rate, not just the interest rate in that economy.



Key Terms

Diversification, p. 100. The division of wealth among many different assets to reduce risk.

Expected return, p. 95. The rate of return expected on an asset during a future period.

Fisher effect, p. 114. The assertion by Irving Fisher that the nominal interest rises or falls point-for-point with changes in the expected inflation rate.

Idiosyncratic (or unsystematic) risk, p. 100.

Risk that pertains to a particular asset rather than to the market as a whole, as when the price of a



particular firm’s stock fluctuates because of the success or failure of a new product.

Market (or systematic) risk, p. 100. Risk that is common to all assets of a certain type, such as the increases and decreases in returns on stocks resulting from the business cycle.

Money market model, p. 120. A model that shows how the short-term nominal interest rate is determined by the demand and supply for money.

Risk, p. 96. The degree of uncertainty in the return on an asset.

Key Terms - Appendix

Closed economy, p. 132. An economy in which households, firms, and governments do not borrow or lend internationally.

Open economy, p. 132. An economy in which households, firms, and governments borrow and lend internationally.

Large open economy, p. 134. An economy in which changes in the demand and supply for loanable funds are large enough to affect the world real interest rates.

Small open economy, p. 133. An economy in which the quantity of loanable funds supplied or demanded is too small to affect the world interest rate.



Chapter Outline

Why Are Interest Rates So Low? During the financial crisis that began in 2007, interest rates, including those banks offered to depositors, fell sharply. By 2009, interest rates fell below 1%, where they remained for more than 10 years. The arrival of the Covid-19 pandemic in the United States during 2020 pushed most interest rates even lower. Some savers responded to low interest rates on bank deposits—including certificates of deposit (CDs—by purchasing Treasury bonds or corporate bonds, although interest rates on these bonds were also low. Because bond investors would suffer significant losses if interest rates rose to their historical averages, financial advisors warned investors that bonds could be risky.

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Teaching Tips The chapter begins with a brief overview of the basics of portfolio selection. The material is worth devoting some class time to because it is the basis for the discussion of interest rate determination in the remainder of the chapter. In addition, the text will return to some of the material when topics such as the behavior of financial institutions and innovations in financial markets and institutions are discussed. Students generally find this material interesting because it provides a rough guide to personal finance (see, for example, the Apply the Concept, “Does Your Portfolio Have Enough Risk?” in Section 4.1).

Sections 4.2 and 4.3 present a demand and supply model for bonds that determines interest rates. Students tend to find this approach intuitive and, of course, it is consistent with the basic demand and supply model for goods and services that they will have learned in their principles course. This approach has the drawback, though, that the graphs show the determination of bond prices, while most discussion of the bond markets in the book focuses on bond interest rates. The arithmetic determining bond prices links the price of a bond to its yield to maturity, so that as the bond price is determined so is the interest rate. You may want to direct students to Figure 4.1 and the accompanying discussion, where this important point is illustrated.

The appendix of the chapter uses the loanable funds model to present a basic analysis of the international capital market. Instructors who are pressed for time can omit this section with no loss of continuity. If you cover this section, it may be worth spending class time on Table 4A.1 of the text, which provides an overview of the loanable funds and the demand and supply for bonds approaches to determining interest rates.

4.1

How to Build an Investment Portfolio (pages 94–102) Learning Objective: Discuss the most important factors in building an investment portfolio.

A. The Determinants of Portfolio Choice The determinants of portfolio choice include wealth, an asset’s expected rate of return compared with the expected returns on other assets, an asset’s degree of risk compared with the risk from investing in other assets, an asset’s liquidity compared with the liquidity of other assets, and the cost of acquiring information about the asset relative to the cost of acquiring information about other assets.

An increase in wealth tends to increase the demand for most financial assets. Demand for some assets, such as CDs, stocks, and bonds, are likely to increase more, while other assets, such as checking accounts, increase less. People choose to acquire assets with higher expected rates of return. When estimating expected returns, investors need to consider possible returns and the probability of those returns occurring. Risk is the degree of uncertainty in the return of an asset.

Most investors are risk averse and will choose to invest in a risky asset only if they are compensated by receiving a higher return. As a result, there tends to be a trade-off between risk and return. The greater an asset’s liquidity, the more desirable the asset is to investors. Therefore, an investor will be willing to receive a lower return on a liquid asset compared to an asset that is less liquid. Investors find assets more desirable if they do not have to spend much time or money acquiring information about them. All else equal, investors will accept a lower return on an asset that has lower costs of acquiring information.

B. Diversification To reduce risk, investors typically buy multiple assets, such as shares of stock issued by different companies. Diversification can eliminate idiosyncratic risk, the risk associated with a particular asset. Much of the remaining risk is market risk or systematic risk, which is common to all assets of a certain type. Diversification cannot eliminate systematic risk.

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Teaching Tips In Apply the Concept: “Will a Black Swan Eat Your 401(k)?,” the authors introduce the concept of a “black swan” event, a term that was developed by Nassim Taleb, a professional investor and professor at New York University. The basic idea of a black swan is that occasionally there are “unique” events that take place (more often than people think) that have a significantly adverse effect on returns. In an article titled “Preparing for the Next Black Swan” in the Wall Street Journal (August 21, 2010), Taleb points out that diversification may not be sufficient in reducing risk when there are black swan events. For example, during the financial crisis in late 2008, virtually all asset classes declined in value at the same time. Instead of relying only on diversification, investors may instead want to use various forms of derivatives to prepare for black swans. But there is no free lunch because there are costs involved in purchasing derivatives while they may not often need to be used. The authors explore this topic further in Chapter 7, “Derivatives and Derivatives Markets.”

4.2

Market Interest Rates and the Demand and Supply for Bonds (pages 102–112) Learning Objective: Use a demand and supply model to determine market interest rates for bonds.

A. A Demand and Supply Graph of the Bond Market The demand curve for bonds represents the relationship between the price of bonds and the quantity of bonds demanded by investors, holding constant all other factors. As the price of bonds increases, the interest rate on the bonds falls and bonds become less desirable to investors, so the quantity demanded will decline, resulting in a downward-sloping demand curve. The supply curve represents the relationship between the supply of bonds and quantity of bonds supplied by investors who own existing bonds and by firms that are considering issuing new bonds. As the price of bonds increases, the interest rate on the bonds falls and holders of existing bonds will be more inclined to sell them, resulting in an upward-sloping supply curve. An excess supply of bonds leads to a lower bond price and, therefore, a higher interest rate, whereas an excess demand for bonds leads to a higher bond price and a lower interest rate.

B. Explaining Changes in Equilibrium Interest Rates Along a given demand or supply curve for bonds, we hold constant everything that could affect the willingness of investors to buy bonds or firms and investors to sell bonds—except for the price of bonds. If any other relevant variable—such as wealth or the expected rate of inflation—changes, then the demand (or supply) curve shifts and we have a change in demand (or supply).

C. Factors that Shift the Demand Curve for Bonds An increase in wealth increases the demand for bonds. If the expected return on bonds rises, relative to expected returns on other assets, then investors will increase their demand for bonds and the demand curve for bonds will shift to the right. If expected inflation increases, the expected real interest rate will decline, reducing the demand for bonds. An increase in the risk of bonds, relative to the riskiness of other assets, decreases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the left. If the liquidity of bonds increases, investors demand more bonds at any given price and the demand curve for bonds shifts to the right. Lower information costs for bonds causes the demand curve for bonds to shift to the right.

Teaching Tips Periodically, some European countries—particularly Greece, Portugal, Italy, and Spain—have experienced sovereign debt crises. Have students discuss what actions investors might take if they come to believe that a government might default on its bonds. Be sure to indicate that when global investors flee from riskier government bonds to government bonds that are perceived to be safe havens—such as those of Germany and the United States—interest rates on those safer bonds decline and interest rates on the riskier bonds rise.

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D.

Factors That Shift the Supply Curve for Bonds An increase in firms’ expectations of the profitability of investments in physical capital will, holding all other factors constant, shift the supply curve for bonds to the right as firms seek to finance new investment. When the government raises business taxes, the profits firms earn on new investments in physical capital decline and firms will issue fewer bonds, causing the supply curve for bonds to shift to the left. An increase in the expected inflation rate results in a decline in the real interest rate for any given nominal interest rate, causing the supply curve for bonds to shift to the right. If the government runs a larger budget deficit, it will need to issue more bonds, causing the supply curve for bonds to shift to the right. If the government runs a deficit, households may save more in anticipation of higher future tax payments, causing the demand curve for bonds to shift to the right. However, studies indicate that households do not increase their saving by the full amount of the budget deficit; therefore, all else equal, bond prices are likely to decline and interest rates increase.

Teaching Tips Encourage students to spend some time reviewing the following tables: Table 4.2, “Factors That Shift the Demand Curve for Bonds.”

Table 4.3, “Factors That Shift the Supply Curve for Bonds.”

4.3

Explaining Changes in Interest Rates (pages 112–119) Learning Objective: Use the bond market model to explain changes in interest rates.

A. Why Do Interest Rates Fall During Recessions?

During recessions, wealth declines as does the expected profitability of investments. The decline in wealth shifts the demand curve for bonds to the left, putting downward pressure on bond prices, while the decline in the expected profitability of investment causes the supply curve for bonds to shift to the left, putting upward pressure on prices. U.S. data show that interest rates decline during recessions, indicating that the supply curve shifts more than the demand curve, resulting in higher bond prices.

B. How Do Changes in Expected Inflation Affect Interest Rates? The Fisher Effect Higher expectations of inflation reduce the expected real interest rate, causing the supply curve for bonds to shift to the right and the demand curve for bonds to shift to the left. As a result, the price of bonds declines and the interest rate on bonds increases. This result is consistent with the Fisher effect, which states that the nominal interest rate increases one-for-one with changes in expected inflation. Economists have found that various real-world frictions result in nominal interest rates not always increasing or decreasing by exactly the amount of a change in expected inflation.

4.4

Interest Rates and the Money Market Model (pages 120–123) Learning Objective: Use the money market model to explain how interest rates are determined.

A. The Demand and Supply for Money The money market model shows how the interaction of the demand and supply for money determines the short-term nominal interest rate. The demand for money curve slopes downward because when nominal interest rates on financial assets are low, the opportunity cost of holding money is low and the quantity of money demanded is high; when interest rates are high, the quantity demanded of money demanded will be low.

B. Shifts in the Money Demand Curve Changes in variables other than the interest rate cause the demand for money to shift. The two most important of these variables are real GDP and the price level.

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C. Equilibrium in the Money Market

Assuming that the Federal Reserve is able to set the supply of money at the level it chooses, the money supply curve is a vertical line and changes in the nominal interest rate have no effect on the quantity of money supplied. Equilibrium in the money market occurs where the money demand curve crosses the money supply curve. In the short run the Fed can cause a decline in the short-run nominal interest rate by increasing the money supply, but long-term interest rates play a more important role in the financial system than short-term interest rates.

4.A

The Loanable Funds Model and the International Capital Market (pages 129–137) Learning Objective: Use the loanable funds model to determine the interest rate in the international capital market.

A. The Demand and Supply for Loanable Funds The demand curve for loanable funds, which shows the relationship between the quantity demanded for loanable funds and the interest rate, is equal to the supply of bonds. The supply curve for loanable funds, which relates the quantity of loanable funds supplied to the interest rate, is equal to the demand for bonds.

B. Equilibrium in the Bond Market from the Loanable Funds Perspective Any of the factors that cause the demand curve for bonds to shift will cause the supply curve for loanable funds to shift. Similarly, any of the factors that cause the supply curve for bonds to shift will cause the demand curve for loanable funds to shift. Interest rates will adjust to ensure that the quantity demanded for loanable funds equals the quantity supplied of loanable funds.

C. The International Capital Market and the Interest Rate Nearly all economies are open economies, where financial capital, or loanable funds, is mobile internationally. Borrowing and lending takes place in the international capital market, which is the capital market in which households, firms, and governments borrow and lend across national borders. The world real interest rate is the interest rate that is determined in the international capital market. A closed economy is an economy that has no interaction in terms of trade or finance with other countries.

D. Small Open Economy In a small open economy, the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate. A small open economy’s domestic real interest rate equals the world real interest rate as determined in the international capital market. If the quantity of loanable funds supplied domestically exceeds the quantity of funds demanded domestically at that interest rate, the country invests some of its loanable funds abroad. If the quantity of loanable funds demanded domestically exceeds the quantity of funds supplied domestically at that interest rate, the country finances some of its domestic borrowing needs with funds from abroad.

E. Large Open Economy A large open economy is an economy that is large enough to affect the world real interest rate. The interest rate will adjust until the excess supply (demand) of loanable funds from the large open economy equals the excess demand (supply) for loanable funds in the rest of the world, resulting in the domestic real interest rate equaling the world real interest rate. Factors that cause the demand and supply of funds to shift in a large open economy will affect not just the interest rate in that economy, but the world real interest rate as well.

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Teaching Tips For years, the United States has experienced huge net capital inflows. Some people are concerned about borrowing from abroad. Have students discuss what would happen to real interest rates in the United States if the country restricted borrowing from overseas (to take the extreme case, what would happen if the United States became a more closed economy).

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 4.1 How to Build an Investment Portfolio Learning objective: Discuss the most important factors in building an investment portfolio.

Review Questions 1.1

There are five determinants of asset demand: (1) The amount of wealth a saver has; (2) the expected rate of return on an asset compared with the expected return on other assets; (3) the comparative risk from owning an asset compared with the risk of owning other assets; (4) the comparative degree of liquidity of an asset compared with the liquidity of other assets; and (5) the comparative degree of the cost of acquiring information about an asset compared with the cost of obtaining information on other assets.

1.2

The expected return is the rate of return expected on an asset during a future period. Risk is the degree of uncertainty in the return on an asset. Most investors are risk averse. Risk-averse investors have an aversion to risk, meaning that when choosing between two assets with the same expected return they would choose the asset with the lower risk.

1.3

The higher the risk that an asset has, the lower the demand for the asset, which raises the yield or return. Low-risk assets have a high demand, which lowers their yield or return. So, for an investor to attain a higher expected return, the investor typically has to accept greater risk.

1.4

Market risk is the risk that is common to all assets of a certain type because of shared economic conditions. Idiosyncratic risk is the risk that pertains to a particular asset, such as an individual stock, rather than to the market as a whole. Diversification is the process by which individuals or firms allocate savings among many different assets. Diversification can eliminate idiosyncratic risk but not systematic risk. Diversification reduces risk because when investors purchase a variety of different assets, if one asset performs poorly the rest of the portfolio may perform well.

Problems and Applications 1.5

a. A diversified portfolio has a variety of assets rather than a single asset (or asset class). b. Diversifying a portfolio reduces risk. In the extreme case, if a portfolio contains only a single asset, its value is determined entirely by what happens to this asset. In a diversified portfolio, losses for one asset or asset class can potentially be offset by gains in another, reducing risk.

1.6

a. A black swan situation is an event that happens very rarely and has a large effect on society. b. A black swan event is surprising and contrary to previous experience. These events are hard to predict because the likelihood of them happening is statistically very low. The coronavirus pandemic is a black swan event. Many of the other factors that affect the demand for oil are far more predictable.

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1.7

a. 401(k) plans are a company-sponsored retirement plan, where you can save for retirement by investing part of your salary in financial assets. Taxes aren’t paid until the money is withdrawn from the account. A retirement portfolio is a selection of assets, usually stocks and bonds, in a 401(k) or other type of retirement account. b. Younger investors can take advantage of long-term gains from riskier investments, such as stock funds, without worrying much about short-term variability in returns. Older investors do not have as much time to recover from market losses and so are usually better off with a more conservative portfolio.

4.2

Market Interest Rates and the Demand and Supply for Bonds Learning objective: Use a demand and supply model to determine market interest rates for bonds.

Review Questions 2.1

The demand curve for bonds will shift to the left when any of following occurs: 1. Wealth decreases.

2. The expected returns on bonds relative to other assets decreases.

3. The expected inflation rate increases.

4. The risk on bonds relative to other assets increases.

5. The liquidity of bonds relative to other assets decreases.

6. The cost of obtaining information on bonds relative to the cost of obtaining information on other assets increases.

The supply curve for bonds will shift to the right when any of the following occurs: 1. The expected profitability of physical capital investments increases.

2. Business taxes decrease.

3. Investment tax credits increase.

4. Expected inflation increases.

5. Government borrowing increases.

2.2

The supply curve for bonds slopes up because as the price of bonds increases, their interest rate will fall, and holders of existing bonds will be more willing to sell them. Also, firms will find it less expensive to borrow at the lower interest rate and will issue more bonds. For both of these reasons, the quantity of bonds supplied will increase. The demand curve for bonds slopes down because as the price of bonds increases, the interest rate on the bonds will fall, and the bonds will become less desirable to investors, so the quantity demanded will decrease.

2.3

The excess supply of bonds causes the price of bonds to fall, increasing the quantity demanded and decreasing the quantity supplied. Neither the demand curve nor the supply curve will shift.

Problems and Applications 2.4

a. False: The quantity demanded of bonds falls when the price of bonds increases because the interest rate falls, which makes the bonds less desirable to investors. b. True: The lower the price, the higher the interest rate, which increases the cost of borrowing. c. True: An increase in wealth of investors shifts the demand curve for bonds to the right. A shift to the right in the demand curve will push the price of bonds up and the interest rate on bonds down. d. False: The belief that the U.S. government might default on its bonds would cause the demand for U.S. government bonds to shift to the left, pushing the price of bonds down and the interest rate on the bonds up.

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2.5

Disagree. The situation the student is describing will result in a movement along the demand for bonds curve, not a shift in the demand for bonds. If the interest rate on bonds falls—perhaps due to a decrease in the supply (which would increase the price of bonds and lower the interest rate)—the quantity of bonds demanded falls as the price moves up along the demand curve. The other possibility is that the cause of the fall in interest rates is because of a shift in demand, in which case the statement is still not true as the direction of causality is wrong.

2.6

a. The expected inflation rate will increase, so the demand curve will shift to the left, and the supply curve will shift to the right. The price of bonds will fall, but the effect on quantity depends on the size of the shifts and elasticity of the curves. b. The expected profitability of physical capital investment has increased, so the supply curve shifts to the right and the rapid economic growth increases household income and wealth, so the demand curve will shift to the right. The quantity of bonds will increase, but the effect on the price of bonds depends on the size of the shifts and elasticity of the curves. c. The federal government will be redeeming more bonds than it issues, so the supply curve will shift to the left. The price of bonds rises, and the quantity falls. d. The relative risk of investing in bonds has increased, so the demand curve will shift to the left. The price of bonds falls, and the quantity falls. e. The return to investing in bonds has decreased and the cost of issuing bonds has increased, so the demand curve will shift to the left, and the supply curve will also shift to the left. The quantity of bonds falls, but the effect on the price cannot be determined without information on elasticity and the size of the shifts.

2.7

a. The supply curve shifts to the right, from S1 to S2, reducing the price of bonds, from P1 to P2, and increasing the equilibrium quantity of bonds, from Q1 to Q2, as shown in this graph:

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b. The demand curve shifts to the right, from D 1 to D2, increasing the price of bonds, from P1 to P2, and increasing the equilibrium quantity of bonds, from Q1 to Q2, as shown in this graph:

c. The supply curve shifts to the right, and the demand curve also shifts to the right. These shifts increase the equilibrium quantity of bonds, from Q1 to Q2, but the change in the price of bonds is indeterminate. The graph shows equal shifts in the demand and supply curves, leaving the price unchanged:

2.8

The profitable business opportunities would shift the supply curve to the right from S1 to S2. The boom in stock prices would reduce the expected return on bonds relative to stocks, causing the demand curve for bonds to shift to the left from D1 to D2. As shown in the graph below, the price of bonds would fall, from P1 to P2, but the equilibrium quantity might either rise, fall, or remain unchanged, depending on the relative sizes of the shifts in the demand and supply curves.

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4.3 Explaining Changes in Interest Rates Learning objective: Use the bond market model to explain changes in interest rates.

Review Questions 3.1

Interest rates typically fall during a recession. As the following graph shows, the demand curve for bonds shifts to the left, from D1 to D2, as households experience declining wealth, and the supply curve for bonds shifts to the left, from S1 to S2, as businesses have fewer profitable opportunities during a recession. For interest rates to fall, the price of bonds must rise, so the shift in the supply curve must be larger than the shift in the demand curve:

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According to the Fisher effect, the nominal interest rate rises or falls point for point with changes in the expected inflation rate. An increase in the expected inflation rate causes the demand curve for bonds to shift to the left, from D1 to D2, and the supply curve to shift to the right, from S1 to S2. As a result, the price of bonds falls, from P1 to P2, and the interest rate on bonds rises. The graph shows the Fisher effect working exactly, with the change in the expected inflation rate leaving the quantity of bonds unchanged.

Problems and Applications 3.3

a. The demand curve for bonds will shift to the right, and the supply curve will shift to the left. The price increases, but it is unclear what happens to the equilibrium quantity of bonds. If the shift of the demand curve is greater than the shift of the supply curve, the equilibrium quantity will rise. If the shift of the supply curve is greater than the shift of the demand curve, the equilibrium quantity will fall. b. The demand curve for bonds will shift to the right with the increase in wealth resulting from the expansion, and the supply curve will shift to the right with the increase in profitable opportunities.

During economic expansions interest rates typically rise, so the price of bonds will likely fall, implying that the shift in the supply curve is greater than the shift in the demand curve. The equilibrium quantity of bonds increases. c. The demand curve for bonds shifts to the right, and the supply curve shifts to the left. The price of bonds rises, but the equilibrium quantity of bonds may rise, fall, or remain unchanged depending on whether the demand curve or the supply curve shifts further. d. The supply curve shifts to the right, forcing the price of bonds down and the quantity of bonds up.

This result assumes no increase in household saving in response to higher expected future taxes as a result of the budget deficit.

3.4

The expected profitability of physical capital investment has increased due to rapid economic growth, so the supply curve shifts to the right and the rapid economic growth increases household income and wealth, so the demand curve will shift to the right. The quantity of bonds will increase, but the effect on the price of bonds depends on the size of the shifts and elasticity of the curves.

3.5

a. “Safer assets” means assets with a lower default risk. U.S government securities are viewed as having almost no default risk, so when investors prefer safer assets, they often buy Treasury bonds, increasing demand. b. Lower inflation expectations increases the demand for bonds and reduces the supply of bonds.

Therefore the demand curve shifts to the right, the supply curve shifts to the left, and the price of bonds rises. The effect on quantity depends on the size of the shifts and elasticity of the curves.

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c. As described in the answer to part b., the demand for bonds increases, the supply of bonds decreases, and the equilibrium price rises, as is shown in the following graph. So bond yields fall.

3.6

3.7

The increase in the budget deficit increases the supply of bonds. Deflation presumably causes a decrease in expected inflation, which increases the demand for bonds. With respect to corporate bonds, we would expect that a decrease in expected inflation will also cause a decrease in the supply of bonds. But the Treasury issues bonds to meet the federal government’s spending needs, so the supply of Treasury bonds is not affected by changes in the expected inflation rate. The effect of these shifts on the equilibrium price (and yield) of Treasury bonds is uncertain. If the demand curve shifts to the right more than the supply curve, the equilibrium price of Treasury bonds will rise (and, therefore, the yield on the bonds will fall). But if the supply curve shifts to the right more than the demand curve, the equilibrium price of Treasury bonds will fall (and, therefore, the yield on the bonds will rise). a. The “hunt for yield” refers to the search for assets that have a higher return. b. Corporate bonds, which vary from slightly more risky than Treasuries to very risky, have a higher return than Treasuries. An increase in the demand for corporate bonds raises their price, which in turn lowers their yield.

4.4 Interest Rates and the Money Market Model Learning objective: Use the money market model to explain how interest rates are determined.

Review Questions 4.1

An increase in the nominal interest rate increases the opportunity cost of holding money, causing people to shift funds from money to Treasury bills and other financial assets.

4.2

The Federal Reserve can decrease the short-run nominal interest rate by increasing the money supply as shown in the following graph.

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a. The decrease in the money supply by the Federal Reserve shifts the money supply curve to the left, from MS1 to MS2, raising the interest rate, from ii to i2.

b. A fall in real GDP shifts the money demand curve to the left, from MD1 to MD2, lowering the interest rate, from ii to i2.

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c. An increase in the price level shifts the money demand curve to the right, from MD1 to MD2, raising the interest rate, from ii to i2.

d. The increase in the money supply by the Federal Reserve shifts the money supply curve to the right from, MS1 to MS2, and the fall in the price level shifts the money demand curve to the left, from MD1 to MD2, lowering the interest rate, from ii to i2.

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The increase in the inflation rate shifts the money demand curve to the right, from MD1 to MD2. The Federal Reserve raises short-term nominal interest rates, from i1 to i2, in response to the higher inflation by decreasing the money supply, shifting the money supply curve to the left, from MS1 to MS2.

Data Exercises D4.1

The following table shows the dates of the business cycle peaks and troughs since 1954 and the graph below shows the 10-year U.S. Treasury note rate. The interest rate on the 10-year Treasury note generally goes up before a recession, down during the recession, and back up after the recession. The pattern is similar, but not exactly the same across every recession. (The most recent recession is omitted because as of January 2021, the end date has not been determined.)

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Peak July 1953 August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007

D4.2

Trough May 1954 April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009

The interest rate on long-term UK government bonds was higher than the interest rate on long-term U.S. government bonds from 1957 through February 1982. From March 1982 through December 2020 each interest rate has had periods where it was higher, but the long-term U.S. government bond was higher about 2/3 of the time. Since 1995, the two interest rates have moved closely together.

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The 10-year Treasury note rate minus the 10-year TIPS rate is an estimate of the average annual expected inflation rate for the upcoming 10 years. As the following table indicates, the average annual expected inflation rate increased from 1.57% in November 2015 to 1.71% in November 2020.

Date 2015 November 2020 November

10-Year Treasury Note Rate 2.26 % 0.87 %

10-Year TIPS Rate 0.69 % –0.84 %

Expected Inflation Rate 1.57 % 1.71 %

Appendix: The Loanable Funds Model and the International Capital Market Learning objective: Use the loanable funds model to determine the interest rate in the international capital market.

Review Questions 4A.1 a. Bond Market: The good is the bond.

Loanable Funds: The good is the use of funds. b. Bond Market: The buyer is the bond holder (the saver or investor).

Loanable Funds: The buyer is the borrower. c. Bond Market: The seller is the borrower (a government or a corporation).

Loanable Funds: The seller is the saver. d. Bond Market: The price is the price of the bond.

Loanable Funds: The price is the interest rate.

4A.2

The demand curve is downward sloping because the higher the interest rate, the smaller the quantity of funds demanded because the cost of borrowing is higher. The supply curve is upward sloping because the higher the interest rate, the larger the quantity of funds suppliers (savers) are willing to lend.

4A.3

The bond market approach is most useful when considering how the factors affecting the demand and supply for bonds affect the interest rate. The loanable funds approach is most useful when looking at the flow of funds between the U.S. and foreign financial markets.

Problems and Applications 4A.4 a. The demand curve for loanable funds shifts to the right, from 𝐿𝐿𝐷𝐷1 to 𝐿𝐿𝐷𝐷2 , raising the world real interest rate from rw1 to rw2. See the following graph. b. The supply curve for loanable funds would shift to the right, from 𝐿𝐿𝑆𝑆1 to 𝐿𝐿𝑆𝑆2 , as shown in the following graph. The world real interest rate will fall from the equilibrium E2 in part (a) to an undetermined equilibrium (for example, E3), depending on how much households increase their saving.

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4A.5

The demand curve for loanable funds in the large open economy shifts to the left, from Ld to Ld’, which lowers the world real interest rate somewhat—but not as much as if the country was a closed economy. See the following graph on the left. The decrease in the demand for loanable funds causes an excess supply of loanable funds in the large open economy, making the economy a net international lender and the rest of the world a net international borrower. See the following graph on the right.

4A.6 a. b. c. d.

The demand for loanable funds increases, increasing the equilibrium interest rate.

The demand for loanable funds decreases, decreasing the equilibrium interest rate.

The supply of loanable funds increases, decreasing the equilibrium interest rate.

The supply of loanable funds decreases, increasing the equilibrium interest rate.

4A.7 a. After-tax expected profitability falls, so the demand for loanable funds decreases. b. Expected profitability rises, so the demand for loanable funds increases. c. After-tax interest expense of mortgage loans rises, so the demand for loanable funds decreases.

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4A.8 a. In the following graph, begin with the world real interest rate equal to 3% and the rest of the world as a net international lender and the United States as a net international borrower. An increase in saving in the rest of the world shifts the supply curve for loanable funds in the rest of the world to the right, lowering the world real interest rate to 1%. With the increased saving, the rest of the world increases its international lending, and with the lower world real interest rate, the United States increases its international borrowing.

b. There is a debate over whether the Federal Reserve during Alan Greenspan’s term as chairman (August 1987 – January 2006) was responsible for low interest rates or whether the global savings glut was responsible. If the global savings glut was responsible, we could argue that the Federal Reserve and Greenspan should take less blame for the low interest rates that helped facilitate the housing bubble.

Data Exercises D4A.1 a. Gross government saving represents the combined federal, state, and local government budget surplus or, when negative, budget deficit. b. The government budget was in deficit both in the third quarter of 2016 and the third quarter of 2016.

Gross government saving decreased from the second quarter of 2020 to the second quarter of 2016 from −$388.178 billion to −$2,983.343 billion. c. In the bond market model, government borrowing or government saving affects the supply of bonds, so in the loanable funds model government borrowing or saving affects the demand for loanable funds. The decrease in gross government saving from 2016 to 2020 indicates an increase in government borrowing, which shifts the demand for loanable funds to the right from 𝐿𝐿𝑑𝑑1 to 𝐿𝐿𝑑𝑑2 , increasing the real interest rate from r1 to r2. See the following graph. Assuming gross private saving remains constant, the decrease in government borrowing leaves less private saving to fund private investment.

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Chapter 5 The Risk Structure and Term Structure of Interest Rates 

Brief Chapter Summary and Learning Objectives

5.1

The Risk Structure of Interest Rates (pages 140–153) Explain why bonds with the same maturity can have different interest rates.

• Bonds that have the same maturity may differ with respect to other characteristics that investors believe are important, such as risk, liquidity, information costs, and taxation.

• Bonds with more favorable characteristics have lower interest rates because investors are willing to accept lower expected returns on those bonds.

5.2

The Term Structure of Interest Rates (pages 153–168) Explain why bonds with different maturities can have different interest rates.

• The liquidity premium theory, the most complete theory of the term structure, holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium that increases in value the longer the maturity of the bond.

• The slope of the yield curve shows the short-term interest rates that bond market participants expect in the future and can be used to help forecast inflation and economic activity.

■

Key Terms

Bond rating, p. 141. A single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds.

Default risk (or credit risk), p. 141. The risk that a bond issuer will fail to make payments of interest or principal.

Expectations theory, p. 156. A theory of the term structure of interest rates that holds that the interest rate on a long-term bond is the average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond.

Liquidity premium theory (or preferred habitat theory), p. 163. A theory of the term structure of interest rates that holds that the interest rate on a longterm bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond plus a term premium that increases in value as the maturity of the bond increases.

Municipal bonds, p. 149. Bonds issued by state and local governments.

Risk structure of interest rates, p. 140. The relationship among interest rates on bonds that have different characteristics but the same maturity.

Segmented markets theory, p. 161. A theory of the term structure of interest rates that holds that the interest rate on a bond of a particular maturity is determined only by the demand and supply for bonds of that maturity.

Term premium, p. 163. The additional interest investors require in order to be willing to buy a longterm bond rather than a comparable sequence of shortterm bonds.

Term structure of interest rates, p. 153. The relationship among the interest rates on bonds that are otherwise similar but that have different maturities.

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Chapter Outline

Can You Use Interest Rates to Predict a Recession?

In August 2019, some economists and investors were worried because the interest rate on the 3-month Treasury bill was 2.04%, while the interest rate on the 10-year Treasury note was only 1.50%. Normally, the interest rate on the 10-year Treasury note is higher than the interest rate on the 3-month Treasury bill. Why would an investor accept the deal available in August 2019 and receive less for lending money to the Treasury for 10 years than for lending to the Treasury for only 3 months? Bond markets usually reward investors with a higher interest rate on 30-year Treasury bonds than the interest rate on 3-month Treasury bills.

Some economists thought they knew the answer: An economic recession was on the way. As it turned out, the U.S. economy did not experience a recession during 2019. (Unexpectedly, and for reasons unconnected to what was happening to interest rates, the U.S. economy did experience a recession beginning in February 2020 as a result of the effects of the Covid-19 pandemic.) But why would economists and investors believe that the relationship between two interest rates might signal an impending recession? As we will see in this chapter, important information about the economy is embedded in the relationships among the interest rates of bonds that mature at different times. There is also important information embedded in the relationships among bonds with the same maturity.

This chapter focuses on why there are so many different interest rates in the economy and the importance that differences in interest rates have for savers, business managers, and policymakers.

Understanding the relationship among interest rates of different maturities and the relationship among interest rates on bonds issued by different corporations is one of the keys to understanding how the financial system works.

Teaching Tips This chapter is important for courses that emphasize financial markets and for courses that emphasize policy. It focuses on why bonds with the same maturity may have different yields (the risk structure); why bonds with the same risk, liquidity, and other characteristics, but with different maturities, may have different yields (the term structure); and how the risk and term structures can be used in forecasting.

Students generally have some awareness that interest rates differ, but little understanding of why. The material on the risk structure is usually easily understood, but the material on the term structure typically requires significant amounts of class time.

5.1

The Risk Structure of Interest Rates (pages 140–153) Learning Objective: Explain why bonds with the same maturity can have different interest rates.

A. Default Risk Default risk is the risk that the bond issuer will fail to make payments of interest and principal.

Bonds with higher default risk pay higher interest rates. The default risk premium on a bond is the difference between the interest rate on the bond and the interest rate on a Treasury bond with the same maturity. An increased perceived risk of default leads to a decline in the demand for a bond, resulting in a lower price and a higher interest rate. During recessions, investors seek safety, leading to an increase in the demand for U.S. Treasury bonds and a decrease in the demand for corporate bonds, resulting in a higher risk premium for corporate bonds.

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Teaching Tips In the fall of 2008, at the height of the 2007–2009 financial crisis, the default risk premium for bonds of companies rated Baa by Moody’s surpassed 6%, higher than any time since the 1930s. Have students discuss how this increase in the default risk premium can be used as a measure of the severity of the financial crisis of 2007–2009; that is, as a measure of the difficulty corporations issuing investment-grade bonds have in obtaining credit. You can also use Figure 5.2 to discuss the differences between what happened in the bond market during the 2007–2009 and 2020 financial crises.

B. Liquidity and Information Costs An increase in a bond’s liquidity or a decrease in the cost of acquiring information about the bond will increase the demand for the bond, resulting in a higher price and a lower interest rate.

C. Tax Treatment Investors care about the after-tax return on their investments; that is, the return the investors have left after paying their taxes. Other things equal, a bond with coupons that are not subject to taxes has a lower interest rate than a bond with taxable coupons. The coupons on municipal bonds are typically not subject to federal, state, or local taxes. The coupons on Treasury bonds are subject to federal tax, but not to state or local taxes. The coupons on corporate bonds can be subject to federal, state, and local taxes.

5.2

The Term Structure of Interest Rates (pages 153–168) Learning Objective: Explain why bonds with different maturities can have different interest rates.

A. Explaining the Term Structure One way to analyze the term structure is by looking at the Treasury yield curve, which is the relationship on a particular day among the interest rates on Treasury bonds of different maturities. See Figure 5.4 for the Treasury yield curves for a day in 2007, a day in 2019, and a day in 2020. Any explanation of the term structure should be able to account for three important facts: 1. Interest rates on long-term bonds are usually higher than interest rates on short-term bonds.

2. Interest rates on short-term bonds are occasionally higher than interest rates on long-term bonds.

3. Interest rates on bonds of all maturities tend to rise and fall together.

B. The Expectations Theory of the Term Structure The expectations theory holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond.

According to the expectations theory, investors view bonds of different maturities as being perfect substitutes. Because interest rates on long-term bonds are usually higher than interest rates on short-term bonds, the expectations theory implies that future short-term rates are typically expected to rise at any particular point in time, which is unrealistic.

C. The Segmented Markets Theory of the Term Structure The segmented markets theory assumes bonds with different maturities are in separate markets.

Factors that affect the demand for Treasury bills or other short-term bonds will have no effect on the demand for Treasury bonds or other long-term bonds. Because long-term bonds carry higher interest-rate risk and tend to be less liquid, investors need to be compensated by receiving higher interest rates on long-term bonds than on short-term bonds. The segmented markets theory fails to explain why short-term interest rates are sometimes higher than long-term interest rates as well as why interest rates tend to move together.

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D. The Liquidity Premium Theory

The liquidity premium theory (also known as the preferred habitat theory) holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium that increases in value the longer the maturity of the bond. Table 5.5 summarizes and compares the three theories of term structure of interest rates: the expectations theory, the segmented markets theory, and the liquidity premium theory.

E. Using the Term Structure to Evaluate Market Expectations Under the expectations and liquidity premium theories, the slope of the yield curve shows the short-term interest rates that bond market participants expect in the future. In addition, if fluctuations in expected real interest rates are small, the yield curve contains expectations of future inflation rates. The Fed and many other financial market participants take this approach in using the yield curve to forecast future inflation.

Teaching Tips In early 2021, some policymakers and economists expressed fear that inflation might increase rapidly in the next few years as a result of increases in the money supply and increases in federal government spending. At that time, interest rates on long-term bonds, such as the 5-year and 10-year Treasury bonds, were at historically low levels of about 0.4% and 0.9%, respectively. Have students discuss what these interest rates on bonds imply about the bond markets’ view of future inflation. Are low interest rates on long-term bonds consistent with expectations of rapidly increasing inflation?

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 5.1 The Risk Structure of Interest Rates Learning objective: Explain why bonds with the same maturity can have different interest rates.

Review Questions 1.1

The risk structure of interest rates is the relationship among the interest rates on bonds that have different characteristics but the same maturity. The differences among interest rates on bonds with the same maturities arise from differences among bonds in terms of default risk, liquidity, information costs, and taxation of coupons.

1.2

A bond rating is a single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds. There are three main agencies that produce bond ratings: Moody’s, Standard & Poor’s (S&P), and Fitch. Default risk is the key factor these agencies evaluate when rating bonds.

1.3

Investors value liquidity, so a bond that is illiquid would have less demand compared to an equivalent bond that is liquid. Lower demand means a lower price for the illiquid bond and a higher interest rate. A bond with high information costs would have lower demand than an equivalent bond that has lower information costs. So a bond with high information costs will have a lower price and a higher interest rate than a bond with low information costs.

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1.4

1.5

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There are two types of income an investor can earn on a bond: I.

Interest income from coupons. Coupon payments, when taxed, are taxed at the individual income tax rate. Coupons on corporate bonds are taxed by the federal government and most state and local governments. Coupons on Treasury bonds are taxed only by the federal government. Coupons on municipal bonds issued by state and local governments are typically not taxed.

II.

Capital gains or losses from price changes. Capital gains, in 2020, were taxed at a lower rate than interest income and taxed only if they are realized.

The bond issued by the city of Houston is a municipal bond and its coupons are not subject to federal, state, or local taxes. The bond issued by Apple is a corporate bond and its coupons are subject to federal taxes, and typically also subject to state and local taxes. The coupons of the U.S. Treasury bond are subject to federal tax, but not to state or local taxes

Problems and Applications 1.6

1.7

The bond rating agencies might lower their ratings on a firm’s bonds if conditions at the firm, or in the industry, or in the economy, have worsened and increased the likelihood that the firm might not make the required bond payments. When a company’s rating is lowered, there is less demand for the bond, shifting the demand curve to the left, from D1 to D2, as shown in the following graph.

The shift lowers the price of the bond from P1 to P2 and increases the interest rate on the bond.

a. The term “obligations” refers to bonds issued by corporations. The name comes from the fact that the bond issuer is legally obligated to make payments to the bond holder. b. Credit risk is the risk of default.

1.8. a. The customers of rating agencies are both investors who seek information about bonds and also the firms issuing the bonds, which hire rating agencies to rate their securities. b. Ordinarily, we would expect that new firms entering an industry will force down prices—in this case, the fees rating agencies charge corporations to rate the corporations’ bonds—and increase efficiency by driving less efficient firms out of business. But because of the unusual nature of the bond rating industry, it’s possible that to lure business away from established rating agencies, new firms may be tempted to give corporations higher ratings than are justified by the default risk on the corporations’ bonds. If this outcome occurs, investors are made worse off if they rely on potentially misleading bond ratings from these agencies.

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1.9

a. Yes. The Apple bond has less default risk, and so the interest rate on the Apple bond is less than the interest rate on the more risky U.S. Steel bond. b. An improvement in U.S. Steel’s expected profitability makes the company less likely to default on bonds in the future. As a result, the demand for U.S. Steel’s bonds should increase, raising the price of the bonds—as shown in the following graph—and reducing their yield.

1.10

The investors in the satellite company’s bonds were worried about default and the possibility that the company would not in fact continue to make payments on the bonds during the following three years. Using the information in Table 5.1 in the text, we can see that the bonds would have received a Caa rating reflecting substantial default risk.

1.11 a. Investors are likely to buy more Treasuries, because they are safer assets, having virtually zero default risk. In a recession, like the one the corona virus caused in 2020, investors worry that some corporations may get into financial difficulties and default on their bonds. b. As shown in the following graphs, in the market for Treasuries, demand rises, so price rises, and yield falls. In the market for corporate bonds, demand falls, price falls, and yield rises.

1.12 a. Junk bonds are “non-investment grade” or “speculative” bonds. The ratings agencies have determined that the issuers of the bonds have a high probability of defaulting on them. b. For the investor, a junk bond potentially has a higher return, but it also has a far higher default risk. c. If investors are skeptical about the ratings, the demand for these bonds will fall, lowering their price from P1 to P2 in the following graph, and increasing their yield.

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d. There are many possible reasons why investors and the ratings agencies could come to different conclusions. Investors may weigh factors differently (specifically, the Wall Street Journal article discusses the extent of firm leverage, which may be weighed differently by investors and agencies). It is also possible that investors may believe that the ratings agencies might inflate ratings to gain firms as customers, or that investors may just be skeptical of the advice of ratings agencies.

1.13

Taxing the coupons reduces the after-tax coupon the bond purchaser receives. A lower after-tax coupon makes the bond less desirable to investors, reducing the demand for the bond. Lower demand reduces the bond’s price and increases the bond’s interest rate.

1.14 a. An increase in yield implies a fall in the price of the WeWork bonds. This increase could occur due to a decrease in demand, but it could also occur due to an increase in supply. b. Because the yield has increased, the price of the bonds must have decreased. c. Knowing that the firm is losing money suggests that investors’ demand for the firm’s bonds is likely to have fallen.

1.15

The coupon on the state bond will not be subject to tax, so its pre-tax yield will also be 8%.

The pre-tax yield on the federal perpetuity must be high enough that after paying the tax on the coupon an investor will receive an after-tax yield of 8%. The pre-tax yield on the federal perpetuity equals: 0.08/(1 − 0.396) = 0.1325 or 13.25%.

5.2 The Term Structure of Interest Rates Learning objective: Explain why bonds with different maturities can have different interest rates.

Review Questions 2.1

Former Federal Reserve Chair Bernanke meant that longer-term rates depend primarily on the path of future expected short-term rates. Bernanke’s remark supports both the expectations theory and the liquidity premium theory of the term structure of interest rates.

2.2

The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar, but differ in maturity. The Treasury yield curve graphically illustrates the term structure of interest rates by showing for a particular day the interest rates on Treasury bonds of different maturities.

2.3

The three key facts about the term structure are: 1. Interest rates on long-term bonds are usually higher than interest rates on short-term bonds.

2. Interest rates on short-term bonds are occasionally higher than interest rates on long-term bonds.

3. Interest rates on bonds of all maturities tend to rise and fall together.

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The three theories of the term structure are: I.

Expectations theory: Assumes that investors have the same investment objective of receiving the highest expected return on their bond investments and that, for a given holding period, investors view bonds of different maturities as perfect substitutes for each other. Interest rates on long-term bonds are an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond.

II.

Segmented market theory: Assumes that investors have different investment objectives and that investors do not see bonds of different maturities as being substitutes for each other. Interest rates on bonds of different maturities are determined in separate markets.

III.

Liquidity premium theory: Assumes that investors view bonds of different maturities as substitutes for each other, but not as perfect substitutes. Interest rates on long-term bonds are averages of the expected interest rates on short-term bonds over the lifetime of the long-term bonds plus a term premium that increases with the maturity of the bond.

Problems and Applications 2.5

Investors may prefer buying short-term Treasury bills because of their greater liquidity and lower interest-rate risk compared to long-term Treasury bonds. For example, money market mutual funds, which buy Treasury bills and other short-term assets, are popular among investors because of their liquidity and low interest-rate risk. In addition, the upward-sloping yield curve may indicate that Treasury bill rates were expected to rise in the future relative to Treasury bond rates.

2.6

Consider what a $1,000 investment in each option would equal after three years: Option (a): $1,000 × 1.08 × 1.11 × 1.07 = $1,282.72 Option (b): $1,000 × 1.1 × 1.1 × 1.07 = $1,294.70 Option (c): $1,000 × (1.085)3 = $1,277.29 If you are indifferent with respect to the maturities of the bonds, you will choose Option (b) because it offers the highest return.

2.7

Option (a): $1,000 × (1.06)4 = $1,262.48 Option (b): $1,000 × (1.055)3 × 1.09 = $1,279.92 Option (c): $1,000 × (1.05)2 × 1.07 × 1.09 = $1,285.85 Option (d): $1,000 × 1.04 × 1.065 × 1.07 × 1.09 = $1,291.79.

Option (d) gives you the highest return.

2.8

2-year: (1% + 2%)/2 = 1.5% 3-year: (1% + 2% + 3%)/3 = 2.00% 4-year: (1% + 2% + 3% + 2%)/4 = 2.00%

2.9

The most likely answers are: First, investors are seeking a safe haven, and second, yields on alternative investments may actually yield less or not enough to compensate investors for the greater default risk on those investments.

2.10 a. A carry trade (interest carry trade) refers to borrowing at a low short-term interest rate and using the borrowed funds to invest at a higher long-term interest rate. You will earn a profit by earning more on your investment than you will pay for the funds you use to finance it.

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b. With the expectations theory, the average of the expected short-term interest rates over the life of the long-term investment should be roughly equal to the interest rate on the long-term investment, which would wipe out any potential profits from the interest carry trade. Moreover, if interest rates rise more than expected, the price of the long-term investment will decline, and the investor will suffer a capital loss. The average investor may also have difficulty borrowing at an interest rate as low as the Treasury bill rate.

2.11

According to the expectations theory, the Treasury’s borrowing cost would be the same whatever mix of bills, notes, and bonds they issue. Although the Treasury would appear to gain from paying the lower interest rate on Treasury bills, the fact that the interest rates on notes and bonds are greater than on bills indicates that investors are expecting interest rates on bills to be higher in the future. The Treasury would be subject to borrowing risk, or roll-over risk, in that after the short-term bills have matured, the interest on new short-term bills may have risen sharply. The uncertainty about future borrowing costs would make it more difficult for the federal government to budget for future interest payments.

2.12

First, we need to calculate the interest rate expected on the one-year Treasury bill one year from now: 𝑒𝑒 i2t = 1.25% = ((0.75% + 𝑖𝑖1𝑡𝑡+1 )/2) + 0.10% 𝑒𝑒 𝑖𝑖1𝑡𝑡+1 = 1.55%

Then, we can answer the problem by calculating the interest rate that investors are expecting on the one-year Treasury bill two years from now:

𝑒𝑒 i3t = 2.00% = ((0.75% + 1.55% + 𝑖𝑖1𝑡𝑡+2 )/3) + 0.25% 𝑒𝑒 𝑖𝑖1𝑡𝑡+2 = 2.95%

2.13 a. Expectations theory states that the long-term rate of interest should be the average of the short-term rates during that time period. So for a central bank to influence long-term rates, it must be able to make credible promises about the path of short-term rates during the life of the long-term bonds. b. Under the segmented markets theory, long- and short-term rates are determined in separate markets, so the path of short-term rates would not matter.

2.14 a. A “steepening of the yield curve” means that long-term rates rose relative to short-term rates. b. A steeper yield curve means that the term spread between long-term rates and short-term rates has widened. In general, this widening would benefit investors who hold long-term securities.

2.15 a. A flatter yield curve means that the term spread between long-term rates and short-term rates has narrowed. A narrowing of the term spread often precedes a recession, signaling that markets expect that interest rates will be relatively lower in the future (than they were before the yield curve flattened). If the yield curve inverts with long-term rates below short-term rates, the concern about an upcoming recession will grow. b. There are two key reasons the predicted recession did not occur in 2019: First, the yield curve was very flat to begin with, so anything that reduced long-term rates or increased short-term rates at all was likely to cause the yield curve to invert, and so the signal the inversion gave may not have been very meaningful. Second, the Fed switched to a policy of cutting rates, and markets believed that further rate cuts were likely, which kept long-term rates low, as the liquidity premium theory would predict. The monetary expansion also helped to stave off any potential recession.

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Data Exercises D5.1

The yield curve is inverted when 3-month Treasury bill rates exceed 10-year Treasury note rates.

The following graph b shows the 3-month Treasury bill rate and the 10-year Treasury note rate from January 1957 to October 2020. The first table that follows shows the dates of the business cycle peaks and troughs, and the second table shows when the yield curve was inverted and whether a recession followed within a year. Until 2019, every period when the yield curve was inverted, except for September 1966 to January 1967, was followed within one year by a recession.

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009

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Chapter 5

Date Yield Curve Was Inverted 1966.09 to 1967.01 1969.01 1969.07 to 1969.08 1969.11 to 1970.01 1973.06 to 1974.06 1974.08 to 1974.09 1978.12 to 1980.04 1980.11 to 1981.08 2000.08 to 2000.12 2006.08 to 2007.04

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Recession within One Year?

No Yes, 1969.12 to 1970.11 Recession Yes, 1969.12 to 1970.11 Recession Yes, 1969.12 to 1970.11 Recession Yes, 1973.11 to 1975.03 Recession Yes, 1973.11 to 1975.03 Recession Yes, 1980.01 to 1980.07 Recession Yes, 1981.07 to 1982.11 Recession Yes, 2001.03 to 2001.11 Recession Yes, 2007.12 to 2009.06 Recession

D5.2

The yield curve on December 11, 2020 was upward sloping with the 1-month Treasury bill rate equal to 0.08%; the 3-month Treasury bill rate equal to 0.08%; the 1-year Treasury bill rate equal to 1%; the 10-year Treasury note rate equal to 0.9%; and the 30-year Treasury bond rate equal to 1.63%. The upward-sloping yield curve and low interest rates across all maturities indicate that investors expect short-term interest rates to rise somewhat but to stay low. The upward-sloping yield curve suggests that investors do not expect a recession in the near future.

D5.3

The difference between the yields on high-grade corporate bonds and on junk bonds has been about 4 to 7 percentage points other than during periods around recessions. During the recession of 2001, the difference rose to almost 22 percentage points. During the financial crisis of 2007– 2009, the difference rose to almost 34 percentage points. The difference between yields did rise to over 18 percentage points in early 2016, but it fell to 11 percentage points by September 2016. In late December 2020, the difference was 7.35%.

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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 

Brief Chapter Summary and Learning Objectives

6.1

Stocks and the Stock Market (pages 174–181) Describe the basic operations of the stock market.

• Publicly traded companies sell stocks on the stock market.

• The overall performance of the stock market is measured using stock market indexes, which are averages of stock prices.

• Fluctuations in stock prices affect the ability of firms to raise funds by selling stock and also affect the spending of households and firms.

6.2

How Stock Prices Are Determined (pages 181–187) Explain how stock prices are determined.

• The fundamental value of a share of stock is the present value of the dividends investors expect to receive from owning the stock.

• For a particular holding period, the rate of return from owning a share of stock equals the dividend yield plus the rate of capital gain.

• The Gordon growth model states that if investors expect a firm’s dividend to increase at a constant growth rate, g, then the price of a stock is related to the current dividend, Dt, and growth rate of dividends and the required return on equities. The equation for the Gordon growth model is:

P= Dt × t

(1 + g ) . (rE − g)

6.3

Rational Expectations and Efficient Markets (pages 188–196) Explain the connection between the assumption of rational expectations and the efficient markets hypothesis.

• The application of rational expectations to financial markets, known as the efficient markets hypothesis, states that when investors and traders use all available information in forming expectations of future dividend payments, the equilibrium price of a stock equals the market’s optimal forecast of the stock’s fundamental value.

• One implication of the efficient markets hypothesis is that stock prices are not predictable.

6.4

Actual Efficiency in Financial Markets (pages 197–202) Discuss the actual efficiency of financial markets.

• Some economists point to three differences between the theoretical behavior of financial markets and their actual behavior: pricing anomalies, mean reversion, and excess volatility.

• Economists debate whether these apparent deviations from efficient markets can be explained within the efficient markets framework.

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6.5

Behavioral Finance (pages 202–205) Describe the basic concepts of behavioral finance.

• Behavioral finance is a field of study that applies the ideas of behavioral economics to understand financial market topics such as workers saving for retirement, the popularity of technical analysis among some stock market investors, and the reluctance of investors to take capital losses.

• Behavioral finance can also help us understand noise trading and herd behavior, which can contribute to financial market bubbles.



Key Terms

Adaptive expectations, p. 188. The assumption that people forecast future values of a variable using only past values of the variable.

Behavioral finance, p. 202. The application of concepts from behavioral economics to understand how people make choices in financial markets.

Bubble, p. 204. A situation in which the price of an asset rises well above the asset’s fundamental value.

Corporation, p. 175. A legal form of business that provides owners with protection from losing more than their investment if the business fails.

Dividend, p. 175. A payment that a corporation makes to stockholders, typically on a quarterly basis.

Dividend yield, p. 183. The expected annual dividend divided by the current price of a stock.

Efficient markets hypothesis, p. 189. The application of rational expectations to financial markets; the hypothesis that the equilibrium price of a security is equal to its fundamental value.

Financial arbitrage, p. 190. The process of buying and selling securities to profit from price changes over a brief period of time.

Gordon growth model (or dividend-discount model), p. 186. A model that uses the current dividend paid, the expected growth rate of dividends, and the required return on equities to calculate the price of a stock.

Inside information, p. 190. Relevant information about a security that is not publicly available.

Limited liability, p. 175. A legal provision that shields owners of a corporation from losing more than they have invested in the firm.

Over-the-counter market, p. 176. A market in which financial securities are bought and sold by dealers linked by computer.

Publicly traded company, p. 175. A corporation that sells stock in the U.S. stock market; only 4,400 of the more than 5 million U.S. corporations are publicly traded companies.

Random walk, p. 191. The unpredictable movements of the price of a security.

Rational expectations, p. 188. The assumption that people make forecasts of future values of a variable using all available information; formally, the assumption that expectations equal optimal forecasts, using all available information.

Required return on equities, rE, p. 182. The expected return necessary to compensate for the risk of investing in stocks.

Stock exchange, p. 176. A physical location where stocks are bought and sold face-to-face on a trading floor.

Stock market index, p. 177. An average of stock prices that investors use to measure the overall performance of the stock market.

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

Chapter Outline

Are You Willing to Invest in the Stock Market?

The chapter opener uses Tesla stock to highlight the volatility of the stock market. The table tracks the price per share of Tesla stock from June 2010 to June 2020. If an investor purchased shares in 2010, the investor would have experienced periods of significant gains as well as significant losses over the following 10 years.

Tesla, however, is only one stock. The Dow Jones Industrial Average (the Dow) is an average of the stock prices of 30 large corporations and is the best-known measure of the performance of the U.S. stock market. Investing in the Dow would have been somewhat more stable than investing in Tesla, but it would have been much riskier than letting funds sit in a bank certificate of deposit (CD).

In this chapter, we explore how swings in stock prices affect investors’ willingness to invest money in the stock market versus bank CDs and government Treasury bills and how these swings affect production and employment in the economy.

Teaching Tips One of the key ideas that students should take away from the course is that financial markets are efficient markets. The basic idea will initially seem counterintuitive to many students, but eventually most come to see the logic of financial markets. Many students falsely believe that investors can make high returns by being knowledgeable about how the stock and bond markets work and closely studying the corporations issuing securities. Some students will probably need some convincing that the stock-picking advice given on cable business programs, online sites, or in newspaper financial columns is largely worthless. The investment strategy implications of the efficient markets hypothesis should prove of great interest to many students. A key point to stress is that asset prices determined in an efficient market provide valuable information to savers and borrowers. The prices of assets traded in markets that are highly liquid and where information costs are low—the market for T-bills, for example—reflect all available information about the fundamental value of the assets. Sections 6.4 and 6.5 address the debate of whether the stock market is an efficient market.

When financial markets are not efficient, problems of excessive price fluctuations and inefficiencies arising from information costs can occur. Because of the inefficiencies of high information costs, financial markets are unable to perform fully the role of matching savings and borrowers. Financial intermediaries exist to reduce information costs for savers and borrowers. Stressing this point can provide a lead-in to the material in Chapter 9, “Transactions Costs, Asymmetric Information, and the Structure of the Financial System.”

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Stocks and the Stock Market (pages 174–181) Learning Objective: Describe the basic operations of the stock market.

A. Common Stock Versus Preferred Stock Corporations can issue two forms of stock: common and preferred. Holders of preferred stock receive fixed dividends set when the stock is first issued, while dividends of common stock may fluctuate with the profitability of the firm. If the company suspends its dividend temporarily and then decides to reinstate it, the company must pay the dividends promised to preferred stockholders before paying holders of common stock. Similarly, if a corporation declares bankruptcy, creditors and bondholders are paid first, followed by holders of preferred stock. Common stockholders are paid only if there are any funds left after preferred stockholders are paid.

B. How and Where Stocks Are Bought and Sold The stock market refers to the many places where stocks are bought and sold, whether physical or virtual. The electronic trading of stocks has become increasingly important. Investors can buy individual stocks or mutual funds. Mutual funds provide investors with diversification by holding many stocks.

C. Measuring the Performance of the Stock Market The most widely watched stock indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index. Although these three stock indexes are averages of the stock prices of different companies, they move broadly together.

D. Does the Performance of the Stock Market Matter to the Economy?

Economists believe that fluctuations in stock prices can affect the economy by affecting the spending of households and firms. Large corporations use the stock market as an important source of funds for expansion. When stock prices rise, so does household wealth, which affects consumer spending. Perhaps the most important consequence of fluctuations in stock prices may be their effect on the expectations of consumers and firms.

6.2

How Stock Prices Are Determined (pages 181–187) Learning Objective: Explain how stock prices are determined.

A. Investing in Stock for One Year The price of a financial asset reflects the present value of the payments to be received from owning it. For a stock held for one year, the payments are the dividends received during the year and the expected stock price at the end of the year. The discount rate used is the required rate of return on equities, rE, which represents the expected return on alternative investments of comparable risk.

B. The Rate of Return on a One-Year Investment in a Stock For a stock held for one year, the rate of return is the dividend yield plus the rate of capital gains.

Teaching Tips Have students calculate the rate of return for a specific stock–such as Amazon, Apple, or Netflix– over the previous year by obtaining data including the price one year ago, the current price, and the dividend paid.

Have students research what news about the company during the year might explain the rate of return they calculated—in particular, what might account for the change in the price of the stock during the year?

C. The Fundamental Value of Stock Economists consider the fundamental value of a share of stock to be equal to the present value of all the dividends expected to be received into the indefinite future. In the case of firms that do not pay dividends, we can use this same approach to calculate the fundamental value of the firm under the assumption that investors expect the firm to eventually start paying dividends.

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D. The Gordon Growth Model Using the assumption that dividends are expected to grow at a constant rate, Gordon developed an equation showing the relationship between the current price of the stock (Pt), the current dividend paid (Dt), the expected growth rate of dividends (g), and the required return on equities (rE):

P= Dt × t

(1 + g ) . (rE − g)

The Gordon model highlights that investors’ expectations of the future profitability of firms and, therefore, their future dividends, are crucial in determining the prices of stocks. Solved Problem 6.2, “Using the Gordon Growth Model to Evaluate GE Stock,” shows students how to apply the Gordon growth model to calculate stock prices for General Electric (GE) and IBM. 6.3

Rational Expectations and Efficient Markets (pages 188–196) Learning Objective: Explain the connection between the assumption of rational expectations and the efficient markets hypothesis.

A. Adaptive Expectations Versus Rational Expectations With adaptive expectations, investors’ expectations of the price of a firm’s stock depend only on past prices of the stock. When using rational expectations, people make forecasts using all available information. In forecasting the price of a firm’s stock, investors would use not just past prices of the stock, but any other information helpful in forecasting the future profitability of the firm.

B. The Efficient Markets Hypothesis The application of rational expectations to financial markets is known as the efficient markets hypothesis. According to this hypothesis, the equilibrium price of a stock equals the market’s optimal forecast—the best forecast given the available information—of the stock’s fundamental value. All investors and traders do not need to have rational expectations because competition among even a few well-informed traders will be enough to quickly drive the price up to its new fundamental value. Stock prices constantly change as news that affects fundamental value becomes available.

C. Are Stock Prices Predictable?

A key implication of the efficient markets hypothesis is that stock prices are not predictable. The best forecast of the price of a stock tomorrow is its price today because the price today reflects every piece of relevant information that is currently available. Rather than being predictable, stock prices follow a random walk, which means that on any given day, they are as likely to rise as to fall.

D. Efficient Markets and Investment Strategies As long as all market participants have the same information, the efficient markets hypothesis predicts that the trading process will eliminate opportunities for above-average profits. Therefore, you should not actively trade or follow hot tips, but instead you should hold a diversified portfolio to minimize risk. Solved Problem 6.3, “Should You Follow the Advice of Investment Analysts?” provides a useful tool to help students think through the real-world implications of the efficient markets hypothesis.

Teaching Tips Choose a stock that has recently reported earnings that have increased, but less than expected. Ask students to consider how they think the stock price responded to the news that earnings increased compared to the previous year. Next, let students know what the forecasted earnings per share were, on average (for example, see http://finance.yahoo.com to find the average forecast). Continue the discussion.

Students should see how the stock price already incorporated expected future earnings and responded to new information that was not included in the forecast.

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Actual Efficiency in Financial Markets (pages 197–202) Learning Objective: Discuss the actual efficiency of financial markets.

A. Pricing Anomalies Some analysts believe they have found trading strategies that exploit apparent pricing anomalies to produce above-average profits. The ability to consistently earn above-average profits contradicts the efficient markets hypothesis. One anomaly, the small firm effect, is not a contradiction because the prices of the stocks of small firms are more volatile than those of large firms and the hypothesis predicts that all stock investments should have the same return only after adjustment for differences in risk, liquidity, and information costs. Returns also need to take into account trading costs and taxes. Although anomalies have often been found in past data, such anomalies have failed to provide the basis for earning above-average profits in the future.

B. Mean Reversion and Momentum Investing Mean reversion is the tendency for stocks that have recently been earning high returns to experience low returns in the future and vice versa. Momentum investing is based on the idea that there can be persistence in stock movements, so that a stock that is increasing in price is somewhat more likely to rise than to fall. Careful studies indicate that, in practice, trading strategies based on these strategies have difficulty earning above-average returns in the long run, particularly when trading costs and taxes are taken into account.

C. Excess Volatility Robert Shiller of Yale University has estimated over a period of decades the fundamental value of the stocks included in the S&P 500 and concluded that the actual fluctuations in the prices of these stocks have been much greater than the fluctuations in their fundamental values. Some have questioned Shiller’s analysis because there are disagreements over estimates of stocks’ fundamental values and other issues. Shiller’s analysis does raise doubts as to whether the efficient markets hypothesis applies exactly to the stock market. In principle, an investor could use Shiller’s results to earn above-average returns by buying stocks when they are below their fundamental values. In practice, though, attempts by investors to use this trading strategy have not been able to consistently produce above-average returns.

6.5

Behavioral Finance (pages 202–205) Learning Objective: Describe the basic concepts of behavioral finance.

Behavioral finance is related to the field of behavioral economics, which is the study of situations in which people make choices that do not appear to be economically rational. By rational, economists mean that investors are taking actions that are appropriate to reach their goals, given the information available to them. Studies have shown examples inconsistent with rationality, such as investors being more likely to sell stocks that have experienced price gains instead of losses (“locking-in gains”).

A. Noise Trading and Bubbles Research has shown that many investors are overconfident in their investment ability, as indicated by overestimating their actual returns. One consequence of overconfidence can be noise trading, which involves investors overreacting to good or bad news. Noise trading can lead to herd behavior in which relatively uninformed investors imitate the behavior of other investors. Investors imitating each other can help fuel a speculative bubble, which occurs when the price of an asset exceeds its fundamental value B. How Great a Challenge is Behavioral Finance to the Efficient Markets Hypothesis?

Few economists now believe that investors can rely on asset prices to continually reflect fundamental values, but many economists still believe that it is unlikely that investors can hope to earn above-average profits in the long run by following trading strategies. Behavioral finance is an area of ongoing research.

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 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 6.1 Stocks and the Stock Market Learning objective: Describe the basic operations of the stock market.

Review Questions 1.1

Stocks are called equities because equity is the difference between the value of a firm’s assets and the value of its liabilities, and stocks represent a legal claim on that value as well as on the firm’s profits. Bonds are loans and are not claims on a firm’s equity or its profits. Therefore, bonds are not equities.

1.2

Dividends are the distribution of profits to stockholders. Dividends are similar to coupons in the sense that they are payments firms make on a regular schedule to investors, but, unlike coupons, dividends on common stock are not fixed but instead change as the issuing firm’s profits change.

1.3

A stock exchange is a physical place where stocks are bought and sold face-to-face. Over-thecounter markets are markets where dealers are linked by computers to sell stocks and bonds. The three most important stock market indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index.

1.4

Stock prices can affect the spending of households and firms. As stock prices rise, households’ wealth increases, which can lead to increased spending. Stock prices also affect the ability of firms to raise money. Stock prices also affect the expectations of consumers and firms. When stock prices fall, households and firms may change their spending and investment plans to adjust to the predicted economic conditions.

Problems and Applications 1.5

Disagree. Like other indexes—such as the Consumer Price Index—indexes of stock prices are set equal to 100 in an arbitrarily chosen base year. The absolute values of index numbers cannot be compared to each other. In addition, each stock index is calculated using a different methodology and has a different number of stocks in the index. Stock price indexes can only be used to analyze movements over time in the average prices of the stocks included in the index.

1.6

If these shares of stock were newly issued by General Motors (GM) and sold to the public in a public offering, this statement would be true. However, it is likely that these were already existing shares traded in the secondary market, in which case GM does not receive any of the money. The transactions take place between the investors selling the stock and the investors buying the stock.

1.7

a. Preferred stock does not carry voting rights, but it does receive a fixed dividend that is set when the corporation issues the stock. These dividends are more like coupon payments than the dividends a corporation pays on common stock because dividends on common stock can fluctuate with the corporation’s profits. So, the preferred stock represents a lower risk investment than do a corporation’s shares of common stock. b. Companies would be more likely to buy back their preferred shares when their stock prices have risen. These buybacks at the original price of the shares would prevent the shareholders of the companies from realizing a capital gain. An investor who had bought the preferred shares after they were issued but before the company repurchased the shares would suffer a loss.

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a. By “an important independent shock to the economy,” Temin means an event that wasn’t the result of other things happening in the economy. That is, if stock prices fell for reasons unconnected with other possible problems in the economy, then the stock market crash would have been an independent shock. b. The crash of 1987, when the S&P 500 declined by more than 20%, was the largest one-day decline in stock prices ever. The decline was almost twice the size of the decline on October 29, 1929, but during the following months no recession occurred. c. Romer argues that the crash of 1929 was more severe and prolonged than later crashes such as in 1987. She argues that the increased uncertainty about future incomes caused a significant drop in spending on consumer durables, which was a major reason that real GDP declined so rapidly during the early months of the Great Depression.

6.2 How Stock Prices Are Determined Learning objective: Explain how stock prices are determined.

Review Questions 2.1

The price of a financial asset such as stock is equal to the present value of the payments to be received from owning it.

2.2

The required return on equities is the expected return necessary to compensate investors for the risk of investing in stocks. The required return on equities and the cost of equity capital are the same thing looked at from different perspectives: What investors consider the required return on equities, firms consider the equity cost of capital.

2.3

R=

Dte+1 ( Pt e+1 − Pt ) . + Pt Pt

The equation states that for a holding period of one year the rate of return on a stock equals the dividend yield plus the expected rate of capital gain.

2.4

The fundamental value of a share of stock is the present value of the dividend payments expected to be received into the indefinite future. Prices of stocks can be different from their fundamental values, especially when speculative demand pushes up prices, causing bubbles.

2.5

P= Dt × t

(1 + g ) . (rE − g )

The key assumption of the Gordon growth model is that the growth rate of dividends is constant.

Problems and Applications 2.6

The present value of the payments you expect to receive from owning the Goldman Sachs stock is: (($1.40/(1 + 0.08)) + ($160/(1 + 0.08)) = $149.44. Because the present value of the payments you expect to receive is greater than the $142 purchase price of the stock, you should buy the stock.

2.7

You received a $2.50 dividend and $10 capital gain on your investment during the year. Your rate of return, calculated as a percentage of your purchase price of $120 is: (($2.50 + $10.00)/$120) × 100 = 10.42%.

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2.8

If the company is paying a dividend per share of $20 per year forever, then the stock is similar to a perpetuity, a type of coupon bond discussed in Chapter 3, Section 3.3. We can calculate the price of the stock by dividing the dividend by the required return on equities: ($20/0.1) = $200.

2.9

a. The yield is the dividend yield—the annual dividend divided by the current price of the stock. b. While the dividend can’t change, the price of the stock can, which would change the value of the dividend yield.

2.10

Although the firm is promising to pay the $5 dividend for 50 years rather than forever, we can still use the perpetuity formula we used in Problem 2.8 (dividing the dividend by the required rate of return) to calculate an upper bound on the price you would be willing to pay: ($5/0.10) = $50. Because this price is less than the $75 price you would have to pay to buy a share of this stock, you should not buy the stock. Even if the company were promising to pay a dividend of $5 per share forever, rather than for 50 years, the price would still be too high.

2.11 a. A capital gain is realized when the price of an asset exceeds its purchase price. For stocks, a capital gain occurs when the stock price exceeds the purchase price. b. The tax rates differ for capital gains and ordinary income, and capital gains are not taxed until they are realized. The tax rate in late 2020 on capital gains was 20% for high-income taxpayers.

Some taxpayers were required to pay an additional 3.8% on their capital gains, raising the top rate to 23.8%. The top individual tax rate on salary and wage income was 37%. Therefore, the tax on capital gains was lower for most taxpayers than the tax on salary and wage income. c. First, corporate profits have been already taxed once through the corporate income tax. Second, taxing capital gains results in a “lock-in effect” because investors may be reluctant to sell stocks that have substantial capital gains. The lock-in effect is magnified by the fact that investors pay taxes on nominal capital gains, not real capital gains. The reluctance to sell may distort stock prices, which sends misleading signals to investors and firms. d. Capital gains are mostly earned by higher-income taxpayers, so equity considerations might make taxing capital gains at a higher rate desirable.

2.12

Using the Gordon growth model, the price per share of Coca-Cola equals: $1.75 × ((1 + 0.05)/(0.08 − 0.05)) = $61.25.

2.13 a. The current stock price reflects three variables: (1) current earnings; (2) expectations about the growth of future dividends; and (3) the required rate of return on equities. b. Expectations about the future growth of dividends may be different, as may the typical investor’s required rate of return on equities.

6.3 Rational Expectations and Efficient Markets Learning objective: Explain the connection between the assumption of rational expectations and the efficient markets hypothesis.

Review Questions 3.1

Adaptive expectations is the assumption that people make forecasts of future values of a variable using only past values of the variable, whereas rational expectations is the assumption that people make forecasts of future values of a variable using all available information.

3.2

The efficient markets hypothesis is the application of rational expectations to financial markets.

It is the hypothesis that the equilibrium price of a security is equal to its fundamental value.

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Stock prices are not predictable because stock prices incorporate all currently available information. The changes in stock prices come from new information that cannot be forecast. A random walk is the unpredictable movements of the price of a security that occur when the conditions for the efficient market hypothesis are met.

Problems and Applications 3.4

3.5

a. If expectations are rational, all current information should be reflected in the current price of a stock. Stock prices will be equal to their fundamental values. b. You would buy an index fund related to the S&P 500. c. If all current knowledge is already incorporated into stock prices, then there is no gain from picking stocks, and so it is at least as desirable to invest in the broad index rather than in individual stocks. Buying a stock index also provides you with greater diversification—and, therefore, less risk—than buying individuals stocks.

“Priced in” means that the effect of the trade war on profits had already been incorporated in stock prices. All available information is already embedded the stock prices. If the trade war continues as expected, it will not lead to a further fall in the price of stock because it was already reflected in stock prices.

3.6

a. “New news” means news that was not already known. b. In the efficient markets hypothesis, stock prices reflect all available information (reflect all old news), so stock prices only change on new news.

3.7

a. If expected future profits increase, then the firm’s stock price should increase. A firm’s expected future profits affect the firm’s expected future dividends and, therefore, the firm’s stock price, even if the profit increase is years in the future. b. If the increase in Biogen’s profits had not been a surprise, the price would not have changed because the information would have already been reflected in the price of the stock.

3.8

The two stocks—Tesla and Amazon—would be equally attractive as investments. Tesla’s stock would have a higher price, but if the two stocks have comparable risk they would have the same expected rate of return. Both stock prices reflect all available information, so if the expected rate of return was higher for Tesla’s stock, investors would bid up the price and drive down the expected rate of return until it was equal to the expected rate of return on Amazon’s stock. The current prices of the two stocks would adjust to equate the two expected rates of return.

3.9

a. An index fund buys a set portfolio of stocks and does not attempt to buy and sell the stocks of individual companies on the basis of news about those companies. Actively managed funds attempt to earn high returns by frequently buying and selling individual stocks. b. In the long run, actively managed funds will not be able to beat the overall market, which index funds reflect because actively managed funds incur higher transactions costs and taxes. Because stock prices reflect all available information, the actively managed funds will not be able to pick which stocks will rise in price and which will fall in price, but the active trading of stocks will create transactions costs (commission fees) and taxes when the funds sell stocks that have capital gains. c. No in terms of picking stocks—which managers of index funds don’t do—but maybe yes in terms of understanding the implications of the efficient markets hypothesis. The managers of the index funds don’t pick winning and losing stocks but instead buy a set portfolio of stocks.

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3.10

If expectations are rational, all available information is included in stock prices. This fact does not mean, however, that new information cannot be revealed, and therefore that individual stocks might not do better than expected and beat the market average. So, an investor who bought this stock would earn more than he or she would have from buying an index fund. But the investor would also have been exposed to more risk because the price of an individual stock is more volatile than is the price of an index fund. Buying an individual stock can result in a high return but it can also result in losses.

3.11

You should agree. If a school could teach a student to be a great investor, many people would want to attend that school. This increase in demand to attend the school would result in a higher price of attending—“an impossibly high tuition.” Because we don’t see impossibly high tuitions being charged by business schools, they must not be able to teach students to be great investors—that is, investors capable of consistently beating the market.

3.12 a. Traditional stock pickers are investors who chose particular stocks rather than, for example, a market index fund. b. On average, it should not be possible to earn a higher return by picking individual stocks. If markets are efficient, all available information is included in stock prices, so if a good manager gets a better return for a while, it is more about luck and the ability to guess correctly which unforeseen events will occur. Even a good manager is unlikely to outperform the market over time.

3.13

On average, it should not be possible to consistently pick winning stocks. If the stock market is efficient, all available information is included in stock prices, so the ability of journalists or fund managers to pick winning stocks is more about luck than about knowledge. However wellinformed managers and financial journalists are, picking stocks that will rise in value over the year is largely a matter of luck (assuming that no one has inside information).

3.14

The efficient markets hypothesis implies that pricing anomalies will not last for long and that in general, stocks prices will be at about their fundamental values. However, this conclusion is only true if investors are actually seeking out profit opportunities, cases where prices and fundamental values are not equal, even briefly. The actions of these investors cause stocks to return to their fundamental values. For example, suppose that a stock is trading at a price below its fundamental value. Some investors must recognize that and buy the stock to bring its price back to the fundamental value.

6.4 Actual Efficiency in Financial Markets Learning objective: Discuss the actual efficiency of financial markets.

Review Questions 4.1

A pricing anomaly refers to the possibility that investors can use trading strategies to earn aboveaverage returns. With the small-firm trading strategy, investors buy stocks issued by small firms and receive higher returns than with stocks issued by large firms. With the January-effect trading strategy, investors buy stocks in December and sell them in January when their prices increase.

Many economists are skeptical, however, that any trading strategy exists that would allow investors to earn above-average returns without taking on above-average risk.

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The basic conclusion of the efficient markets hypothesis is that investors cannot consistently earn above-average returns without accepting above-average risk (or accepting below-average liquidity). Trading strategies that appear to offer above-average returns without above-average risk often result from data mining or fail to take into account the costs of buying and selling stocks and the tax implications of the strategies. Although the stock market may not be as efficient as economists at one time thought, most economists still accept the basic conclusion of the efficient markets hypothesis.

Problems and Applications 4.3

No. Once the strategy of buying and selling stocks as Fed announcements occur becomes public knowledge, many investors will follow the strategy and compete away the above-average returns. The increased number of buyers would drive up the price at which stocks could be bought, and the increased number of sellers would drive down the price in which the stocks could be sold. Buying the stocks at higher prices and selling the stocks at lower prices would eliminate the above-average returns.

4.4

a. Momentum investing is based on the idea that there can be persistence in stock movements, so that a stock that is increasing in price is somewhat more likely to rise than to fall, and a stock that is decreasing in price is somewhat more likely to fall than to rise. b. Not really. Momentum traders base decisions on trends, whether the price of a stock has been rising or falling, rather than on the fundamental values of a stock. c. Because momentum traders buy stocks whose value is rising, they will cause the price to rise more. Likewise, selling stocks whose prices are already falling will cause the prices to fall more. So these momentum traders amplify price movements—that is, they make the price movements larger. d. While some momentum traders claim that you can earn above-average return using this strategy, it is unlikely that on average investors will be able to. Studies suggest that it is difficult to earn an above-average return with this strategy, and if it were possible, more investors would adopt the strategy, which in turn would tend to make prices even more volatile and further reduce the possibility of above-average returns, adjusted for risk.

4.5

No, it is not inconsistent. As in problem 3.14, the efficient markets hypothesis simply implies that pricing anomalies will not last for long and that in general, stocks prices will be at about their fundamental values. Once a pricing anomaly becomes public knowledge, it is likely that the ability of investors to earn above-average returns using stock investing strategies that take into account the anomaly will disappear.

4.6 a. In both of these cases, the prices of financial assets for a time did not reflect fundamental values, contradicting the efficient markets hypothesis. b. These are pricing anomalies, which can still exist if the efficient markets hypothesis is largely true. Arguably in the 1990s, there was not enough known about the values of dot.com companies to determine fundamental values, although clearly there were other factors as well, such as excessive optimism about the future of these companies. Likewise, the information that investors had about the risks of subprime mortgages was in many cases incorrect (or it was very costly to obtain accurate information), and so investors failed to require a sufficiently high premium to compensate for the true risks involved. Over time and as more information became available, the value of these stocks and mortgage-backed securities reverted to their fundamental values, as the efficient markets hypothesis would predict. Rational expectations does not mean perfect foresight. It is possible that even with full information investors overestimated the future profitability of Internet companies and underestimated the risk of mortgaged-backed securities.

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4.7

a. A risk-adjusted return is, as it is called, adjusted for risk. Therefore, a stock with a higher return plus higher risk might have the same risk-adjusted return as a stock with a lower return plus a lower risk. The existence of these two situations is consistent with the efficient markets hypothesis. A result inconsistent with the efficient markets hypothesis would be the ability of investors consistently to earn a risk-adjusted return that is higher than the return from investing in an index fund. b. An investor making an above-average return due to a pricing anomaly is technically not consistent with the efficient markets hypothesis, although certainly this outcome can occur in the short run. If the information on the anomaly is published and the anomaly disappears, this outcome supports the efficient markets hypothesis because available information is now reflected in prices.

4.8

a. To forecast future industrial stock prices, the Dow Theory presumably uses historical patterns between the prices of transportation stocks and industrial stocks (technical analysis), as opposed to all currently available information (fundamental analysis). b. The investor would not be able to earn an above-average return on her stock investments once other investors recognized the same relationship. Many investors selling industrial stocks whenever transportation stocks declined would substantially lower the selling price of industrial stocks, and many investors buying industrial stocks whenever transportation stocks rose would substantially raise the purchase price of industrial stocks. As with other trading strategies, economists have been unable to find evidence that following the Dow Theory allows investors to earn above-average returns.

6.5 Behavioral Finance Learning objective: Describe the basic concepts of behavioral finance.

Review Questions 5.1

Behavioral finance applies the ideas of behavioral economics to financial decision making.

Behavioral economics is the study of situations in which people make choices that do not appear to be economically rational.

5.2

Behaving rationally means investors are taking actions that are appropriate to reach their goals, given the information available to them.

5.3

Noise trading involves investors overreacting to good or bad news and can lead to herd behavior.

Herd behavior is when uninformed investors imitate the behavior of other investors rather than attempting to trade on the basis of fundamental values. The herd momentum can result in a speculative bubble if a stock price soars well above its fundamental value.

Problems and Applications 5.4

a. With stock prices reflecting all available information, an average investor will not consistently be able to pick which stock prices will rise and which will fall. The investor will, however, incur trading costs such as commissions on each sale or purchase, and a taxable capital gain when she sells a stock for a higher price than she bought it for. A better strategy is to buy and hold a diversified portfolio of stocks and other assets by buying an index fund. b. Some investors are overconfident in their ability to pick stocks because they experience hindsight bias. Investors with hindsight bias remember the stocks they bought that increased in price, while forgetting about some stocks that fell in price.

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5.5

a. Any unexpected news that changed the fundamental value of the stock, such as an unexpected increase in earnings or dividends or other positive news about the company, would be expected to increase the price of the stock. b. One possibility is that investors may see the value of the stock rising and decide to join the herd in buying it, thereby causing the price to increase further. c. No. At some point, the value of the stock will diverge so much from its fundamental value that some investors will sell. This selling, in turn, could pop the speculative bubble and the price may fall rapidly.

5.6

A bubble is an increase in the price of an asset to levels well above the asset’s fundamental value. Investors can have different opinions about the fundamental value of an asset because the fundamental value depends on forecasting future returns to the asset. What one investor or Fed official sees as a price bubble, another investor or Fed official may see as a justified increase in price because of increases in an asset’s fundamental value. Once a bubble has popped, generally it is easy for investors (and Fed officials) to see that the asset was overvalued.

5.7

The efficient markets hypothesis assumes people are rational, whereas animal spirits by definition involve people acting irrationally on the basis of a “spontaneous urge to action or inaction.” If people act primarily as the result of animal spirits, then the efficient markets hypothesis does not hold. However, the efficient market hypothesis does not require that all investors and traders act rationally. Competition among a few well-informed traders acting rationally will be enough to drive asset prices to their fundamental values.

5.8

a. The investing herd is the large number of investors who simply follow what others are doing.

Relatively uninformed investors imitate the behavior of other investors rather than attempting to trade on the basis of fundamental values. b. The explanation may be the greater fool theory, where an investor is not a fool to buy an overvalued asset as long as there is a greater fool to buy it later for a still higher price. The behavior, by not being based on the fundamental value of the asset, is not consistent with the efficient markets hypothesis.

Data Exercises D6.1

Here is a graph of the S&P 500 Index. The table that follows the graph details how stock prices moved just before, during, and just after recessions from 1957 to the present, excluding the 2020 recession (whose end date has not been determined by the NBER at the time of this writing).

Stock prices typically declined just before recessions, declined and then rose during recessions, and rose just after recessions.

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Date of Recession August 1957 – April 1958 April 1960 – February 1961 December 1969 – November 1970 November 1973 – March 1975 January 1980 – July 1980 July 1981 – November 1982 July 1990 – March 1991 March 2001 – November 2001 December 2007 – June 2009

Stock Prices Just Before Recession

Stock Prices During Recession

Stock Prices Just After Recession

Declined Declined

Rose Rose

Declined

Declined, then rose Rose, declined, and then rose Declined, then rose

Declined

Declined, then rose

Rose

Rose Declined

Declined, then rose Declined, then rose

Rose Rose

Declined Declined

Declined, then rose Rose, declined, then rose Declined, then rose

Rose Rose

Declined

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Here are the dividend per share of these three companies at the close of trading on December 11, 2020: Company

Dividend per share

Dividend Yield

Microsoft

$2.24

1.05%

Apple

$0.82

0.67%

Coca-Cola

$1.64

3.07%

Tesla

Did not pay a dividend

---

Note that the dividends per share are quarterly and the dividend yield uses the total annual dividend payments divided by the current price. Microsoft paid the highest dividend per share and Coca-Cola had the highest dividend yield. Tesla did not pay a dividend. A firm may not pay a dividend if either it incurs losses, earns a low profit, or if it reinvests its profit into the firm rather than using it to pay dividends. Investors would still buy the stock of a firm that does not currently pay a dividend if the investors expect that the firm will pay dividends in the future (or that the firm’s stock price will increase in the future).

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Chapter 7 Derivatives and Derivatives Markets 

Brief Chapter Summary and Learning Objectives

7.1

Derivatives, Hedging, and Speculating (pages 215–216) Explain what derivatives are and distinguish between using them to hedge and using them to speculate.

• Derivatives are financial securities that derive their value from an underlying asset.

• An important use of derivatives is to hedge or reduce risk.

• Derivatives can also be used to speculate, which means placing financial bets on movements in asset prices.

7.2

Forward Contracts (pages 216–217) Define forward contracts and explain their role in the financial system.

• Forward contracts give firms and investors an opportunity to hedge the risk on transactions that depend on future prices.

7.3

Futures Contracts (pages 217–228) Explain how futures contracts can be used to hedge and to speculate.

• Hedging involves taking a short (long) position in the futures market to offset a long (short) position in the spot market.

• Investors can use commodity futures to speculate on the price of a commodity.

7.4

Options (pages 228–237) Distinguish between call options and put options and explain how they are used.

• A call option gives the buyer the right to buy the underlying asset at the strike price (or exercise price), at any time up to the option’s expiration date.

• A put option gives the buyer the right to sell the underlying asset at the strike price.

• Firms, banks, and individual investors can use options to hedge the risk from fluctuations in commodity or stock prices, interest rates, and foreign currency exchange rates.

7.5

Swaps (pages 237–242) Define swaps and explain how they can be used to reduce risk.

• A swap is an agreement between two or more counterparties to exchange sets of cash flows over some future period.

• Firms engage in swaps to transfer risk to parties that are more willing to bear it.

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Key Terms

Call option, p. 228. A type of derivative contract that gives the buyer the right to buy the underlying asset at a set price during a set period of time.

Counterparty risk, p. 217. The risk that the counterparty—the person or firm on the other side of the transaction—will default.

Credit default swap (CDS), p. 240. A derivative that requires the seller to make payments to the buyer if the price of the underlying security declines in value; in effect, a type of insurance.

Credit swap, p. 239. A contract in which interest-rate payments are exchanged, with the intention of reducing default risk.

Currency swap, p. 239. A contract in which counterparties agree to exchange principal amounts denominated in different currencies.

Derivative securities (or derivatives), p. 214.

An asset, such as a futures contract, that derives its economic value from an underlying asset, such as a stock or a bond.

Forward contract, p. 216. An agreement to buy or sell an asset at an agreed-upon price at a future time.

Futures contract, p. 217. A standardized contract to buy or sell a specified amount of a commodity or a financial asset on a specific future date.

Hedge, p. 215. To take action to reduce risk by, for example, purchasing a derivatives contract that will increase in value when another asset in an investor’s portfolio decreases in value.

Interest-rate swap, p. 237. A contract under which counterparties agree to swap interest payments over a specified period on a fixed dollar amount, called the notional principal.

Long position, p. 218. In a futures contract, the right and obligation of the buyer to receive or buy the underlying asset on the specified future date.

Margin requirement, p. 227. In the futures market, the minimum deposit that an exchange requires from the buyer and seller of a financial asset; the margin requirement reduces default risk.

Marking to market, p. 227. In the futures market, a daily settlement in which the exchange transfers funds from a buyer’s account to a seller’s account or vice versa, depending on changes in the price of the contract.

Option, p. 228. A type of derivative contract in which the buyer has the right to buy or sell the underlying asset at a set price during a set period of time.

Option premium, p. 230. The price of an option.

Put option, p. 228. A type of derivative contract that gives the buyer the right to sell the underlying asset at a set price during a set period of time.

Settlement date, p. 217. The date on which the delivery of a commodity or financial asset specified in a forward contract must take place.

Short position, p. 218. In a futures contract, the right and obligation of the seller to sell or deliver the underlying asset on the specified future date.

Speculate, p. 216. To place financial bets, as in buying or selling futures or option contracts, in an attempt to profit from movements in asset prices.

Spot price, p. 217. The price at which a commodity or financial asset can be sold at the current date.

Strike price (or exercise price), p. 228. The price at which the buyer of an option has the right to buy or sell the underlying asset.

Swap, p. 237. An agreement between two or more counterparties to exchange sets of cash flows over some future period.

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Chapter Outline

You, Too, Can Buy and Sell Crude Oil … But Should You? Most economists recommend investing by regularly buying shares in a mutual fund that tracks stock market indexes. However, some individuals “day trade” to attempt to earn short-term profits. During the past 15 years, oil prices have been particularly volatile, swinging between a high of $145 per barrel in 2008, to a low of $34 in 2009, back above $100 several times between 2010 and 2014, and then below $30 in 2016, only to rise again above $60 during most of 2018, and then most spectacularly, to fall to negative $37 in April 2020 during the Covid-19 pandemic. Some individual investors believe they have enough insight into what causes these price fluctuations to make a profit by buying and selling oil, essentially oil day traders.

Unlike stock day traders who usually directly buy and sell firms’ stocks, commodity day traders buy and sell derivative securities, whose value is based on the value of some underlying asset. Investors who buy and sell derivatives with the hope of profiting from price changes are speculators, most of whom suffer losses over the long run. Derivatives also enable individuals and firms to hedge, that is, reduce the risks they face from price fluctuations. Although many U.S. businesses and investors have used derivatives for decades, they were the subject of widespread debate as a result of the financial crisis of 2007-2009.

In 2020, Forbes magazine described Warren Buffett as the most successful financial investor in the world and estimated his wealth at $65.5 billion. In 2002, Buffet had denounced financial derivatives as “time bombs, both for the parties that deal in them and for the economic system.

Although criticisms of exotic derivative securities are valid, we’ll see in this chapter that derivatives play a useful role in the economy by offering investors and firms risk sharing, liquidity, and information services not otherwise available.

Teaching Tips In the past, instructors frequently omitted the material in this chapter from money and banking courses, particularly from courses that focus on policy. The events of the 2007-2009 financial crisis, however, showed the importance to students of having some basic understanding of derivatives. The discussion in this chapter focuses on forward contracts, futures contracts, and options, with a brief concluding section on swaps. The risk-sharing, liquidity, and information services provided by derivative securities are analyzed. Here, as elsewhere in the text, you can pique student interest by spending time on the financial listings. Students often struggle to understand derivatives. One point to emphasize is the essentially financial nature of derivatives.

Derivatives are intended to give investors and firms a way of hedging by giving them a mechanism to profit if there is an adverse price movement in an underlying asset. (Or to give speculators an opportunity to profit from their ability to forecast future price movements in the underlying asset.) The derivatives markets are ordinarily separate from the markets for the underlying assets.

7.1

Derivatives, Hedging, and Speculating (pages 215–216) Learning Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate.

Derivatives are financial securities that derive their value from an underlying asset. Most derivatives allow investors and firms to profit from price movements in their underlying assets. An important use of derivatives is to hedge, or reduce risk. Typically, hedging involves the purchase of a derivative that increases in value if there is an adverse price change in the underlying asset in the derivative contract.

Investors can also use derivatives to speculate, or place financial bets on movements in asset prices.

Speculators serve two useful purposes: First, hedgers are able to transfer risk to speculators. Second, studies of derivatives markets have shown that speculators provide essential liquidity.

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Derivatives and Derivatives Markets

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Forward Contracts (pages 216–217) Learning Objective: Define forward contracts and explain their role in the financial system.

Forward contracts give firms and investors an opportunity to hedge the risk on transactions that depend on future prices. Forward contracts make possible forward transactions, which are transactions agreed to in the present, but settled in the future. Forward contracts typically involve an agreement in the present to exchange a specific amount of a commodity or financial asset in the future. Although forward contracts provide risk sharing, they have liquidity and information problems.

7.3

Futures Contracts (pages 217–228) Learning Objective: Explain how futures contracts can be used to hedge and to speculate.

Futures contracts share the benefits of forward contracts while having greater liquidity, less risk, and lower information costs due to being traded on exchanges. The market determines the prices of futures contracts, and futures contracts are standardized in terms of the quantity of the underlying assets to be delivered and the settlement dates.

A. Hedging with Commodity Futures Hedging involves taking a short position in the futures market to offset a long position in the spot market, or taking a long position in the futures market to offset a short position in the spot market.

Someone has a short position if he or she has promised to sell or deliver the underlying asset, while the person who buys the contract is taking the long position.

B. Speculating with Commodity Futures Some investors who are not connected with a commodity market can use commodity futures to speculate on the price of a commodity. Without speculators, most futures markets would not have enough buyers or sellers to operate, thereby reducing risk sharing available to hedgers.

C. Hedging and Speculating with Financial Futures The process of hedging risk using financial futures is very similar to the process of hedging risk using commodity futures. An investor who believes that he or she has superior insight into the likely path of future interest rates can use the futures market to speculate.

Teaching Tips Students can enhance their understanding of using futures contracts to hedge risk by completing Solved Problem 7.3, “How Can You Hedge an Investment in Treasury Notes When Interest Rates Are Low.” How to hedge against possible changes in interest rates is an issue that students may face in the future, either personally, for instance when planning to buy a house, or professionally, for instance when considering how to finance capital purchases at the companies they work for.

D. Trading in the Futures Market To reduce default risk, the futures exchange requires both the buyer and seller to make an initial deposit called a margin requirement into a margin account. At the end of each trading day, the exchange carries out a daily settlement known as marking to market in which, depending on the closing price of the contract, funds are transferred from the buyer’s account to the seller’s account or vice versa.

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Extra Apply the Concept The Impact of the Dodd-Frank Act on Farmers Some policymakers and economists have argued that the use of derivatives contributed to the financial crisis of 2007–2009. In response to these concerns, in July 2010, Congress passed the Wall Street Reform and Consumer Protection Act, popularly known as Dodd-Frank, after its Congressional sponsors. Dodd-Frank contains some restrictions on trading in derivatives and requires that some derivatives that were previously traded over-thecounter be instead traded on exchanges.

As we have seen, farmers use commodity futures frequently because weather and other factors cause wide fluctuations in the market prices of most crops. Although Dodd-Frank leaves futures trading on organized exchanges, such as the Chicago Board of Trade, largely unaffected, some farmers are worried because the bill gives the Commodity Futures Trading Commission (CFTC), the federal agency charged with regulating futures exchanges, the authority to write new rules. In particular, farmers worried that they might have to post more collateral to trade futures, which would raise the costs of using these contracts to hedge risk. In addition, some farmers hedge risk by using forward contracts arranged for them by small community banks or special agriculture banks. The farmers worry that the CFTC will no longer allow these banks to offer forward contracts.

Former Senator Saxby Chambliss of Georgia argued against regulating derivatives trading by small banks in agricultural areas: “All of a sudden they are going to be treated like Goldman Sachs or those major firms on Wall Street.”

Farmers breathed a sigh of relief in 2012, when the CFTC decided to exempt from the new regulations firms that use derivatives to hedge risk, including risk from fluctuations in commodity prices. The CFTC also decided to exempt cooperatives from the regulations. Rather than buy and sell forward or futures contracts as individuals, farmers often do so through cooperatives called farm credit associations, which will now be exempt from regulations.

Sources: Ben Protess, “Regulators Clarifying Timing of New Derivatives Rules,” New York Times, September 5, 2012; Jamila Trindle, “CFTC Approves Key Derivatives Rules,” Wall Street Journal, July 10, 2012; and Michael M. Phillips, “Finance Overhaul Casts Long Shadow on the Plains,” Wall Street Journal, July 14, 2010.

7.4

Options (pages 228–237) Learning Objective: Distinguish between call options and put options and explain how they are used.

The buyer of an option has the right to buy or sell the underlying asset at a set price during a set period of time. A call option gives the buyer the right to buy the underlying asset at the strike price (or exercise price), at any time up to the option’s expiration date. A put option gives the buyer the right to sell the underlying asset at the strike price. With options contracts, the buyer has rights, while the seller has obligations.

A. Why Would You Buy or Sell an Option?

If you expect the price of a stock to rise, you can purchase call options that would allow you to buy the stock at a strike price above the existing price. If the price of the stock never reaches the strike price, you can allow the options to expire without exercising them, which limits your loss to the price of the options. Similarly, you can buy a put option if you expect the price of a stock to decline, while limiting your loss to the price of the option.

B. Option Pricing and the Rise of the “Quants” The price of an option is called an option premium. The size of the option premium reflects the probability that the option will be exercised and can be divided into two parts—the option’s intrinsic value and its time value. The intrinsic value of an option equals the net gain to the buyer of the

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option from exercising it immediately. The time value is affected by how far away the expiration date is and by how volatile the stock price has been in the past. The further away the expiration date, the greater the chance that the intrinsic value of the option will increase. Similarly, if the volatility in the price of the underlying asset is small, the chance that the intrinsic value of the option may increase substantially because of a large price swing is small. The Black-Scholes formula developed in 1973 uses sophisticated mathematics to price options. As a result of the success of the BlackScholes formula, financial firms began hiring people with advanced degrees in economics, finance, and mathematics to build models that can be used to price new securities. People with these skills have come to be known as “quants.”

Teaching Tips Many students have read information about stocks, but few have interpreted data about options. Ask students to complete Solved Problem 7.4, “Interpreting the Options Listings for Tesla” to practice how to interpret information about options.

C. Using Options to Manage Risk Firms, banks, and individual investors can use options, as well as futures, to hedge the risk from fluctuations in commodity or stock prices, interest rates, and foreign currency exchange rates.

Though options are more expensive than futures contracts, they have the important advantage that an investor who buys options will not suffer a loss if prices should move in the opposite direction being hedged against.

7.5 Swaps (pages 237–242) Learning Objective: Define swaps and explain how they can be used to reduce risk.

A swap is an agreement between two or more counterparties to exchange sets of cash flows over some future period.

A. Interest-Rate Swaps With an interest-rate swap, the counterparties agree to swap interest payments on a fixed dollar amount, called the notional principal. One motivation for firms to engage in interest-rate swaps is to transfer interest-rate risk to parties that are more willing to bear it.

Swaps are more flexible than futures or options because they can be custom-tailored to meet the needs of counterparties. Swaps also involve more privacy, less regulation, and can be written for longer periods of time. Unlike with futures and exchange-traded options, the counterparties in a swap must be sure of the creditworthiness of their partners.

B. Currency Swaps and Credit Swaps In a currency swap, counterparties exchange principal amounts denominated in different currencies. Firms may engage in currency swaps when some firms have a comparative advantage in borrowing in their domestic currency. In a credit swap, interest rate payments are swapped with the intention of reducing default or credit risk.

C. Credit Default Swaps Developed in the mid-1990s, a credit default swap is a derivative that requires the seller to make payments to the buyer if the price of the underlying security declines in value; in effect, a credit default swap is a type of insurance. By 2005, some investors began to speculate on credit default swaps on mortgage-backed securities and collateralized debt obligations while some companies issued an increasing number of credit default swaps, eventually resulting in huge losses for the companies involved.

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 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 7.1 Derivatives, Hedging, and Speculating Learning objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate.

Review Questions 1.1

Derivatives allow investors to hedge the risk of price changes in underlying assets. Derivatives also allow investors to speculate on price changes in underlying assets.

1.2

Hedging is an action to reduce risk, such as purchasing a derivative contract that will increase in value when another asset in an investor’s portfolio decreases in value. Speculating is placing a financial bet in an attempt to profit from movements in asset prices.

Problems and Applications 1.3

1.4

Speculators play two important roles in derivatives markets: (1) Speculators accept risk transferred from hedgers; and (2) speculators add liquidity to derivatives markets. Because of the two important roles that speculators play, the derivatives market would be worse off if only hedgers were in the market. a. The risk involves falling corn prices. The derivative would need to increase in value if corn prices fall. b. The risk involves rising corn prices because corn is an input into cornbread. The derivative would need to increase in value if corn prices increase. c. The risk is a decrease in the prices of the bonds if interest rates rise. The derivative would need to increase in value if interest rates rise (bonds prices fall).

7.2 Forward Contracts Learning objective: Define forward contracts and explain their role in the financial system.

Review Question 2.1

Forward contracts give firms and investors an opportunity to hedge the risk on transactions that depend on future prices. Forward contracts can also be used to speculate on future prices.

2.2

The person or firm on the other side of the forward contract, the counterparty, may be unable or unwilling to fulfill the obligation in the contract—the buyer may not fulfill the buyer’s obligation to the seller, or the seller may not fulfill the seller’s obligation to the buyer.

Problems and Applications 2.3

You could enter into a forward contract to sell oil at some settlement date in the future. If the price of oil indeed goes down, then at the settlement date you could buy oil at the cheap spot price and sell oil at the agreed upon higher forward price.

2.4

The buyer in the oil forward contract has an incentive to default because he or she has to buy oil at the agreed upon forward price, which presumably is considerably higher than the current spot price with oil prices having declined by 50%.

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7.3 Futures Contracts Learning objective: Explain how futures contracts can be used to hedge and to speculate.

Review Questions 3.1

Futures contracts are traded on exchanges, have prices that change as a result of trading until the settlement date, and are standardized in terms of the quantities of the underlying assets to be delivered and the settlement dates for the available contracts. Futures contracts lack the flexibility of forward contracts, but futures contracts have reduced counterparty risk, lower information costs, and greater liquidity. A commodity future takes a long or short position in the commodities market. Two examples are selling corn futures and oil futures to hedge against falling corn and oil prices. A financial future is a future that takes a long or a short position on a financial asset. Two examples are selling Treasury note futures contracts to hedge against an increase in interest rates and selling U.S. dollar futures contracts to hedge against a decline in the exchange value of the dollar.

3.2

A firm, such as an airline that uses jet fuel refined from crude oil, may take a long position in the futures market for oil (buy oil futures) to hedge against an increase in the price of oil. A firm, such as an oil producer, may take a short position in the futures market for oil (sell oil futures) to hedge against a decrease in the price of oil.

3.3

Speculating is placing a financial bet in an attempt to profit from movements in asset prices. An example of speculating using commodity futures would be buying wheat futures expecting the future spot price to exceed the current futures price. An example of speculating using financial futures would be buying Treasury futures expecting future interest rates to be lower (and the prices on the Treasury security to be higher) than indicated by the current price of Treasury futures.

Problems and Applications 3.4

Futures markets originated in agricultural markets because the supply of agricultural products depends on weather and can be subject to wide fluctuations. With demand for agricultural products typically being price inelastic, fluctuations in supply cause large swings in prices. A farmer will generally sell futures contracts to reduce the risk of falling agricultural prices. By selling futures contracts, the farmer can earn a profit in the futures market to offset his or her losses in the spot market if agricultural prices fall. General Mills would buy futures contracts in wheat (or other grains) to reduce the risk of rising prices. By buying futures contracts General Mills can offset its losses in the spot market if wheat prices rise.

3.5

a. Refinancing means that borrowers take out a new loan, presumably at a lower interest rate or more favorable terms, and then pay off the older loan with the new loan. b. Falling interest rates increase the price of all long-term assets, so if interest rates fall, banks will gain from increases in the prices of the Treasury notes they buy. These gains will offset any losses they incur from receiving lower interest rates on mortgages after the buyers have refinanced them.

Buying Treasurys, therefore, hedges the risk of losses on mortgages. c. Banks could also hedge against the risk of falling interest rates by buying futures contracts on Treasury notes.

3.6

a. A long position in the futures market is the right to buy the underlying asset at some future date. b. Reducing their long positions means that they believe that there is a greater chance that the value of the underlying asset (in this case, oil) will be lower in the future.

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3.7

a. Using hedges to “lock in prices,” oil companies would be worried about prices of crude oil falling. b. Oil companies hedge against falling oil prices by selling oil futures contracts. If oil prices decrease, the oil producers offset the loss from receiving lower oil prices with the gain they realize when they settle their positions in the futures market by buying oil futures contracts at a lower price than they sold the contracts for.

3.8

a. The fund would purchase derivatives such as forward or futures contracts or options that will increase in value when interest rates rise. For example, the fund could sell Treasury futures, expecting the spot market price at the time that the contract is settled to be lower than the contract price. The fund would then buy Treasurys in the spot market and use them to settle the futures contracts, thereby making money on the difference between the contract price and the spot market price. b. If interest rates fell, these derivatives would be worth less. c. Rising interest rates cause bond prices to decrease, so good news for the fund manager is bad news for investors who own bonds.

3.9

a. The farmer would want to sell wheat futures. The farmer would sell 10 contracts. The contracts in total would value (10 contracts × 5,000 bushels × $2.75 per bushel) = $137,500. b. In November, the farmer closes his position in the futures market by buying back the contracts at the current futures price of $2.85. Therefore, he loses 10 × 5,000 × $0.10 = $5,000 (or $142,500 − $137,500). However, he gains in the spot market by selling his wheat at the November spot price of $2.60: $0.10 × 50,000 = $5,000. This gain is relative to what he would have earned if the November spot price was the same as the September spot price. The farmer has completely hedged his risk (leaving aside the transactions costs of carrying out the hedge).

3.10 a. The prices of crude oil futures are determined by buying and selling between experts knowledgeable in the oil market and oil futures market. To earn a consistent profit buying and selling oil futures, the investor would have to beat the experts by having a better understanding of the oil market and the oil derivatives market. b. Even though the investor knows certain aspects of the tech field, he would still have to beat the Wall Street experts who focus on the tech field and the buying and selling of derivatives and other securities.

3.11

Volatility in onion prices is driven by changes in the demand and supply for onions, so it is unlikely that banning trading in onion futures has reduced volatility in onion prices. Banning trading in onion futures has likely eliminated the ability of onion farmers to hedge against volatile onion prices, making them worse off as a group.

3.12 a. Two contracts expiring in December 2020 would cost $130.50 × 1,000 × 2 = $261,000. The price is $130.50 per $100 of face value and there are 1,000 $100 of face value in a $100,000 contract. b. Open interest reports the volume of contracts outstanding. In March 2021, there were 118,728 contracts outstanding. c. As a speculator, you would buy these futures contracts, anticipating a rise in the price of Treasury notes. d. Interest rates went up, Treasury note prices went down, and the value of your contract increased, causing the exchange to pay funds into your margin account.

3.13 a. You would be more worried about rising interest rates because rising interest rates would cause a decline in the price of your Treasury notes. b. To hedge the risk of rising interest rates (falling Treasury note prices), you would sell Treasury futures.

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7.4 Options Learning objective: Distinguish between call options and put options and explain how they are used.

Review Questions 4.1

A call option is a derivative contract that gives the buyer the right to buy the underlying asset at a set price during a set period of time, and a put option is a derivative contract that gives the buyer the right to sell the underlying asset at a set price during a set period of time. An option writer is the seller of the option contract. There would be no options contract to buy without option writers.

4.2

With futures contracts, buyers and sellers have symmetric rights and obligations. In contrast, with options contracts the buyer has rights and the seller has obligations. For example, if the buyer of a call option exercises his or her right to buy the underlying asset, the seller of the call option has no choice but to fulfill the obligation to sell the asset. The buyer of the call option has no obligation to exercise it and may choose, instead, to allow the option to expire, unexercised.

4.3

The option premium is the price of an option. The option’s intrinsic value is the payoff to the buyer of the option from exercising it immediately. The amount of time until the option’s exercise date and the past volatility of the asset’s price also affect the option premium.

4.4

Options can be used to hedge risk against commodity price, stock price, interest rate, or foreign currency movements. An investor can hedge against a price decline by buying a put option and hedge against a price rise by buying a call option. Options are more expensive than other means of hedging but they do not suffer a loss if the value of the asset moves in the opposite direction of that being hedged against.

Problems and Applications 4.5

a. With a call option, the buyer has a right to purchase Netflix stock at a given price. If investors buy call options, they expect the price of Netflix stock to increase. b. Investors would have bought put options, allowing them to sell the stock in Netflix at the strike price if the company’s stock price falls. c. There is less cost and less risk to buying the option than buying the stock.

4.6

a. A put option allows you to sell stocks at the strike price. If stock prices fall, this is desirable, but if stock prices rise, it is not. Therefore, the prices of airline stocks must have been falling “yesterday” and stock prices must be rising “today.” b. The investor’s loss is limited to the original price of the put options.

4.7

a. A put option allows you to sell stocks at the strike price if stock prices fall, which would allow you to put a limit on your losses if the stocks you own fall in price. b. A put option provides insurance against a decline in stock prices, while allowing you to still gain if stock prices rise. To buy the put option, you will have to pay the option premium. If stock prices fall, you can exercise your put option and sell the stock at the higher strike price. If stock prices rise, you can let the put option expire without exercising it. If you own the stocks and sell them, you cannot benefit if the stock prices rise, and you no longer receive dividends from stock ownership. If you engage in a short sale (borrow stocks from a broker and then sell them), you will lose money if the price of the stock rises rather than falls because you will have to buy back the stocks at a higher price than you sold them for.

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4.8

a. The intrinsic value of the call option is the market price minus the strike price, which equals $114.19 – $100.00 = $14.19. b. The put option is out of the money (the strike price of $100 is below the market price of $114.19), so the intrinsic value of the option is zero. An investor would not want to exercise the option and sell the stock at a price of $100 when the investor could sell at the higher market price of $114.19. c. The call with a $100 strike price has a higher intrinsic value than the call with a $110 strike price, while the put with a $110 strike price has a higher intrinsic value than the put with a $100 strike price. d. You will earn $15 ($125 – $110) minus the option price of $16.37, for a loss of $1.37. With 100 shares in the options contract, your total loss would be $137.00. e. You would not exercise your option, so your loss is equal to what you paid for the option: $11.30 × 100 = $1,130.00.

4.9

Volatility is an important part of the Black-Scholes options pricing model. The lower the volatility, the less valuable are the put and call options. When the price of an underlying asset is volatile, the chances that an option that is currently not in the money will move into the money increase, so investors are willing to pay a higher price for the option.

4.10

By buying both call options and put options, the traders could exercise either the call or put option depending on whether the stock price rose or fell and let the other option expire. For example, if the stock price rose, the traders could exercise the call option to buy the stock at the strike price and sell it at the higher market price and let the put option expire. With the strike price near the stock’s current market price, any large movement in the stock price would put either the call options or the put options in the money and be sufficiently large to cover the costs of buying both call and put options.

4.11

Investors who had bought put options would have made the greatest profit because the strike price in the puts is likely to be well above the current market prices of the stocks the put options were written on. The biggest losers would be investors who had sold put options because they are likely to have to buy stocks at prices far above their current market prices as the buyers of those put options exercise them.

4.12

The VIX provides a measure of investors’ expectations of the future volatility of stock prices. The VIX constructs this measure by isolating that part of an option’s price that represents investor forecasts of future price movements in the underlying stock. When investors are expecting significant movements up or down in stock prices, the VIX will increase.

7.5 Swaps Learning objective: Define swaps and explain how they can be used to reduce risk.

Review Questions 5.1

A swap contract is an agreement between two or more counterparties to exchange sets of cash flows over some future period. A swap contract is different from a futures contract because as a private agreement between counterparties, swap terms are flexible. Compared to futures contracts, swaps can be custom-tailored to meet the needs of the counterparties, offer more privacy, are subject to little government regulation, and offer longer-term hedging.

5.2

An interest-rate swap is a contract under which counterparties agree to swap interest payments over a specified period on a fixed dollar amount, called the notional principal. A credit swap is a contract in which interest-rate payments are exchanged, with the intention of reducing default risk. A credit swap is similar to an interest-rate swap, but with the intention of reducing default risk, or credit risk, rather than interest-rate risk.

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Derivatives and Derivatives Markets

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A credit default swap is a derivative that requires the seller to make payments to the buyer if the price of the underlying security declines in value. Unlike the other swap contracts discussed in this chapter, credit default swaps do not involve exchanges of interest payments or currencies. Instead, credit default swaps are a type of insurance. Large sellers of credit default swaps, such as AIG, dramatically mispriced the credit default swaps and therefore sold “insurance” at prices far below what turned out to be its true value. When the time came to pay off the buyers of the credit default swaps, AIG could not do so and the federal government had to bail out the firm in 2008.

Problems and Applications 5.4

a. An increase in inflation causes nominal interest rates to increase, as shown by the Fisher effect discussed in Chapter 4. Higher nominal interest rates decrease the present value of existing fixed interest loans just as higher nominal interest rates decrease the present value of existing bonds. The present value of the fixed future stream of loan payments (or bond payments) drops as the nominal interest rate rises. b. The bank could enter into an interest-rate swap contract under which the interest payments from some of their fixed interest rate loans were swapped for the interest payments on another bank’s variable rate loans.

5.5

Credit default swaps insure the value of the underlying security. The buyer pays premiums to the seller of credit default swaps for promises by the seller to make payments to the buyer if the underlying security declines in price.

5.6

a. A credit default swap (CDS) allows an investor to pass the risk of a company defaulting on bonds or other obligations to someone else. The seller of a CDS is assuming the credit risk from the buyer in exchange for a fee but the seller pays the buyer only if there is a default. b. The analyst’s firm would buy credit default swaps on distressed firms, which are valuable if the company defaults.

5.7

a. Credit Suisse would be selling credit default swaps because they believe that the company won’t default on its debt (or that the debt won’t fall significantly in value—it depends on how the language in the contract reads) and therefore there will be no payments due to the buyers of the credit default swaps. b. The counterparty would be investors who expect that either the company will default on its debt or that the debt will fall enough in value to trigger the terms of the credit default swap. If the company fails, the CDS on its debt would increase in price because buyers would be able to collect according to the terms of the contract. Credit Suisse’s counterparties would gain because they would be able to collect on the CDS that Credit Suisse had sold.

5.8

a. Counterparty risk is the risk that if the underlying security falls in value the seller of the derivative does not have the funds to make the required payments to the buyer. b. Stocks and bonds are primarily traded on exchanges or in regulated trades over the counter and therefore do not involve counterparty risk. Derivatives that are not traded on exchanges are subject to—potentially substantial—counterparty risk.

5.9

a. Many derivatives are thinly traded, which makes them difficult to value, and since they are difficult to value, it is hard to evaluate the financial health of firms that trade heavily in them. b. It depends on the derivative. Those derivatives that are not standardized or traded on exchanges or that involve high counterparty risk can be difficult to price and are highly illiquid. If firms are counting the value of these derivatives as assets, it may be difficult for investors to analyze the financial condition of the firms because of the difficulty of determining the prices of the derivatives.

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Data Exercises D7.1.

The data series for the VIX index for Apple’s stock starts on June 2010. The VIX index for Apple’s stock has more volatility than the VIX index for the S&P 500. During a recession, the VIX index for S&P 500 would increase in volatility relative to the VIX index for Apple’s stock as the recession would affect most of the S&P 500 firms.

D7.2.

On Tuesday, December 29, 2020, the stock price for Facebook was $279.55 per share. For December 29, 2020 with a strike price of $280-285, call options had a volume of trading of 23,016 contracts and an open interest of 11,484 contracts. Put options had a volume of trading of 884 contracts and an open interest of 994 contracts. With considerably more volume in call options than put options, the market expected Facebook’s stock price to rise.

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Chapter 8 The Market for Foreign Exchange 

Brief Chapter Summary and Learning Objectives

8.1

Exchange Rates and The Foreign Exchange Market (pages 250–257) Explain how markets for foreign exchange operate.

• Foreign exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as units of foreign currency per U.S. dollar.

• The nominal exchange rate is the price of one country’s currency in terms of another country’s currency.

• The real exchange rate measures the rate at which goods and services in one country can be exchanged for goods and services in another country.

8.2

Exchange Rates in the Long Run (pages 257–261) Use the theory of purchasing power parity to explain how exchange rates are determined in the long run.

• The theory of purchasing power parity is based on the law of one price, the idea that identical products should sell for the same price everywhere.

• In the long run, exchange rates should make it possible to buy the same amount of goods and services with the equivalent amount of any country’s currency.

• In the short run, real-world complications keep purchasing power parity from completely explaining exchange rates.

8.3

A Demand and Supply Model of Short-Run Movements in Exchange Rates (pages 261–275) Use a demand and supply model to explain how exchange rates are determined in the short run.

• The demand for U.S. dollars represents the demand by households and firms outside of the United States for U.S. goods and U.S. financial assets. The supply of U.S. dollars in exchange for a foreign currency is determined by the willingness of households and firms that own U.S. dollars to exchange them for the foreign currency.

• Anything that increases the willingness of foreign households and firms to buy U.S. goods or U.S. assets will cause the demand curve for dollars to shift to the right; anything that increases the willingness of households and firms in the United States to buy foreign goods or assets will cause the supply curve for dollars to shift to the right.

• The interest-rate parity condition holds that differences in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates.

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Key Terms

Appreciation, p. 251. An increase in the value of a currency in exchange for another currency.

Depreciation, p. 251. A decrease in the value of a currency in exchange for another currency.

Exchange-rate risk, p.266. The risk that an investor or a firm will suffer losses because of fluctuations in exchange rates.

Foreign-exchange market, p. 256. An over-thecounter market where international currencies are traded and exchange rates are determined.

Interest-rate parity condition, p. 267. The proposition that differences in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates.

Law of one price, p. 257. The fundamental economic idea that identical products should sell for the same price everywhere.



Nominal exchange rate, p. 251. The price of one currency in terms of another currency; also called the exchange rate.

Quota, p. 259. A limit a government imposes on the quantity of a good that can be imported.

Real exchange rate, p. 254. The rate at which goods and services in one country can be exchanged for goods and services in another country.

Tariff, p. 259. A tax a government imposes on imports.

Theory of purchasing power parity (PPP), p.

257. The theory that exchange rates move to equalize the purchasing power of different currencies.

Chapter Outline

The Coronavirus, the U.S. Dollar, and Coca-Cola In early 2020, Covid-19 began infecting significant numbers of people worldwide. In response, many people in the United States stopped taking airline flights, going to movies and sporting events, and eating in restaurants.

As sales declined, many of these businesses suffered losses and laid off workers. Given the worldwide economic downturn caused by the spread of the virus, firms that relied on exports found their foreign sales declining.

Disruptions to global supply chains also hurt firms such as Apple that relied on suppliers in China and other countries where production was hard hit by the virus.

At any time, if a firm exports products overseas, imports products for resale, or imports some of its inputs, the firm has an important concern: the exchange rate. At the beginning of the Covid-19 pandemic, the value of the U.S. dollar first rose and then declined relative to the values of the currencies of most U.S. trading partners.

This movement in the exchange rate was important because in today’s global economy, many large firms manufacture products in several countries and sell them in other countries.

Consider Coca-Cola, which sells more than 4,000 varieties of soft drinks in 200 countries. Less than 20% of the firm’s sales are in the United States. As a result, fluctuations in the value of the dollar in exchange for other currencies affect Coca-Cola’s profit. In some years, converting revenue from foreign currencies yields more dollars than in other years. For example, in 2019, Coca-Cola’s global revenue was $1.4 billion lower when measured in U.S. dollars than when measured in local currencies. This difference is explained by the value of the dollar having risen during 2019, which meant that converting foreign currencies into dollars yielded fewer dollars for Coca-Cola.

Coca-Cola’s profits are affected not just by fluctuations in the value of foreign currencies against the dollar but also by fluctuations in the values of some foreign currencies against other foreign currencies. For instance, Coca-Cola produces the soft drinks it sells in Indonesia in Malaysia, so the profitability of the firm’s sales in Copyright © 2022 Pearson Education, Inc.

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Indonesia is affected by changes in the exchange rate between Malaysian and Indonesian currency. Increased instability in foreign exchange markets following the spread of Covid-19 has made it difficult for Coca-Cola and other U.S. firms that operate in multiple countries to estimate how the pandemic would affect their sales and their costs.

Why does the exchange rate between the dollar and other currencies fluctuate? One key factor is that during the past 25 years, financial investment across borders has increased, and investors have become more sensitive to differences in interest rates among countries. When the Federal Reserve responded to the effects of Covid19 on the U.S. economy by cutting its target interest rate, foreign investors became less likely to buy U.S. financial assets. As a result, the demand for dollars declined relative to the demand for other currencies, causing the exchange rate between the dollar and these currencies to decline. Other factors also determine exchange rates, particularly in the long run. But in the modern international financial system, the Federal Reserve, the European Central Bank, and other central banks cannot ignore how their policies affect the economies of other countries and how financial and economic developments in other countries affect their economies.

Teaching Tips Many students are intrigued by questions of foreign exchange. Students who closely follow the financial news are familiar with discussions about the strength of the dollar. Some are confused as to whether references to the “declining value of the dollar” refer to declines in the domestic purchasing power of the dollar or to declines in the exchange value of the dollar.

One of the strengths of this text is that exchange rates are discussed in an early chapter. This chapter provides clear definitions of basic concepts, such as the real exchange rate and purchasing power parity, and provides a simple demand and supply model of exchange rate determination. The chapter concludes with a discussion of the interest-rate parity condition, which is linked to the discussion of monetary policy found in the chapter opener.

8.1

Exchange Rates and The Foreign Exchange Market (pages 250–257) Learning Objective: Explain how markets for foreign exchange operate.

The nominal exchange rate is the price of one country’s currency in terms of another country’s currency. An increase in the value of one country’s currency in exchange for another country’s currency is called an appreciation, while a decrease is called a depreciation. Fluctuations in the exchange rate between the dollar and foreign currencies affect the prices U.S. consumers pay for foreign imports.

A. Is It Dollars per Yen or Yen per Dollar?

Foreign exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as units of foreign currency per U.S. dollar.

B. Nominal Exchange Rates Versus Real Exchange Rates When we are interested in the relative purchasing power of two countries’ currencies, we use the real exchange rate, which measures the rate at which goods and services in one country can be exchanged for goods and services in another country. The following is the expression for the real exchange rate in terms of the nominal exchange rate and the price levels in each country: Real exchange rate between the dollar and the foreign currency = U. S. consumer price index Foreign price index × Nominal exchange rate

In this equation, the nominal exchange rate is measured as dollars per foreign currency.

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C. Foreign Exchange Markets As with other prices, exchange rates are determined by the forces of demand and supply. Currencies are traded in foreign exchange markets. With daily trading in the trillions of dollars, the foreign exchange market is the largest financial market in the world. Participants in this market include commercial banks, investment portfolio managers, and central banks.

8.2

Exchange Rates in the Long Run (pages 257–261) Learning Objective: Use the theory of purchasing power parity to explain how exchange rates are determined in the long run.

A. Law of One Price and the Theory of Purchasing Power Parity The law of one price states that identical products should sell for the same price everywhere. In the context of international trade, the law of one price is the basis for the theory of purchasing power parity (PPP), which holds that exchange rates move to equalize the purchasing power of different currencies. PPP predicts that if one country has a higher inflation rate than another country, then the currency of the high-inflation country will depreciate relative to the currency of the low-inflation country.

B. Is PPP a Complete Theory of Exchange Rates?

Though PPP provides some useful insights, it doesn’t always hold true, particularly in the short run.

Reasons for this include: not all goods are traded internationally, products are differentiated, and governments impose trade barriers. Therefore, prices are not always equalized across countries.

8.3

A Demand and Supply Model of Short-Run Movements in Exchange Rates (pages 261–275) Learning Objective: Use a demand and supply model to explain how exchange rates are determined in the short run.

A. A Demand and Supply Model of Exchange Rates The demand for U.S. dollars represents the demand by households and firms outside of the United States for U.S. goods and U.S. financial assets, while the supply of dollars in exchange for foreign currency is determined by the willingness of households and firms that own U.S. dollars to exchange them for the foreign currency. The demand curve for dollars in exchange for foreign currency is downward sloping because the quantity of dollars demanded will increase as the exchange rate declines. Similarly, the supply curve for dollars is upward sloping because the quantity of dollars supplied will increase as the exchange rate increases.

B. Shifts in the Demand and Supply for Foreign Exchange Anything, other than a change in the exchange rate, that increases the willingness of foreign households and firms to buy U.S. goods or U.S. assets will cause the demand curve for dollars to shift to the right, whereas anything that increases the willingness of Americans to buy foreign goods or assets will cause the supply curve for dollars to shift to the right. Changes in relative interest rates can also affect the demand and supply of foreign exchange. For example, if interest rates in the United States rise relative to interest rates in other countries, the demand for U.S. dollars will increase as foreign investors exchange their currencies for dollars in order to purchase U.S. financial assets. An increase in the demand for U.S. dollars leads to an appreciation of the dollar, while an increase in the supply of dollars leads to a depreciation of the dollar.

C. The Interest-Rate Parity Condition On a typical day, more than 95% of the demand for foreign exchange is the result of a desire by investors to buy foreign financial assets. International financial investment involves exchange-rate risk. The interest-rate parity condition holds that differences in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates. In practice, interest-rate Copyright © 2022 Pearson Education, Inc.

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parity may not hold because of: (1) The differences among bonds with respect to default risk and liquidity; (2) the transactions costs involved in buying foreign financial assets; and (3) the exchangerate risk involved in investing in a foreign financial asset.

D. Forward and Futures Contracts in Foreign Exchange In the foreign-exchange market, spot market transactions involve an exchange of currencies or bank deposits immediately (subject to a two-day settlement period) at the current exchange rate. In forward transactions, traders agree today to a forward contract in which they commit to exchanging currencies or bank deposits at a specific future date at an exchange rate known as the forward rate.

Futures contracts in foreign exchange also exist.

E. Exchange-Rate Risk, Hedging, and Speculation Exchange-rate risk is the risk that a firm will suffer losses because of fluctuations in exchange rates.

Companies can hedge, or reduce, the exchange-rate risk they face by entering into a forward contract– or, more likely, having a bank carry out the forward transaction for a fee. A hedger uses derivatives markets to reduce risk, while a speculator uses derivatives markets to place bets on the future values of currencies. Compared with futures contracts, options contracts have the advantage to hedgers that if the price moves in the opposite direction to the one being hedged against, the hedger can decline to exercise the option and instead can gain from the favorable price movement. A speculator who believes that the value of a currency is likely to rise more than expected would buy calls, while a speculator who believes that the value of a currency is likely to fall more than expected would buy puts.

Extra Apply the Concept Should You Invest in Emerging Markets?

In response to stubbornly sluggish economic growth, in September 2012, Ben Bernanke, who was then Federal Reserve chair, announced further monetary policy actions that would likely keep interest rates at record low levels for at least several more years. While low interest rates are good news for borrowers, they offer meager returns for savers. With the economies of the world becoming more integrated over time, the choices for investors have expanded to include not only stocks and bonds of companies from high-income economies but also from “emerging markets.” In the early 1980s, economists at the International Finance Corporation coined this term when referring to mutual funds that invested in companies located in developing countries. Since then, media sources have used emerging markets to refer to economies of countries, such as China and India, that beginning in the 1990s have experienced rapid rates of economic growth after making fundamental changes in their business environments.

The International Monetary Fund has estimated that emerging markets now account for about one-half of the world economy. When the United States struggled to recover from the 2007–2009 financial crisis and with Europe mired in an economic crisis of its own, many investors viewed rapid growth in many developing countries as a good reason to diversify their portfolios with stocks and bonds of emerging-market companies.

But rapid economic growth does not guarantee high returns on investment. One study found little correlation between long-term investment returns and growth in gross domestic product.

Although investors will continue to seek profits from emerging markets, analysts cite several reasons for caution. In rapidly growing economies, expectations of future growth are already reflected in stock prices.

Some companies will experience higher-than-expected growth, but it is difficult to predict winners and losers in advance. And rapid growth typically results in a constant flow of new stocks that creates a “dilution effect,” as financial investment is spread over an increasing number of stocks. One study estimates that the dilution effect in emerging markets can cost investors 10% annually, versus only 2% in the United States. Investors also pay fees to invest in funds that specialize in emerging market stocks that are higher than fees charged by more heavily traded funds.

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Still, many investors are betting that long-run profits from stocks and bonds in emerging market stocks will ultimately make the risks worth it. Emerging-market analysts suggest two ways for investors to minimize these risks: (1) buy shares of a single international index fund that includes companies from both developed and emerging markets and (2) combine investments in a fund that includes emerging market stocks and bonds with more conventional investments.

Sources: Jon Hilsenrath, “How Bernanke Pulled the Fed His Way,” Wall Street Journal, September 28, 2012; Tarun Khanna and Krishna G. Palepu, “How To Define Emerging Markets,” Forbes, May 27, 2010; Brett Arends, ” Emerging Markets . . . It’s a Jungle Out There,” Wall Street Journal, March 17, 2012; and Walter Updegrave, “Emerging-Market Investing for the Long Haul,” CNNMoney, September 13, 2012.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 8.1 Exchange Rates and the Foreign Exchange Market Learning objective: Explain how markets for foreign exchange operate.

Review Questions 1.1

The nominal exchange rate is the price of one country’s currency in terms of another country’s currency. Nominal exchange rates tell you how many yen or euros or Canadian dollars you will receive in exchange for a U.S. dollar, but they do not tell you how much of another country’s goods and services you can buy with a U.S. dollar. When we are interested in the relative purchasing power of two countries’ currencies we use the real exchange rate, which measures the rate at which the goods and services of one country can be exchanged for the goods and services of another country.

When newspapers use the term “the exchange rate,” they usually refer to the nominal exchange rate.

1.2

Direct quotations express exchange rates as units of domestic currency per unit of foreign currency.

Indirect quotations express exchange rates as units of foreign currency per unit of domestic currency. The yen has depreciated against the dollar because it takes more yen to exchange for a dollar. The dollar has appreciated against the yen because one dollar can exchange for more yen.

1.3

European exports will increase because European products will sell for lower dollar prices in the United States, while U.S exports to Europe will decrease because U.S. products will sell for higher euro prices in Europe.

1.4

An over-the-counter market consists of dealers linked together by computers, rather than a market where traders meet face-to-face.

Problems and Applications 1.5

Disagree. An exchange rate is not an indication of wealth in a country, it simply measures the value of one currency in terms of another currency.

1.6

Agree. As the euro depreciates, it becomes less expensive for U.S. citizens to travel to Disneyland Paris and more expensive for European citizens to travel to Walt Disney World in the United States.

1.7

The British pound has appreciated and the U.S. dollar has depreciated. The appreciation of the pound raises the cost in dollars of British exports and lowers the cost in pounds of British imports, making it bad news for Brompton Bicycle and good news for British consumers. The depreciation of the U.S. dollar lowers the cost in pounds of U.S. exports and raises the cost in dollars of U.S. imports, making it good news for U.S. firms that export to the UK and bad news for U.S. consumers.

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1.8

Applying the expression for the real exchange rate given on page 255 of the text: The dollar-yen real exchange rate = ¥100 × ($400/¥70,000) = 0.5714. The dollar-pound real exchange rate = (£1/$1.5) × ($400/£130) = 2.05. Note that in the real exchange rate formula, the nominal exchange rate is expressed as units of foreign currency per unit of domestic currency.

1.9

Eurodollars are dollar deposits in banks outside the United States. In other words, the Eurodollar deposits, which are in banks outside the United States, are not in terms of the domestic currency of the country where the bank is located, but in terms of U.S. dollars. U.S. banks sometimes find that they can better serve the needs of multinational U.S. firms by holding dollar deposits in foreign banks. Euros are the actual currency of countries in the Eurozone.

8.2 Exchange Rates in the Long Run Learning objective: Use the theory of purchasing power parity to explain how exchange rates are determined in the long run.

Review Questions 2.1

The law of one price is the fundamental economic idea that identical products should sell for the same price everywhere. The law of one price is the basis for the theory of purchasing power parity (PPP).

Purchasing power parity is the theory that the exchange rates move to equalize the purchasing power of different currencies.

2.2

Purchasing power parity (PPP) is a theory of exchange rate determination in the long run. It therefore does a poor job explaining movements in exchange rates in the short run.

2.3

Because of lower inflation in Japan than in Canada, the Japanese yen will appreciate in exchange for the Canadian dollar in order to preserve purchasing power parity.

Problems and Applications 2.4

Foreign-exchange traders might not find purchasing power parity useful as they trade currencies day-to-day because short-term movements in exchange rates are driven by news, particularly changing expectations about future interest rates. Purchasing power parity is primarily a guide to long-run movements in exchange rates, not the short-run movements that interest currency traders.

2.5

a. Undervalued means that the exchange value of the Lebanese pound was lower than the relative price levels between Lebanon and the United States would suggest. Being undervalued implies that too many reals were required in exchange for a U.S. dollar on purchasing power parity grounds. b. [Note: In an earlier printing of this edition, this part of the problem was incorrectly worded. The correct wording is: “Why would inflation in Lebanon result in the Lebanese currency no longer being undervalued relative to the U.S. dollar?”] As prices in Lebanon increased relative to prices in the United States, then purchasing power parity reasoning would indicate that it should take more reals to exchange for a U.S. dollar. In other words, the real would no longer be undervalued relative to the U.S. dollar.

2.6

When Easterly wrote that Brazil’s currency, the Brazilian real, was overvalued he meant that the foreign exchange value of the real was higher than the relative price levels between Brazil and the United States would suggest. Being overvalued implies that too few reals were required to purchase a U.S. dollar than would be indicated on purchasing power parity grounds. He could tell that the real was overvalued because the prices of U.S. goods in terms of reals were considerably less than the cost of similar products in Brazil.

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2.7

First, current exchange rates change daily so the calculated value of world GDP measured in U.S. dollars would also change daily as current exchange rates change. Those fluctuations would not reflect fluctuations in the production of goods and services in the different countries whose GDP were being compared. Second, current exchange rates often do not reflect differences in price levels across countries. Purchasing power parity exchange rates take into account the relative purchasing power of each currency in its respective country.

2.8

a. If purchasing power parity holds for Big Macs, then the price of Big Macs should be the same, $5.71, in every country when we use the exchange rate to convert the domestic currency price into dollars. To convert the domestic currency price into dollars, divide the price of the Big Mac in the domestic currency by the exchange rate. The following table shows the Big Mac prices in domestic currencies, the exchange rates, and the converted Big Mac prices in dollars. Given that the dollar price of Big Macs ranges from $2.03 in Turkey to $5.75 in Sweden, the statistics in the table are not consistent with purchasing power parity. If purchasing power parity held, we would expect that the price of a Big Mac measured in dollars would be the same in every country.

Country United States Brazil Israel South Korea Sweden Turkey

Big Mac Price In Domestic Currency

Exchange rate (units of foreign currency per U.S. dollar)

$5.71 20.9 reals 17 shekels 4,500 won 52.6 krona 13.99 lira

---5.34 3.45 1,201 9.14 6.86

Big Mac Price in Dollars $5.71 $3.91 $4.92 $3.71 $5.75 $2.03

b. The exchange rate would equal the price of a Big Mac in Israel divided by the price of a Big Mac in Brazil = 17 shekels/20.9 reals, or 0.81 shekels per Brazilian real.

2.9

a. If the United States experiences an average annual inflation rate of 3% while Mexico experiences an average annual inflation rate of 8%, then the U.S. dollar will appreciate against the Mexican peso by 5%. b. Placing tariffs and quotas on many imported goods will decrease the demand for Mexican imports and, therefore, the demand for Mexican pesos. The Mexican peso will depreciate, and the U.S. dollar will appreciate. c. The United States experiencing deflation while Mexico experiences inflation means that the inflation rate in Mexico is higher than in the United States, so the U.S. dollar will appreciate relative to the Mexican peso.

8.3 A Demand and Supply Model of Short-Run Movements in Exchange Rates Learning objective: Use a demand and supply model to explain how exchange rates are determined in the short run.

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Review Questions 3.1

3.2

a. The demand curve for foreign exchange is downward sloping because as the exchange rate falls it becomes cheaper to convert a foreign currency into dollars and there is a larger quantity of dollars demanded. As the exchange rate declines, the foreign currency (for example, yen) price of U.S. goods, services, and financial assets becomes less expensive. b. The supply curve for foreign exchange is upward sloping because as the exchange rate rises the more foreign exchange U.S. households and firms will receive in exchange for dollars and the larger the quantity of dollars supplied. As the exchange rate increases, the U.S. dollar price of foreign goods, services, and financial assets becomes cheaper. c. U.S. households and firms importing or buying Japanese goods, services, or assets would be interested in exchanging dollars for yen, as would currency speculators. d. Japanese households and firms importing or buying U.S. goods, services, or assets would be interested in exchanging yen for dollars, as would currency speculators.

The interest-rate parity condition is: Interest rate on domestic bond = Interest rate on foreign bond − Expected appreciation of the domestic currency.

The differences in interest rates reflect the expected changes in the exchange rate. The main reasons that interest-rate parity might not hold exactly are: (1) The differences among bonds with respect to default risk and liquidity; (2) the transactions costs involved in buying foreign financial assets; and (3) the exchange-rate risk involved in investing in a foreign financial asset.

3.3

International capital mobility refers to the free flow of capital mobility across nation borders. As investors want to purchase financial assets in other countries, they demand more foreign currencies to pay for these assets. This increased demand has greatly increased the volume of transactions in the foreign exchange market.

3.4

A spot transaction involves exchanging currency immediately (subject to a two-day settlement period), whereas a forward transaction involves agreeing today to exchange currency in the future.

Forward contracts are private agreements, typically between banks and other financial firms, to exchange any amount of currency on any future date. Futures contracts are traded on exchanges and are standardized, including a stated settlement date. With forward contracts, the exchange rate is fixed at the time the contract is agreed to. With futures contracts, the exchange rate changes continually as contracts are bought and sold on the exchange. The volume of forward contracts is about 10 times greater than the volume of futures contracts because the counterparty risk between big banks is relatively low, and banks value the flexibility of forward contracts.

3.5

Exchange-rate risk is the risk that a firm will suffer losses because of fluctuations in exchange rates.

To hedge against a fall in the exchange rate, firms can sell forward or futures contracts, or buy a put option. To hedge against a rise in the exchange rate, firms can buy forward or futures contracts or buy a call option. For forward or futures contracts, if an investor becomes convinced that the future value of a foreign currency will be lower than other traders in the foreign exchange market currently believe, the investor can sell forward or futures contracts in that currency. If the value of the currency falls, the spot price of the currency in the future will be lower, which will allow the investor to fulfill the forward or futures contract at a profit. Alternatively, the investor could buy put options on the foreign currency. If the exchange rate falls below the strike price, the firm could exercise the option and sell at the (above-market) strike price. If an investor expects the foreign currency to be higher than other traders in the market believe, the investor can buy forward or futures contracts in that currency or buy call options on the foreign currency.

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Problems and Applications 3.6

a. Japanese importers need dollars to pay Apple for iPhones and iPads. Demand for dollars increases, shifting the demand curve to the right from Demand1 to Demand2 and raising the exchange rate from ¥1 to ¥2.

b. The supply of U.S. dollars increases as investors exchange dollars for yen to purchase Japanese financial assets, shifting the supply curve to the right from Supply1 to Supply2 and lowering the exchange rate from ¥1 to ¥2.

c. The supply of U.S. dollars falls as investors exchange fewer dollars for yen as they begin selling Japanese government bonds, shifting the supply curve to the left from Supply1 to Supply2 and raising the exchange rate for dollars from ¥1 to ¥2.

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3.7

Falling interest rates decrease the demand for the country’s financial assets, which decreases the demand for its currency. The decrease in the demand for the currency decreases its foreign exchange value. Falling interest rates put downward pressure on the foreign exchange value of currencies.

Therefore, a decrease in U.S. interest rates relative to the interest rates in other developed countries—such as Japan and the countries of Western Europe—will cause the value of the dollar to decline. However, if all countries reduced interest rates in the same proportion, there would be no change in the demand for currencies, all else equal, so the differential between U.S. and developed country interest rates is important.

3.8

The interest-rate parity condition states that: Interest rate on domestic bond = Interest rate on foreign bond − Expected appreciation of the domestic currency. Therefore, investors believe that the U.S. dollar will appreciate by 1%, which would change the exchange rate to ¥101 = $1.

3.9

a. A “strong dollar” means the dollar buys more units of foreign currency. b. A “more global business” means that a larger percentage of Coca-Cola’s sales and production come from non-U.S. sources than PepsiCo’s do. c. The strong dollar increases the domestic currency price of Coca-Cola’s exports from the United States and also reduces the value of revenues and profits from other countries when converted into U.S. dollars.

3.10

The interest-rate parity condition states that: Interest rate on domestic bond = Interest rate on foreign bond − Expected appreciation of the domestic currency. In this case, the exchange rate between the pound and the euro is expected to change from €1.50 per £1 to €1.35 per £1, or depreciate 10%.

Therefore, the UK interest rate would be 4% − (−10%) = 14%.

3.11 a. Investors borrow in a low-interest rate country (like the United States), convert the dollars to pesos, and then lend in pesos, making a profit on the interest rate differential (as long as the exchange rate does not change). b. “Stability of the peso” means that the value of the peso is not expected to change significantly. c. A stable peso means that investors are not expecting to face exchange-rate risk. That is, the investors won’t have to worry that while they are holding investments denominated in pesos, the value of the peso will decline in exchange for the U.S. dollar. d. The peso depreciated relative to the dollar. So, while investors still receive a higher interest rate on their peso-denominated loans, when they convert the proceeds back into dollars, they will receive less than they had anticipated and possibly even lose money on the investment. (For example, if the U.S.-Mexico interest rate differential is 4%, so interest rates are 4% higher in Mexico, if the peso depreciates by 4% or more, investors will either break even or lose money.)

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3.12 a. A flight to dollars describes the situation where investors distrust risky assets and move their capital into safer assets, such as U.S. Treasury bonds, to guard their wealth. Who is doing the fleeing is any investor holding assets in some country that is perceived as more risky (or risky assets in some other country). b. A flight to dollars would increase the demand for U.S. dollars, shifting the demand curve to the right from Demand1 to Demand2, which would increase the value of the dollar relative to the British pound or the euro.

3.13 a. Alcoa faces the exchange-rate risk of the British pound declining in value in exchange for the U.S. dollar. If the pound declines in value, Alcoa will receive fewer dollars in exchange for the scheduled payment from the British firm. b. Alcoa can sell pound futures, sell pounds in a forward contract, or buy a put option on pounds. Alcoa can sell £1,333,333.33 at the forward rate to hedge the risk of the pound falling. That is, Alcoa would agree today to sell the £1,333,333.33 it will receive in 90 days for dollars at the current forward rate. If the current forward rate is the same as the spot rate of $1.50 = £1, then Alcoa will have completely hedged its risk. Typically, the current spot rate and the 90-day forward rate are close together, allowing Alcoa to hedge most of the exchange-rate risk it faces.

3.14 a. ¥250 million in one year/1.04 = ¥240.38462 million today; ¥240.38462 million/100 yen per dollar = $2,403,846.20, which is the amount that Halliburton needs to exchange today for yen and invest in one-year Japanese government bonds at the interest rate of 4% in order to have ¥250 million in one year. b. ¥250 million/98 yen per dollar forward rate = $2,551,020.40 needed in one year to settle the forward contract (note that the yen is expected to appreciate); $2,551,020.40/1.06 = $2,406,623.02, which is the amount that Halliburton needs today to invest in one-year U.S. Treasury bills at an interest rate of 6%. c. Halliburton doesn’t know. The firm accepts exchange-rate risk because the amount of dollars the firm needs to fulfill its equipment contract in one year depends on the exchange rate at the end of the contract. d. Hedges are provided by (a) and (b); (c) is not a hedge; (a) is preferred because it costs less.

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e. We can use the nominal interest parity condition, which states that exchanging currency today at the spot rate and investing in a foreign asset should yield the same return as entering a futures contract to exchange currency in the future and investing in a domestic asset. Working backward from part (a), we have: $2,403,846.20(1.06) = $2,548,076.97; $2,548,076.97 × (¥ per dollar) = 250 million yen, so the forward rate has to be ¥98.1132 = $1 in order for the results in (a) and (b) to be equivalent.

3.15

You could buy Canadian dollars in the forward market, buy Canadian dollar futures, or buy a call option on the Canadian dollar.

Data Exercises D8.1 a. From November 2019 to November 2020, the euro declined by 1.91%: ((1.1826 – 1.1051)/1.1051) × 100 = 7.013%. b. The dollar depreciated against the euro. It took more dollars to buy a euro in November 2019 than it did in November 2020.

D8.2

The following graph shows the exchange rate of U.S. dollars for euros and Canadian dollars for U.S. dollars.

The following graph shows the exchange rate of U.S. dollars for Japanese yen.

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a. During the 2001 to 2020 period, the euro reached its highest value in July 2008: 1.5759 dollars per euro. b. During the financial crisis of 2007-2009, the yen appreciated against the U.S. dollar. It took fewer yen to buy a dollar at the end of the crisis than at the beginning of the crisis. Using the official dates of the 2007-2009 recession, the yen appreciated from 112.4490 yen per dollar in December 2007 to 96.6145 yen per dollar in June 2009. c. From January 2001 to November 2020, the euro went from 0.9376 dollars per euro to 1.1826 dollars per euro. The dollar depreciated against the euro by 26.13%. Against the Japanese yen, the U.S. dollar went from 116.6719 yen per dollar to 104.4061 yen per dollar, so the dollar depreciated against the yen by 10.51%. Against the Canadian dollar, the U.S. dollar went from 1.5032 Canadian dollars per U.S. dollar to 1.3073 Canadian dollars per U.S. dollar, so the U.S. dollar depreciated against the Canadian dollar by 13.03%. Over the 2001 to 2020 period, the U.S dollar depreciated the most against the euro.

D8.3 a. The long-term trend since 1973 in the trade-weighted exchange rate for the U.S. dollar against major currencies has been downward. The downward trend would have increased U.S. net exports as a decline in the exchange rate makes U.S. exports cheaper and imports into the United States more expensive. Note that this series ends in 2019.

b. This graph uses the new series, TWEXAFEGSMTH.

The trade-weighted exchange rate for the U.S. dollar against major currencies decreased, which would have increased U.S. exports and decreased U.S. imports, all else equal. However, the Covid-19 pandemic has changed a large number of other factors.

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D8.4 a. b. c.

d.

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Exchanges rates are for December 23, 2020.

The exchange rates are quoted as foreign currency per U.S. dollar: Japanese yen per U.S. dollar, Chinese yuan per U.S. dollar, and Mexican new pesos per U.S. dollar.

The exchange rate between the Japanese yen and the U.S. dollar was 104.4061 Japanese yen per U.S. dollar.

In Japan, a Big Mac would cost 300 yen/103.52 yen = $2.89.

In China, a Big Mac would cost 14 yuan/6.54 yuan = $2.14.

In Mexico, a Big Mac would cost 34 pesos/20.08 pesos = $1.69.

You would want to purchase a Big Mac in Mexico for 34 Mexican pesos, or $1.69, and sell the Big Mac in Japan for ¥300, or $2.89. The profit per Big Mac is $1.20. This profit assumes that Big Macs are not perishable.

Note that the Japanese bond series listed in the question begins in 1999 and ends in 2017, so it can only be used to help explain movements in the yen-dollar exchange rate for that period. Pending update, the following answer illustrates a possible answer to this question.

The question involves the interest-rate parity condition, where the difference in interest rates on similar bonds in different countries reflects expectations of future changes in exchange rates. The difference between the U.S. 3-month Treasury bill rate and the Japanese government securities rate would be positive when the U.S. dollar is expected to depreciate against the Japanese yen, and would be negative when the U.S. dollar is expected to appreciate against the Japanese yen. The difference between the U.S. 3-month Treasury bill rate and the Japanese government securities rate would increase when the U.S. dollar is expected to depreciate more than the market had previously anticipated. Comparing the two series (as shown in the following graphs), the difference between the two interest rates generally increases when the yen-dollar exchange rate is falling and generally decreases when the yen-dollar exchange rate is rising. The inverse relationship is not perfect for several reasons, primarily because the change in the actual yen-dollar exchange rate does not directly measure the change in the expected yen-dollar exchange rate.

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Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 

Brief Chapter Summary and Learning Objectives

9.1

The Financial System and Economic Performance (pages 283–285) Evaluate the reasons economists believe economic performance depends on the financial system.

• Developing a strong financial system can be essential to providing a foundation for robust economic growth and a rising standard of living.

9.2

Transactions Costs, Adverse Selection, and Moral Hazard (pages 285–301) Analyze the problems that transactions costs, adverse selection, and moral hazard pose for the financial system.

• Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment.

• Regulations, collateral, and financial intermediaries help to reduce adverse selection, but do not eliminate it.

• Moral hazard is the problem investors experience in verifying that borrowers are using their funds as intended.

• Corporate boards of directors, incentive contracts, and financial intermediaries help to reduce, but not eliminate, moral hazard.

9.3

Conclusions About the Structure of the U.S. Financial System (pages 301–305) Use economic analysis to explain the structure of the U.S. financial system.

• Loans are the primary source of funds for small-to-medium-sized firms, while the bond market is the primary source of funds for large corporations.

• Financial intermediaries are continually searching for ways to earn a profit by expediting the flow of funds from savers to borrowers.



Key Terms

Adverse selection, p. 287. The problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment.

Asymmetric information, p. 287. The situation in which one party to an economic transaction has better information than does the other party.

Net worth, p. 291. The difference between the value of a firm’s assets and the value of its liabilities.

Principal–agent problem, p. 296. The moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals).

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Collateral, p. 291. Assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan.

Credit rationing, p. 289. The restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate.

Economies of scale, p. 286. The reduction in average cost that results from an increase in the volume of a good or service produced.

Information costs, p. 286. The costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired.

Moral hazard, p. 287. The risk that people will take actions after they have entered into a transaction that will make the other party worse off; in financial markets, the problem investors experience in verifying that borrowers are using their funds as intended.



Private equity firm (or corporate restructuring firm), p. 299. A firm that raises equity capital to acquire shares in other firms to reduce free-rider and moral hazard problems.

Relationship banking, p. 292. The ability of banks to assess credit risks on the basis of private information about borrowers.

Restrictive covenant, p. 297. A clause in a bond contract that places limits on the uses of funds that a borrower receives.

Transactions costs, p. 286. The cost of a trade or a financial transaction; for example, the brokerage commission charged for buying or selling a financial asset.

Venture capital firm, p. 298. A firm that raises equity capital from investors to invest in startup firms.

Chapter Outline

Can Fintech or Crowdsourcing Fund Your Startup?

Recently, some entrepreneurs have turned to fintech firms—firms that use technology to provide innovative financial services—to find funding to start their businesses. Unlike banks, fintech firms finance their loans from funds provided by individual investors and other financial firms and use sophisticated software to analyze a firm’s creditworthiness. Entrepreneurs can also obtain funds from crowdsourcing sites, which raise small amounts of money from many people. Beginning in 2016, investors with incomes or net worth of less than $100,000 could buy up to $2,000 of equity in startups through online crowdsourcing sites and investors with incomes or net worth greater than $100,000 can invest more than $2,000. However, these new means for firms to raise money can be risky for investors because of problems arising from asymmetric information—the startups know much more about how likely they are to be successful than do small investors.

Teaching Tips Students often remark that their money and banking course seems to jump from one topic to the next, without providing a framework for understanding how the pieces fit together. This chapter should help students to understand the relationships among some of the key topics of the course. The unifying theme of this chapter is the idea that many aspects of the financial system evolved to deal with the costs that arise from asymmetric information. The chapter covers the main problems arising from asymmetric information—adverse selection and moral hazard. When students grasp these ideas, recent developments in the financial system become easier to understand.

The chapter discusses the role of financial intermediaries in reducing adverse selection and moral hazard problems. This approach provides students with a clearer understanding of why financial markets provide funds to large firms and intermediaries provide funds to small firms.

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The Financial System and Economic Performance (pages 283–285) Learning objective: Evaluate the reasons economists believe economic performance depends on the financial system.

Many economists believe that a strong financial system is essential to provide a foundation for a country to experience the robust growth required for a rising standard of living. The early development of a modern financial system helps to explain the rapid growth of the U.S. economy during the 1800s, and the connection between the development of a country’s financial system and the performance of its economy remains strong today. The lack of a developed financial system makes it difficult for a country to have a high standard of living.

9.2

Transactions Costs, Adverse Selection, and Moral Hazard (pages 285-301) Learning Objective: Analyze the problems that transactions costs, adverse selection, and moral hazard pose for the financial system.

A. The Problems Facing Small Investors Because of transactions costs and information costs, savers receive lower returns on their investments and borrowers must pay more for the funds they borrow. These costs reduce the efficiency of the financial system, but they also create a profit opportunity for individuals and firms that discover ways to reduce these costs.

B. How Financial Intermediaries Reduce Transactions Costs To avoid high transactions costs, small savers and small and medium-sized firms use financial intermediaries, including commercial banks and mutual funds, to meet their financial needs.

Financial intermediaries take advantage of economies of scale to reduce transactions costs enough to meet the needs of savers and borrowers and still make a profit.

C. Information Problems in Financial Markets Unfortunately for savers, borrowers in poor financial health have an incentive to disguise this fact.

Asymmetric information is the situation in which one party to an economic transaction has more information than does the other party. Adverse selection is the problem investors experience in distinguishing high-risk borrowers before making an investment. Moral hazard is the problem investors experience in verifying that borrowers are using their funds as intended.

D. Adverse Selection Nobel prize winning economist George Akerlof used the example of the used car market to illustrate adverse selection. Because potential car buyers lack the information to distinguish good cars from bad cars, or “lemons,” the market price is likely to be lower than the value of a good car, but higher than the value of a lemon. To reduce the costs of adverse selection, car dealerships act as intermediaries between buyers and sellers. Because investors may be unable to distinguish good firms from lemon firms, investors are reluctant to invest in firms unless there is a great deal of information available about them. This information problem makes it difficult for small-to-mediumsized firms to raise external funds. The Securities and Exchange Commission (SEC) requires publicly traded firms to disclose financial statements as well as material information that may affect the price of a firm’s stock. These regulations reduce the likelihood of adverse selection, but they do not eliminate it. Some private firms, such as Moody’s and Dunn and Bradstreet, attempt to collect information about companies to help investors to better judge the quality of borrowers.

To reduce the problems caused by asymmetric information, lenders often require borrowers to pledge some of their assets as collateral, which the lender can claim if the borrower defaults. Investors often reduce the chance of adverse selection by restricting their lending to high net worth firms because these firms have more to lose in case of default.

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Teaching Tips The Apply the Concept, “Has Securitization Increased Adverse Selection Problems?” explores the possible role of securitization in contributing to the 2007-2009 financial crisis. Students can compare the potential benefits of securitization with the possibility that it can result in increased adverse selection problems. This comparison can help you start a class discussion about one aspect of financial reform—requiring banks to hold a portion of mortgage-backed securities that they sell.

E. Moral Hazard Moral hazard is the problem investors experience in verifying that borrowers are using their funds as intended. Economists refer to the possibility that managers will pursue objectives different from those of shareholders as a principal-agent problem. The shareholders, as owners of the firm, are the principals, while the top managers, who are hired to carry out the owners’ wishes, are the agents.

Corporate boards of directors may be able to reduce moral hazard, but not eliminate it. Incentive contracts are used to better align the goals of top managers with the goals of shareholders. Although options contracts can reduce moral hazard, they can at times also increase it by leading managers to make decisions not in the best interests of shareholders.

A key way investors try to reduce moral hazard in bond markets is by writing restrictive covenants into bond contracts. Restrictive covenants either place limits on the uses of the funds the borrower receives or require that the borrower pay off the bond if the borrower’s net worth drops below a certain level. Commercial banks specialize in monitoring borrowers and have developed effective techniques for ensuring that the funds they loan are actually used for their intended purpose. Venture capital firms raise funds from investors and use the funds to make investments in small startup firms. Venture capital firms often take large ownership stakes in small startup firms and have their employees serve on boards of directors. Private equity firms (or corporate restructuring firms) have helped establish a market for corporate control, which can reduce moral hazard problems by providing a means to remove top management that is failing to carry out the wishes of shareholders.

9.3

Conclusions About the Structure of the U.S. Financial System (pages 301–305) Learning Objective: Use economic analysis to explain the structure of the U.S. financial system.

The following are key features of the financial system: 1. Loans from financial intermediaries are the most important external source of funds for small-tomedium-sized firms.

2. The stock market is a less important source of external funds to corporations than is the bond market. 3. Debt contracts usually require collateral or restrictive covenants.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 9.1 The Financial System and Economic Performance Learning objective: Evaluate the reasons economists believe economic performance depends on the financial system.

Review Questions 1.1

A country without a strong financial system might struggle to achieve high rates of economic growth because it will have a difficult time providing funding for entrepreneurs with new ideas as well as small and medium-sized businesses that want to expand or buy new technology.

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The World Bank’s data tells us that countries with a more developed financial system tend to have a higher level of real GDP per capita. The total amount of credit banks and financial markets extend to households and firms as a percentage of GDP—which is the way the World Bank measures a country’s financial development—has a positive correlation with a country’s real GDP per capita.

Problems and Applications 1.3

The ability of entrepreneurs to start and expand small firms is important for a country’s growth.

Many small firms have an easier time borrowing from small banks than from large banks. So, the fact that in China banks would prefer to lend to large, state-owned firms and that small banks are having difficulty attracting the deposits they need to make loans means business startups will have a more difficult time acquiring funding and small-to-medium-sized firms will have a more difficult time acquiring funds for expansion and new technology.

1.4

a. By the “financial foundations,” Sylla means establishing the credit of the United States government, the development of a bond market, the establishment of a central bank, and the development of a stock market. b. These financial foundations allowed the U.S. government to borrow to fund investment projects for the country, and businesses could raise funds to acquire new capital and new technology.

1.5

We would expect future growth rates to be higher for countries below the line, as their high levels of financial development help firms in the countries acquire the funds they need to expand. As the firms expand, the levels of real GDP per capita in the countries will likely rise.

9.2 Transactions Costs, Adverse Selection, and Moral Hazard Learning objective: Analyze the problems that transactions costs, adverse selection, and moral hazard pose for the financial system.

Review Questions 2.1

Savers with small amounts of money to invest rarely make loans directly to individuals or firms because transactions and information costs make small transactions expensive relative to the expected return. Transactions costs are the costs of a trade or exchange. Savers incur information costs in determining the creditworthiness of borrowers and monitoring how they use the acquired funds.

2.2

This article is referring to a moral hazard problem. When people are insured, they are less likely to take the steps needed to avoid an insurable event happening. For instance, a business may not take on the expense of installing a sprinkler system in a warehouse if it has a fire insurance policy.

2.3

Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment. Moral hazard is the risk that people will take actions after they have entered into a transaction that will make the other party worse off. The “lemons problem” refers to the adverse selection problem that arises from asymmetric information.

Because potential investors have difficulty in distinguishing good borrowers from bad borrowers, these investors offer good borrowers terms they are reluctant to accept. Because banks specialize in gathering information, they are better able to overcome this problem.

2.4

Credit rationing occurs when banks or other financial intermediaries ration the number of loans rather than raising the price of loans (the interest rate). As interest rates increase, problems of adverse selection rise (that is, only those that are less creditworthy are willing to take out a loan at higher interest rates). Therefore, rather than raise interest rates, which can result in making loans only to those who are less creditworthy, banks keep rates lower but engage in credit rationing.

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2.5

The principal-agent problem is an example of moral hazard that occurs when managers (agents) follow their own self-interests rather than the interests of shareholders (principals).

2.6

Venture capital firms raise funds from investors to invest in startup firms. Private equity firms raise funds to acquire shares in established firms with the intention of reducing moral hazard problems.

Crowdfunding raises small amounts of funds from a large number of people on social networking sites for investing typically in small businesses and startups. Crowdfunding plays a role that is more similar to the role played by venture capital firms than to the role played by private equity firms.

Problems and Applications 2.7

Financial intermediaries are able to take advantage of economies of scale, such as standardized legal contracts, specialized loan officers, and sophisticated computer systems, to reduce transactions and information costs. If everyone were perfectly honest, the differences in transactions costs between financial intermediaries and small savers would decline but would not disappear. Evaluating loans would be easier but still necessary because perfectly honest people may propose business ideas that have too low a chance of succeeding. Loans would still need to be processed and contracts would still need to be written so that it would be clear what collateral the lender could claim if the borrower has to default. Even in a perfectly honest world, these transactions costs would still exist and financial intermediaries would still be able to reduce the transactions costs per loan because they make many more loans than would an individual saver.

2.8

Writing bank records in ledgers would not have had significant economies of scale because bank workers would have written in ledgers one by one. There would be little reduction in average cost from workers writing in 20 ledgers versus writing in only 10 ledgers. Computers, however, significantly increase economies of scale in recording bank records. One computer can store thousands of bank records nearly as easily as it can store 10, and the bank would need to purchase the software for entering the records only once (for a given version of software.)

2.9

a. Yes. Landlords know more about the quality of the property, and therefore its true value, than renters. For example, landlords know more about how well an apartment’s heating and air conditioning systems work, whether the apartment has problems with insects, and whether the apartment is quiet, than will potential renters. b. Landlords with inferior apartments may attempt to charge higher rents than they otherwise would receive in the absence of the information asymmetry. Landlords with better quality apartments will have trouble renting them for their true value when potential renters suspect the apartments have hidden defects. There is a possibility of the “lemons problem” of bad rental properties driving good rental properties out of the market. c. The rental property market and the used car market are similar in that a landlord and a current car owner know more about their property and car than the potential renter or buyer. The landlord and car owner differ in that the landlord is not selling the apartment, but merely renting it. If a landlord wants the tenant to renew the lease, the landlord will be forced to maintain the property so that its value approaches the rental rate. This incentive to maintain the property would be similar to a car dealer offering a warranty.

2.10 a. The article describes the adverse selection problem. b. The consequence of adverse selection is that some individuals and firms will be unable to purchase insurance because they may have difficulty convincing insurance companies that they have a low probability of filing a claim. For example, someone who takes precautions to secure his or her home against burglaries may still have difficulty buying property insurance if the person lives in a neighborhood with a high crime rate.

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2.11 a. Yes, this is an example of moral hazard. The government is in effect providing the banks with a form of insurance when the banks make bad loans. As a result, the banks are likely to be less careful in screening loan applicants than they would if they lacked this (implicit) insurance. b. Many problems might arise but, in general, banks will continue to make bad loans and require government bailouts, which diverts funds from other uses and slows economic growth.

2.12 a. Fintech firms are lenders that specialize in making loans to individuals and small businesses that have difficulty borrowing from banks. b. Fintech firms believe that they can profit by making loans to those who are creditworthy but cannot get credit through conventional sources. In particular, young borrowers or anyone without much credit history may be creditworthy but may not be able to get a loan through a bank. These borrowers may be just as creditworthy than those with high FICO scores, but cannot easily prove it.

(Although, on average, a large business or an individual with a good credit history may be more creditworthy). If Fintech firms can correctly assess creditworthiness, they can earn a profit from making these loans because new or small borrowers may indeed be creditworthy and willing to pay a higher interest rate because they cannot get bank loans.

2.13 a. Securitization is the process of combining (or bundling) loans, such as mortgages, into securities that can be sold on financial markets. b. When the loans are bundled together and sold off, the bank that issued the loan doesn’t bear the cost if the borrower fails to pay back the loan. The bank that issues the loan makes its money primarily by originating and selling the loans on the secondary market. This process creates a moral hazard problem. c. The investors did not know that the securities contained bad commercial real estate loans. It is highly unlikely that these securities had high enough interest rates to compensate investors for the additional risk because during this period the market consistently underestimated the risk involved with mortgage-backed securities.

2.14

The insurance companies are trying to avoid the “lemons problem” arising from a disproportionately large number of high-risk policyholders buying insurance. Raising the annual premiums may make the adverse selection problem worse. Low-risk policyholders who live in safe environments and are more careful will be less likely to pay the higher premiums, leaving the insurance company with more of the high-risk policyholders.

2.15 a. The GSEs create a secondary market in home mortgages by selling mortgage-backed securities (MBS) to investors and using the funds to buy mortgages from banks and other lenders. b. Most of the adverse selection and moral hazard problems are shifted from banks and other lenders to the GSEs. Because banks sell loans to the GSEs, they have a reduced incentive to screen borrowers for credit problems—thereby increasing adverse selection problems—and if a borrower stops paying, the GSE and not the bank that originated the loan will suffer the loss. c. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress allowed those borrowers with federally insured loans to apply for forbearance under which they would not have to make payments on their loans for up to one year. But a loan on which a borrower might seek forbearance couldn’t be sold to Fannie Mae or Freddie Mac unless the lender paid a penalty, reducing the willingness of banks and other mortgage lenders to make such loans. In addition, a borrower who sought forbearance would be unable to refinance the loan by taking out a new mortgage at a lower interest rate. Some lenders also worried that if a borrower was granted forbearance, the lender was still responsible for making the payments due to the investor in the MBS. Although Fannie Mae and Freddie Mac agreed to refund these payments to lenders, the process was likely to take months. Banks could rely on their deposits as a source of funds until receiving reimbursement from Fannie Mae and Freddie Mac, but the majority of mortgage lenders in

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2020 were not banks, which means they would have to borrow to fund the payments to investors in MBS. The need to borrow would reduce or in some cases eliminate their profit from making the loan. Lenders also had to determine whether a loan applicant was suffering only a temporary reduction in income as a result of the pandemic or whether the person might be unemployed for an extended period. If the lender made an incorrect decision, the loan might end up not meeting the requirements of the GSEs, and the lender might be required to buy back the mortgage. These provisions effectively shift adverse selection and moral hazard problems back to mortgage lenders rather than the GSEs.

9.3 Conclusions About the Structure of the U.S. Financial System Learning objective: Use economic analysis to explain the structure of the U.S. financial system.

Review Questions 3.1

The owners’ personal funds and profits are the primary sources of funds for small to medium-sized firms. Loans—particularly mortgage loans—from financial intermediaries are the most important source of external funds for small to medium-sized firms.

3.2

The bond market is the most important method of debt financing for corporations.

3.3

The three key features of the financial system are: (1) Loans from financial intermediaries are the most important external source of funds for small to medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms; (2) The stock market is a less important source of external funds for corporations than is the bond market. There is less moral hazard involved with bonds than with stocks; and (3) Debt contracts usually require collateral or restrictive covenants.

The purpose of the collateral and restrictive covenants is to reduce moral hazard.

Problems and Applications 3.4

Insurance companies don’t offer income insurance of this type for two key reasons: (1) Moral hazard. Once insured, a person may not work hard and may actually want to be fired from his job, and (2) Adverse selection. People who are more likely to be fired or get small raises would be more likely to buy such insurance.

3.5

Restrictive covenants in loan agreements may seem a waste to the borrowers, but lenders use restrictive covenants, just as insurance companies use co-payments, to reduce moral hazard.

3.6

Asymmetric information makes information costs for external funds higher than for internal funds.

Information costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal. The answer depends on the extent to which asymmetric information problems are overcome through debt finance (loans and bonds); takeovers and threats of takeovers financed by private equity firms; firms having high net worth; or shareholders exercising greater control of public firms. If asymmetric information problems cannot be overcome, then firms may spend less on expansion than would be economically optimal in the absence of such problems.

3.7

a. A junk bond is a bond with a rating below investment-grade, which means that the firm issuing the bond has a higher probability of default on its payments. Investors typically require a higher yield on these bonds to compensate them for this greater default risk. b. Investors might be willing to buy these bonds if the return on safer investments was even lower. c. Investors face default risk as well as interest-rate risk, where increases in interest rates could substantially decrease the prices of corporate bonds, causing investors to incur capital losses. So these bonds can be risky even if Ball Corporation does not default.

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The more complex the product, the more difficult it is for an investor to assess the risk of the product.

When investors buy simpler products, they typically have more information and can make more informed choices about the products. The more complex deal is often one for which information costs increase, which reduces the resulting return on the investment.

Data Exercises D9.1

Currently (February 2021), all three of these brokerages have no transactions fees. In principle, high transactions fees could make some investments less desirable.

D9.2

Recessions are shown on the following graph.

a. Household net worth is the value of households’ total assets minus the value of their total liabilities. b. During the eleven recessions over the 1952 to 2020 period, household net worth typically either fell or increased slowly just before a recession and rose after a recession. During the recessions, the change in household net worth varied across the recessions. For example: • Household net worth declined during the 2007-2009 and 2001 recessions.

• Household net worth rose during the 1953-1954, 1957-1958, 1980, and 1981-1982 recessions.

• Household net worth declined and then rose during the 1960-1961, 1969-1970, and 1973-1975 recessions. c. Household net worth declined by so much during the recession of 2007-2009 because of the large decline in housing prices and the subsequent decline in stock prices. The decline in household net worth decreased consumption spending, increasing the severity of the 2007-2009 recession.

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D9.3

a. A nonfinancial corporation is a corporation that is not a financial firm such as a commercial or investment bank. Examples of a nonfinancial corporation are ExxonMobil and Microsoft. Corporate net worth is the value of the corporations’ total assets minus the value of their total liabilities.

Corporate net worth is also called shareholders’ equity. b. During the 1952 to 2016 period, nonfinancial corporate net worth either fell or increased slowly before five recessions and rose before five other recessions. Nonfinancial corporate net worth rose during six recessions, declined during one recession, and was flat or fluctuated during three other recessions. Nonfinancial corporate net worth rose after nine recession and fell after one recession. c. Corporate net worth declined due to the decline in commercial real estate prices. For all but the largest corporations, commercial real estate is a key source of collateral. The decline in net worth and the decline in commercial real estate values combined with increased caution among lenders made it more difficult for companies to borrow. With reduced access to credit, firms curtailed expenditures relative to what they otherwise would have been.

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Chapter 10 The Economics of Banking 

Brief Chapter Summary and Learning Objectives

10.1 The Basics of Commercial Banking: The Bank Balance Sheet (pages 311–321) Evaluate a bank’s balance sheet.

• A bank’s balance sheet provides a summary of a bank’s sources and uses of funds.

• Bank liabilities are the funds banks acquire from savers and use to make investments or to make loans to borrowers.

• A bank’s managers build a portfolio of assets that reflect both the demand for loans by the bank’s customers and the bank’s need to balance returns against risk, liquidity, and information costs.

• Bank capital is the difference between the value of a bank’s assets and its liabilities.

10.2 The Basic Operations of a Commercial Bank (pages 321–325) Describe the basic operations of a commercial bank.

• Banks use deposits to acquire interest-bearing assets, which results in a profit if the interest earned on the assets is sufficiently higher than the interest paid on deposits.

• A bank’s profitability can be measured in several ways, including net interest margin, return on assets, and return on equity.

10.3 Managing Bank Risk (pages 325–333) Explain how banks manage risk.

• Liquidity risk refers to the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost. Banks can reduce this risk by asset and liquidity management.

• Credit risk is the risk that borrowers might default on their loans. Banks can reduce this risk by diversifying across borrowers, regions, and industries.

• Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital.

Banks can reduce this risk by making variable-rate loans and using interest-rate swaps.

10.4 Trends in the U.S. Commercial Banking Industry (pages 333–343) Explain the trends in the U.S. commercial banking industry.

• The United States currently has a dual banking system in which banks can be chartered either by state governments or by the federal government.

• Congress created the Fed as a lender of last resort and the Federal Deposit Insurance Corporation to reduce the likelihood of bank panics.

• In recent decades, the federal and state governments have lifted restrictions on interstate banking and on the number of branches banks can have, giving rise to nationwide banking.

• Off-balance-sheet activities and electronic banking have expanded the boundaries of banking.

• In response to the Financial Crisis of 2007–2009, Congress created the Troubled Asset Relief Program (TARP), which injected funds into banks with the intent of avoiding a surge in bank failures.

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Key Terms

Asset, p. 312. Something of value that an individual or a firm owns; in particular, a financial claim.

Liquidity risk, p. 325. The possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.

Balance sheet, p. 311. A statement that lists an individual’s or a firm’s assets and liabilities to indicate the individual’s or firm’s financial position on a particular day.

Loan commitment, p. 340. An agreement by a bank to provide a borrower with a stated amount of funds during a specified period of time.

Bank capital, p. 312. The difference between the value of a bank’s assets and the value of its liabilities; also called shareholders’ equity.

Bank leverage, p. 324. The ratio of the value of a bank’s assets to the value of its capital, the inverse of which (capital to assets) is called a bank’s leverage ratio.

Checkable deposits, p. 329. Accounts against which depositors can write checks.

Credit rationing, p. 336. The restriction of credit by lenders with the result that borrowers cannot obtain the funds they desire at the given interest rate.

Credit risk, p. 326. The risk that borrowers might default on their loans.

Credit-risk analysis, p. 326. The process that bank loan officers use to screen loan applicants.

Dual banking system, p. 334. The system in the United States in which banks are chartered by either a state government or the federal government.

Duration analysis, p. 332. An analysis of how sensitive a bank’s capital is to changes in market interest rates.

Excess reserves, p. 317. Any reserves banks hold above those necessary to meet reserve requirements; as of March 2020, because the Fed had eliminated all reserve requirements, all bank reserves are excess reserves.

Federal deposit insurance, p. 314. A government guarantee of deposit account balances up to $250,000.

Gap analysis, p. 331. An analysis of the difference, or gap, between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities.

Loan sale, p. 340. A financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.

National bank, p. 334. A federally chartered bank.

Net interest margin, p. 323. The difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.

Off-balance-sheet activities, p. 339. Activities that do not affect a bank’s balance sheet because they do not increase either the bank’s assets or its liabilities.

Prime rate, p. 329. Formerly, the interest rate banks charged on six-month loans to high-quality borrowers; currently, an interest rate banks charge primarily to smaller borrowers.

Required reserves, p. 317. Reserves the Fed requires banks to hold against demand deposit and NOW account balances; note that as of March 2020, banks are no longer required to hold reserves.

Reserves, p. 317. A bank asset consisting of vault cash plus bank deposits with the Federal Reserve.

Return on assets (ROA), p. 323. The ratio of the value of a bank’s after-tax profit to the value of its assets.

Return on equity (ROE), p. 324. The ratio of the value of a bank’s after-tax profit to the value of its capital.

Standby letter of credit, p. 340. A promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures.

T-account, p. 322. An accounting tool used to show changes in balance sheet items.

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Interest-rate risk, p. 330. The effect of a change in market interest rates on a bank’s profit or capital.

Leverage, p. 324. A measure of how much debt an investor assumes in making an investment.

Liability, p. 312. Something that an individual or a firm owes.

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Troubled Asset Relief Program (TARP), p. 342.

A government program passed by Congress in 2008 under which the U.S. Treasury purchased stock in hundreds of banks to increase the banks’ capital.

Vault cash, p. 317. Cash on hand in a bank; includes currency in ATMs and deposits with other banks.

Chapter Outline

A Pandemic Shows the Importance of Banks Federal aid was available to many individuals and small businesses in the spring of 2020, but for some of these people and businesses, receiving the aid turned out to be difficult. The aid was available under the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Under the act, if you earned less than $75,000, you would receive a payment of $1,200 from the federal government. Using information from your 2019 tax return, the U.S. Treasury would directly deposit the amount into your bank checking account without your needing to apply for it. If you didn’t have a checking account, you could still receive the payment in the form of a paper check or a debit card mailed to you, but you would have to apply and wait longer. Some economists and policymakers believed that this event highlighted the difficulties that people without bank accounts face.

One proposal to increase access to banking was to have the Federal Reserve for the first time offer banking services to households and businesses. Several members of Congress also introduced legislation to revive a version of the Postal Savings System, under which between 1911 and 1967 local post offices offered households certain banking services.

The CARES Act also provided help to small businesses and their employees through the Paycheck Protection Program (PPP). Under the PPP, small businesses were eligible for loans to be administered through the federal Small Business Association. If a business spent 60% of the loan amount on payroll expenses, the loan would be converted to a grant that the business would not have to pay back. Many businesses found that if their business checking account was with a large bank, but they didn’t have an existing loan with the bank, the bank gave their PPP loan application a low priority. Some small businesses were more successful in securing loans through the PPP if they had business checking accounts with a small bank, often called a community bank. Community banks practice relationship banking, which involves banks gathering private information on borrowers to assess credit risks.

The presence of significant economies of scale in some aspects of banking have led to a consolidation in the industry, with the ten largest banks now holding almost half of all deposits. But in some areas of banking services, such as loans to small businesses, economies of scale appear to be much more limited, which has allowed some small banks to thrive. Following the difficulty during the pandemic of distributing government payments to people without bank accounts, policymakers were considering whether small banks might also be the key to extending banking services to rural and lower-income urban areas or whether a different approach would be required.

Teaching Tips This is a key chapter. It focuses on the role commercial banks play as intermediaries in the savinginvestment process and on how banks manage the risks involved in their deposit and lending activities.

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students. The chapter begins with a discussion of bank balance sheets. Most students will be familiar with the basics of balance sheets from their principles of economics course. Those students who have taken an introductory accounting course will have even greater familiarity with the topic. Nevertheless, try to spend some time reviewing the fundamentals of the definitions of assets and liabilities and how assets and liabilities enter a balance sheet. The mechanics of T-accounts can be mysterious to many students who have been exposed to them in their principles course but have not yet fully understood them. The money creation process that T-accounts illustrate can be one of the most difficult topics in the course, so it is worthwhile making students comfortable with this material before they encounter the discussion in Chapter 14 that relies on understanding it.

10.1 The Basics of Commercial Banking: The Bank Balance Sheet (pages 311–321) Learning Objective: Evaluate a bank’s balance sheet.

A bank’s balance sheet provides a summary of a bank’s sources and uses of funds. The balance sheet illustrates the relationship among a bank’s assets, liabilities, and capital (or shareholders’ equity).

A. Bank Liabilities Bank liabilities are the funds that banks acquire from savers, which banks use to make investments or loans to borrowers. There are two types of checkable deposits: 1. Demand deposits, which do not pay interest.

2. NOW accounts, which do pay interest.

Nontransaction deposits consist of savings accounts, money market deposit accounts, and certificates of deposits (CDs), also known as time deposits. CDs worth more than $100,000 can be traded in secondary markets prior to maturity. Banks also can borrow from other banks in the federal funds market, execute repurchase agreements with other financial firms, or take out discount loans from the Federal Reserve. Repurchase agreements involve a bank selling a security, while typically agreeing to buy it back the next day with interest.

B. Bank Assets A bank’s managers build a portfolio of assets that reflect both the demand for loans by customers and the bank’s need to balance returns against risk, liquidity, and information costs.

The most liquid asset that banks hold is reserves, which can be held as vault cash or as bank deposits at the Fed. Required reserves are the portion of demand deposits and NOW accounts that the Fed requires banks to hold. Any reserves beyond what is required are called excess reserves. Banks are allowed to hold marketable securities including those issued by the U.S. Treasury and other government agencies, corporate bonds that were rated investment grade when first issued, and a limited amount of municipal bonds. The largest asset of banks is loans, which are illiquid and have higher information costs and default risk than marketable securities.

Other bank assets include physical assets and collateral received from borrowers who have defaulted on loans.

C. Bank Capital Bank capital is the difference between the value of a bank’s assets and its liabilities. Bank capital includes funds obtained from purchases of stocks issued by the bank plus accumulated retained profits.

10.2 The Basic Operations of a Commercial Bank (pages 321–325) Learning Objective: Describe the basic operations of a commercial bank.

Banks use deposits to acquire interest-bearing assets and earn a profit if the interest earned on the assets is sufficiently greater than the interest paid on the deposits. To be successful, a bank must

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make prudent loans and investments so that it earns a high enough rate of return to cover its costs.

Banks avoid large swings in reported losses and profits by setting aside loan loss reserves in anticipation of future declines in the value of their loans.

A. Bank Capital and Bank Profit A bank’s profitability can be measured in several ways. A bank’s net interest margin is the difference between the interest it receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets. Return on assets (ROA) is the ratio of the value of a bank’s after-tax profit to the value of its assets. Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to the value of its capital. The ratio of assets to capital is a measure of bank leverage because banks take on debt by, for instance, accepting deposits to gain the funds needed to accumulate assets. Leverage can magnify small ROAs into large ROEs (or small losses into large losses). Because depositors are shielded from losses by federal deposit insurance and bank managers are compensated in part based on ROE, moral hazard may result in high bank leverage. Regulators deal with this risk by imposing capital requirements on banks.

Extra Apply the Concept Is Your Neighborhood ATM About to Disappear?

ATMs came into widespread use in the United States during the early 1970s and revolutionized banking.

For the first time, customers could withdraw money and deposit checks without waiting in line for a teller during normal banking hours. Banks were also able to process more transactions with fewer employees, thereby increasing productivity. Some economists have argued that ATMs were the first important product of modern information technology because they appeared before personal computers became widely available. ATMs have continued to evolve over the years, and current ATMs can, among other things, accept deposits without the depositor having to use an envelope and are equipped with scanners that can detect counterfeit currency.

As important as ATMs have been in banking in recent years, is it possible that they are on their way out? There are conflicting influences on ATM usage. Banks have responded to regulations that limit the fees they can charge merchants for processing debit cards and regulations limiting overdraft charges by increasing monthly charges on basic checking accounts and by reducing some services offered to lowerincome customers. Some banks closed branches in lower-income neighborhoods, forcing customers to either use ATMs or travel further to use a branch. A few banks began charging customers fees if they use a bank teller for transactions that could be handled by using an ATM. These developments have led to increased use of ATMs. During the Covid-19 pandemic that began in the spring of 2020, many branches closed or reduced their hours. People who needed or preferred to use cash for purchases relied more heavily on ATMs during that time.

Other developments, however, are leading to reduced use of ATMs. For example, increased use of debit cards has reduced the demand for currency, thereby reducing the necessity of using ATMs. A possibly greater threat to ATMs, though, may come from smartphones and other mobile devices. New apps, such as Apple’s Apple Pay, makes it possible for consumers to pay for some goods using their phones or Venmo and Zelle, which allow people to send—usually small—amounts of money to friends. It seems likely that these apps will further reduce the demand for currency. In addition, some convenience stores, restaurants, and other businesses in the United States are moving toward not accepting currency, requiring consumers to make payments with credit cards, debit cards, or phone apps. Although some local governments have begun requiring all businesses to accept currency, if the trend toward stores not accepting cash continues, it will reduce the demand for currency and, accordingly the demand for the services of ATMs.

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ATMs are much less costly to banks than are bank branches, but ATMs still have to be maintained, filled with cash, and have deposits picked up. It costs a bank about $1,100 per month to run an ATM at a branch and $1,700 per month to run one at a mall, a service station, or another location the bank doesn’t own. As usage of ATMs has declined, some locations have ceased to be profitable.

Whether the ATM, once seen as a marvel of modern information technology, will go the way of the electric typewriter remains to be seen.

Sources: Scott Calvert, “Philadelphia Is First U.S. City to Ban Cashless Stores,” Wall Street Journal, March 7, 2019; Peter Rudegeair, “Venmo Has 40 Million Users, Outnumbering Most Big Banks,” Wall Street Journal, April 24, 2019; Robin Sidel, “Banks Join the Do-It-Yourself Craze,” Wall Street Journal, May 15, 2012; Ann Carrns, “Whither the ATM?” New York Times, July 25, 2012; Rachel Swaby, “Safe, Smart, and … Fun? The Surprising Science of ATMs,” gizmodo.com, March 22, 2012; and Hugh Son and Zachary Tracer, “BofA Yanks Most Teller Machines from Malls, Gas Stations,” Bloomberg.com, July 23, 2012.

10.3 Managing Bank Risk (pages 325-333) Learning Objective: Explain how banks manage risk.

A. Managing Liquidity Risk Liquidity risk refers to the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost. Banks typically reduce liquidity risk through asset management and liquidity management. Two options include: 1. Lending funds in the federal funds market.

2. Engaging in reverse repurchase agreements.

Banks may also engage in liability management through: 1. Borrowing funds in the federal funds market.

2. Engaging in repurchase agreements.

3. Obtaining discount loans from the Fed. B. Managing Credit Risk Credit risk is the risk that borrowers might default on their loans. By diversifying across borrowers, regions, and industries, banks can reduce their credit risk. In performing credit-risk analysis, bank loan officers screen loan applicants to obtain a pool of creditworthy borrowers.

To combat problems due to adverse selection, banks generally require that a borrower put up collateral. Banks can also minimize the costs of adverse selection and moral hazard through credit rationing, which means that banks limit the size of a loan or refuse to lend any amount to some borrowers at the current interest rate. Banks keep track of whether borrowers are obeying restrictive covenants or explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities. One of the best ways for a bank to gather information about a borrower’s prospects or to monitor a borrower’s activities is to have a long-term business relationship with the borrower.

C. Managing Interest-Rate Risk Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital.

Gap analysis looks at the difference between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities and can help a bank assess the effect of a change in interest rates on its profits. Duration analysis is an analysis of how sensitive a bank’s capital is to changes in market interest rates. A bank can use its duration gap, which is the difference between the average duration of its assets compared to the average duration of its liabilities, to gauge how much the value of its capital will decline if interest rates rise. Banks can reduce interest-rate risk by making adjustable-rate loans and using interest-rate swaps.

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Extra Apply the Concept Your Bank’s Message to You: “Please Go Away!”

Many people complain about the very low interest rates banks pay on checking accounts. Some checking accounts pay zero interest. You are letting the bank use the money in your checking account, and that’s all the return you get? Actually, if you are like many bank customers, your bank may well be losing money on your checking account. It costs banks about $300 per year to process the checks, prepare checking account statements, and cover the other costs involved with a typical checking account. And that amount doesn’t include the costs of running bank branches, such as the salaries of tellers.

How do banks expect to cover the costs of your checking account? Clearly not just from loaning out your money. Suppose you have $1,000 in your checking account, on which your bank is paying you no interest. Even if the bank can bundle your $1,000 with funds from other people’s checking accounts to make a car loan at 6%, the bank has earned only $60 in interest on your deposit. Traditionally, banks have earned income from depositors in three other ways: (1) By collecting fees from stores when depositors use their debit cards for purchases; (2) by charging overdraft fees when depositors have insufficient funds in their accounts to cover the checks they write; and (3) by collecting fees when depositors take out loans or purchase mutual funds or other financial products. Income from the first two sources began to decline sharply as a result of new regulations authorized by the Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act that Congress passed and then President Obama signed in 2010. These regulations put a cap on the amount that banks could charge merchants for debit card transactions. The cap was estimated to reduce bank revenues by $8 billion per year.

The new regulations meant that banks had to concentrate on the fees they could earn when depositors took out mortgage loans, bought mutual funds, or hired banks to manage their wealth. Low-to-moderateincome depositors, though, only infrequently take out mortgages, buy financial products, or hire anyone to manage their wealth. As a result, banks were losing money on the checking accounts held by these depositors. One industry analyst was quoted as saying: “Banks for a long time have been unable to charge enough to cover the cost of maintaining a checking account. The changes made by Congress certainly made it even harder.”

Banks have responded to the new environment in a number or ways. Some banks have closed branches in lower-income neighborhoods while opening additional branches in higher-income neighborhoods. Banks have increased their marketing of securities and financial advice to higher-income customers. Nearly all banks have raised minimum balance requirements for free checking accounts and many have adopted a long-term strategy of trying to push low-income customers to transact most of their business through ATMs rather than by using tellers at bank branches.

Mark Williams of Boston University argues that: “The traditional banking model is fractured. Some lower-margin customers will have to go elsewhere to find the same level of service.” During the Covid-19 pandemic, many bank branches were temporarily closed or offered only limited hours. Those branches that were open typically had fewer visits from customers. It was unclear in early 2021 whether decline in business during the pandemic would accelerate the trend of banks closing branches.

Sources: Orla McCaffrey, “People Aren’t Visiting Branches. Banks Are Wondering How Many They Actually Need,” Wall Street Journal, June 7, 2020; Robin Sidel, “‘Free’ Checking Costs More,” Wall Street Journal, September 24, 2012; Aaron Elstein, “Chase Chief Loses Money on Nearly Half His Retail Customers,” Bloomberg News, March 4, 2012; and Nelson D. Schwartz, “Got $100,000? Have a Cookie: Banks Try Luring the Top 10%,” New York Times, March 10, 2012.

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10.4 Trends in the U.S. Commercial Banking Industry (pages 333-343) Learning Objective: Explain the trends in the U.S. commercial banking industry.

A. The Early History of U.S. Banking The United States has a dual banking system in which banks can be chartered either by state governments or by the federal government. The National Banking Acts of 1863 and 1864

prohibited banks from using deposits to buy ownership of nonfinancial firms.

B. Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation In the nineteenth and early twentieth centuries, if many banks simultaneously experienced runs, the result would be a bank panic, which often resulted in banks being unable to return depositors’ money and having to at least temporarily close their doors. In response to the Panic of 1907, Congress created the Federal Reserve System and assigned it the role of lender of last resort. The bank panics of the early 1930s led Congress to create the Federal Deposit Insurance Corporation (FDIC) in 1934, which insures bank deposits. The FDIC handles bank failures either by closing the bank and paying off depositors, or by purchasing and controlling the bank until it finds another bank that is willing to purchase the failed bank.

C. Legal Changes, Economies of Scale, and the Rise of Nationwide Banking A series of federal laws prohibited interstate banking, while many states prohibited banks from operating more than one branch. Most economists think these restrictions made banks inefficient because they could not take advantage of economies of scale. After the mid-1970s, most states removed restrictions on branches; in the 1990s, the federal government removed most restrictions on interstate banking. During and after the financial crisis of 2007-2009, there has been debate over whether restrictions should be imposed on the size of banks because some banks are considered “too big to fail.”

D. The Expanding Boundaries of Banking Banks have increasingly turned to generating fee income from off-balance-sheet activities, including standby letters of credit, loan commitments, loan sales, and trading activity. Although banks generate fee income from off-balance-sheet activities, they also take on additional risk. In recent years, banks have made increasing use of virtual or online banking.

E. The 2007-2009 Financial Crisis, TARP, and Partial Government Ownership of Banks During the financial crisis of 2007-2009, the market for mortgage-backed securities froze, making it very difficult to determine the market prices of these securities. The true value of bank capital—or even whether a bank still had positive net worth—was difficult to determine.

Beginning in August 2007, banks responded to their worsening balance sheets by tightening credit standards for consumer and commercial loans. This resulted in a credit crunch that contributed to the severe recession that began in December 2007. In October 2008 Congress passed the Troubled Asset Relief Program (TARP), which provided up to $700 billion to be used to stabilize the banking system. Some of these funds were used as capital injections into banks, resulting in partial government ownership. In return, banks had to pay dividends of 5% of the value of the stock to the Treasury as well as to issue warrants that allowed the Treasury to purchase additional shares up to 15% of the Treasury’s original investment. Some critics of TARP claimed it was a bailout that increased moral hazard and argued that TARP might lead banks to make loans based on political pressure. Supporters of TARP argued that it was necessary given the fear that there would be a surge in bank failures leading to another Great Depression. By mid-2016, the TARP program had earned a $30 billion profit.

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 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 10.1 The Basics of Commercial Banking: The Bank Balance Sheet Learning objective: Evaluate a bank’s balance sheet.

Review Questions 1.1

Assets = Liabilities + Shareholders’ equity. The most important bank assets are reserves and other cash assets, securities, and loans. The most important bank liabilities are checkable deposits, non-transaction deposits, and borrowings.

1.2

A bank’s liabilities, principally deposits and borrowings, are the sources of the funds the bank loans out or invests. A bank’s assets, principally loans and securities, are the bank’s uses of those funds.

1.3

Funds in your checking account are an asset to you (because you are making a loan of your funds to the bank, but you can withdraw those funds at any time), and they are a liability to the bank because they have to repay the funds to you.

1.4

Real estate loans have become a much higher percentage of total loans since 1973, while commercial and industrial loans have declined significantly and consumer loans have declined moderately.

Problems and Applications 1.5

On the one hand, by owning a significant amount of stock, banks might be better able to monitor the behavior of the companies they had made loans to, so moral hazard should decrease. On the other hand, stocks have more moral hazard than bonds, so an increase in the amount of stocks relative to bonds would increase the overall level of moral hazard in the financial system.

1.6

Banks offering interest on checking accounts has not increased the popularity of checking accounts for several reasons: (1) Banks have created several savings instruments, including certificates of deposit and money market deposit accounts, that offer higher interest rates and that many savers prefer to checking accounts; (2) in 1981, banks introduced money market deposit accounts, which pay higher interest rates than checking accounts, while still allowing savers to write three checks per month; and (3) as wealth has increased over time, households have held less of their wealth in checking accounts relative to other financial assets.

1.7

a. The long-term lending represents an asset to the banks and a liability to the firms borrowing the funds. b. The value of the bank’s assets relative to liabilities must have increased if bank capital has increased. c. U.S. Treasury securities are highly liquid assets held by banks.

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1.8

a.

Assets

Liabilities and Bank Capital

U.S. Treasury bills $20

Savings accounts $10

Mortgage-backed securities $30

Now accounts $40

C&I loans $50

Discount loans $5

Municipal bonds $5

Demand deposits $40

Cash items in the process of collection $5

Loans from other banks $5

Bank building $4 Reserve deposits with Federal Reserve $8 Assets $122

Liabilities $100 Capital $22

b. Using the data from part (a): Capital/asset = $22 million/$122 million = 0.18, so the bank’s capital is equal to 18% of its assets.

1.8

a. No, a loan from the Treasury would not be counted as bank capital. The loan would be counted as borrowing and appear on the right side of the balance sheet. b. The member of Congress is incorrect because bank capital appears on the right side of the balance sheet, not the left side.

10.2 The Basic Operations of a Commercial Bank Learning objective: Describe the basic operations of a commercial bank.

Review Questions 2.1

A T-account is an accounting tool used to show changes in balance sheet items. We can show the effect of your deposit on Bank of America’s balance sheet using a T-account by adding $50 to the bank’s assets as vault cash (vault cash is part of the bank’s reserves) and $50 to the bank’s liabilities as checkable deposits.

Bank of America Assets

Liabilities

Vault cash +$50

Checkable deposits +$50

2.2

Return on assets (ROA) is the ratio of a bank’s after-tax profit to the value of its assets. Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to the value of its capital.

The two ratios are related because ROE equals ROA × (Bank assets/Bank Capital).

2.3

“Highly leveraged” means that a bank has a high ratio of bank assets to the value of its capital, meaning that the bank has funded a high proportion of its assets with debt (deposits) as opposed to capital. The managers of a bank typically have their salaries determined in part by the bank’s return on equity or by measures of the bank’s success—such as the price of the bank’s stock— that are related to the return on equity. As a result, the managers have an incentive to increase the bank’s leverage in order to increase the bank’s return on equity. The resulting risk is often greater than shareholders would want the managers to take because higher leverage increases the chances of the bank suffering losses and may even force it into bankruptcy.

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Problems and Applications 2.4

Bank of America’s holdings of securities fall by $10 million and its reserves increase by $10 million. PNC Bank holdings of securities increase by $10 million and its reserves fall by $10 million.

Bank of America Assets

Liabilities

Reserves +$10 million Securities −$10 million PNC Bank Assets

Liabilities

Reserves −$10 million Securities +$10 million 2.5

SunTrust Bank’s checkable deposits fall by $100 and its reserves fall by $100. National City Bank’s checkable deposits increase by $100 and its reserves increase by $100.

SunTrust Bank Assets

Liabilities

Reserves −$100

Checkable deposits −$100 National City Bank

Assets

Liabilities

Reserves +$100

Checkable deposits +$100

2.6

National Bank of Guerneville has $3.4 million in required reserves (10% of $34 million), so the bank has $0.6 million in excess reserves. Commonwealth Bank has $4.7 million in required reserves (10% of $47 million), so the bank has $0.3 million in excess reserves. After the check clears, National Bank of Guerneville loses $1 million in checkable deposits and $1 million in reserves, and Commonwealth Bank gains $1 million in checkable deposits and $1 million in reserves. After the transaction: National Bank of Guerneville now has −$0.3 million in excess reserves (total reserves decline by $1 million to $3 million and required reserves are now $3.3 million (10% of $33 million)), and Commonwealth Bank has $1.2 million in excess reserves (total reserves rise to $6 million and required reserves increase to $4.8 million (10% of $48 million)). National Bank of Guerneville must take steps to bring its level of required reserves back up to the minimum by borrowing in the federal funds market, selling assets, or borrowing from the Federal Reserve.

2.7

ROE = ROA × (Bank assets/Bank Capital). In this case, ROE = 0.02 × ($40 billion/$4 billion) = 0.2, or 20%.

2.8

a. ROE = ROA × (Bank assets/Bank Capital). In this case, ROE = 0.02 × ($200 million/$20 million) = 0.2, or 20%. b. ROE = 0.02 × ($200 million/$10 million) = 0.4 or 40%.

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2.9

a. Shareholders care mostly about the return on their investment – the return on their equity. A lower return on equity means a lower return on shareholder’s investment, which would decrease the value of owning a share of stock in the bank. b. More capital relative to assets lowers bank leverage, and therefore, for a given return on assets, lowers the return on equity.

2.10 a. Leverage is a measure of how much debt an investor assumes in making an investment. A bank’s leverage ratio is the ratio of bank capital to assets. The inverse, the ratio of assets to capital, is a measure of bank leverage because banks take on debt by, for instance, accepting deposits to gain the funds to accumulate assets. b. Reducing the leverage ratio means that banks can hold less capital relative to assets (or more assets relative to capital). That means that they can take in more deposits and make more loans without having to increase the amount of capital held, increasing both the asset and liability sides of the bank balance sheet and thereby “growing” it. c. During a financial crisis, the Fed would like banks to make more loans, thereby easing credit conditions.

2.11

10.3

The bank has a ratio of assets to capital of ($5,000 million/$300 million) = 16.7. The higher the ratio of assets to capital the more leveraged the bank and the higher the bank’s return on equity for a given return on assets. But the greater the bank’s leverage the greater the bank’s losses if its return on assets becomes negative. The text notes that for the banking system as a whole, in May 2020, the ratio of assets to capital was 10.2. It would be unwise, generally speaking, for you to invest in a bank with a ratio of assets to capital as high as the one in this problem.

Managing Bank Risk

Learning objective: Explain how banks manage risk.

Review Questions 3.1

Liquidity risk is the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost. Banks manage liquidity risk on the asset side by lending funds in the federal funds market and using reverse repurchase agreements to make very short-term loans, and on the liability side by borrowing in the federal funds market, borrowing from businesses or other banks using repurchase agreements, and borrowing from the Federal Reserve. Credit risk is the risk of credit default. Banks can manage credit risk by: (1) diversifying their assets; (2) performing credit risk analysis: (3) requiring borrowers to put up collateral; (4) credit rationing; (5) monitoring borrowers and using restrictive covenants; and (6) creating long-term business relationships through which the bank can acquire information about borrowers. Interest-rate risk is the risk associated with the effect of a change in interest rates on a bank’s profits or capital. Banks can reduce interest-rate risk by: (1) making more variable-rate loans; (such as adjustable-rate mortgages); (2) using interest rate swaps; and (3) using futures and options contracts.

3.2

A credit report states a person’s credit history. The report includes how much the person owes on loans, how many credit cards he has and what their balances are, how reliably he pays bills on time, where he lives, and who he works for. A credit score summarizes with a numerical value a person’s credit history. The higher the credit score the better the credit history.

3.3

Gap analysis looks at the difference between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities to gauge how sensitive the bank’s profits are to movements in interest rates. Duration analysis looks at the durations of the bank’s assets and its

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liabilities to gauge how sensitive a bank’s capital is to changes in market interest rates. The purpose of both gap analysis and duration analysis is to determine the extent of a bank’s interestrate risk.

Problems and Applications 3.4

The liquidity risk would have been larger because the absence of deposit insurance created the incentive for depositors to withdraw funds whenever they became concerned about a bank’s financial health. Therefore, banks were periodically subject to large deposit withdrawals.

3.5

In principle, banks could meet the need for currency during a bank run by drawing down their reserves. But if the reserves are required, banks can’t use the funds for this purpose. They could, of course, use excess reserves to meet deposit withdrawals. Except to the extent that holding required reserves reassured depositors that if a bank failed the depositors would eventually get at least some of their money bank, reserve requirements did not make it easier for banks to deal with bank runs.

3.6

a. Agree. When interest rates increase, the bank will be earning more on its rate-sensitive assets, such as adjustable-rate loans, because it will have more of them, and paying less on its variablerate liabilities, such as short-term CDs, because it will have fewer of them. b. Agree. A fall in interest rates with a positive duration gap will increase a bank’s capital by increasing the value of the bank’s assets relative to its liabilities. c. Disagree. A longer duration of the bank’s liabilities will increase their value when interest rates fall, thereby reducing the value of the bank’s capital relative to what it would otherwise have been.

3.7

a. Fintech lenders like SoFi are alternatives to conventional lenders like banks. b. Fintech lenders often target young people with little or no credit histories. Because less is known about the ability of these borrowers to repay loans, and also because younger borrowers may be more subject to layoffs during recessions, the default rates of these borrowers may be higher than average.

3.8

The problem with the bill is that it increases adverse selection in the market for loans. With high interest rates, the low-risk borrowers in this group will be likely to drop out of the loan pool, leaving mainly high-risk borrowers.

3.9

Duration gap = Average duration of assets – Average duration of liabilities = 5 years – 3 years = 2 years.

10.4

Trends in the U.S. Commercial Banking Industry

Learning objective: Explain the trends in the U.S. commercial banking industry.

Review Questions 4.1

The phrase “dual banking system” refers to the mixture of state banks and national banks. A state bank has a charter from a state government, and a national bank has a charter from the federal government. The United States has maintained this dual banking system since 1863, when the National Banking Act made it possible for a bank to obtain a federal charter.

4.2

Congress established the FDIC (Federal Deposit Insurance Corporation) in 1934 after the country experienced a series of bank panics. Congress wanted to reduce the occurrence of bank runs by reassuring depositors that even if their banks failed, their deposits were safe because they were insured by a federal agency.

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4.3

Historically in the United States, there was a fear of banks having too much power and a belief that banks should use the funds they received from local depositors only to fund loans in that area.

These views led Congress to pass laws against nationwide banks.

4.4

Off-balance-sheet activities are activities that generate fee income but do not affect a bank’s balance sheet because they do not increase either the bank’s assets or its liabilities. Four offbalance sheet activities are: (1) Standby letters of credit, which represent a promise by a bank to lend funds, if necessary, to the seller of commercial paper at the time that the commercial paper matures; (2) loan commitments, under which a bank agrees to provide a borrower with a stated amount of funds during some specified time; (3) loan sales, which are financial contracts in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party; and (4) activities such as trading in the futures, options, or swaps markets.

4.5

Electronic banking refers to banking transactions done electronically, such as with ATMs, online banking, and mobile banking. Virtual banks conduct all banking transactions online.

4.6

Congress originally authorized TARP, or the Troubled Asset Relief Program, in October 2008 in response to the financial crisis. TARP was originally intended to restore an active market in mortgage-backed securities to help banks that held these illiquid assets on their balance sheets. In fact, a large portion of the funds were used for the Capital Purchase Program (CPP), where the U.S. Treasury purchased stocks in hundreds of banks to increase the banks’ capital. The stock purchases were meant to increase the banks’ solvency and to reassure the public that the federal government had taken strong action to stabilize the financial system. During the period from October 1, 2008, through September 30, 2009, the Treasury invested $245 billion in the CPP. Eventually, $275 billion was paid back or received as interest or dividends, leaving the program with a profit of $30 billion.

Problems and Applications 4.7

The statement is misleading because state government restrictions on the number of branches a bank could have and federal government restrictions on nationwide banking resulted in the United States having an unusually large number of banks compared with other countries.

Although most government restrictions on the size of banks have been repealed, the large number of banks in the United States is a reflection of these past restrictions. As a result of substantial economies of scale in banking, the 10 largest U.S. banks hold half of all deposits (see Table 10.4 in the text). The U.S. banking system is starting to resemble the systems of other countries, which typically have relatively few banks. The many small banks that remain generally engage in limited competition for depositors or for borrowers, and do not contribute much to the overall level of competition in the U.S. banking system. Most economists believe that the level of competition in the banking systems of Canada and the United States is about the same.

4.8

a. Without deposit insurance, depositors would have an incentive to monitor banks and the investments the banks make, and depositors would require that banks pay interest on their deposits high enough to compensate for the riskiness of the investments being made with their funds. Some depositors might withdraw their funds if a bank’s assets appeared too risky. Paying higher interest rates and attracting fewer deposits would decrease bank profits and potentially lead to more bank failures. The fact that these failures were occurring might result in banks making less risky investments with depositors’ funds. b. Deposit insurance creates the moral hazard that depositors have no incentive to monitor the use of their funds. If depositors closely monitored their banks’ investments, they would require higher interest rates on deposits. Lower interest rates constitute an implicit federal subsidy to the banks. c. Deposit insurance reduces systemic risk in the banking system by eliminating bank panics.

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4.9

a. Financial inclusion refers to the ability of everyone to participate in the financial system. The poor, the uneducated, people who are not English speakers, and those in rural areas are all likely to be excluded from the financial system. b. The Postal Service would have to retrofit offices, hire new employees with significant financial expertise, and build internal systems to run a massive branch network. There would also be operating costs and many of the costs of regulation and compliance faced by banks in general.

4.10

Small banks compete by practicing relationship banking where they gather private information on borrowers from their relationships with the borrowers over a period of years. Small banks use this private information to assess credit risks and to assign interest rates. Large banks use more rigid criteria for loans, and so small businesses are more likely to be successful obtaining loans from smaller banks.

4.11

Stabilizing the banking industry allowed banks to provide more consumer loans to households, commercial and industrial loans to small-to-medium businesses, and real-estate loans to households and businesses. These loans helped businesses continue to operate and expand.

Data Exercises D10.1

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009

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a. Just before a recession, net interest margins decrease. Just after a recession, net interest margins increase. During a recession, net interest margins generally increase, but during the 2007-2009 recession net interest margins decreased and then increased. b. There is a downward trend in net interest margins, which would tend to decrease bank profitability.

D10.2

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009

a. Nonperforming loans increase just before and during a recession and then decrease after a recession. The pattern is the same across all three recessions. b. There was a downward trend in nonperforming loans up through the beginning of the financial crisis. The downward trend would have increased bank profitability. Nonperforming loans have declined since the end of the financial crisis, but they have risen slightly since the onset of the Covid-19 crisis.

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D10.3

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009

a. The trend from 1988 to 2020 in the number of banks has been rapidly downward. The consolidation in the number of banks in the United States has been the result of states eliminating restrictions on branching within the state, the federal government allowing interstate banking, and economies of scale in banking. b. The data do not indicate a significant effect of recessions on the number of banks in the United States.

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Chapter 11 Beyond Commercial Banks: Shadow Banks and Nonbank Financial Institutions 

Brief Chapter Summary and Learning Objectives

11.1 Investment Banking (pages 350–366) Explain how investment banks operate.

• The central activities of investment banks include providing advice on new security issues, underwriting new security issues, and providing advice and financing for mergers and acquisitions.

• In recent years, investment banks have also engaged in activities such as financial engineering, research, and proprietary trading.

• Investment banks are often relatively highly leveraged because they borrow funds (for example, through repurchase agreements) to finance their investment activities.

• Some policymakers and economists argue that the repeal of the Glass-Steagall Act in 1999, which allowed commercial banks to engage in investment banking, helped contribute to the financial crisis of 2007–2009.

11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies (pages 366–374) Distinguish between mutual funds and hedge funds and describe their roles in the financial system.

• Mutual funds are financial intermediaries that allow savers to purchase shares in a portfolio of financial assets. This reduces transactions costs and provides risk sharing.

• Modern hedge funds tend to speculate by selling stocks short or by pursuing investment strategies other than hedging.

• Finance companies are financial intermediaries that raise money through sales of commercial paper and other securities and use the funds to make small loans to households and firms.

11.3 Contractual Savings Institutions: Pension Funds and Insurance Companies (pages 374–379) Explain the roles that pension funds and insurance companies play in the financial system.

• Employees may prefer to save through pension plans provided by employers rather than through savings accounts for three reasons: (1) lower transactions costs for portfolio management; (2) the availability of life annuities; and (3) favorable tax treatment.

• Insurance companies are financial intermediaries that specialize in writing contracts to protect their policyholders from the risks of financial loss associated with particular events.

11.4 Risk, Regulation, and the Shadow Banking System (pages 380–384) Explain the connection between the shadow banking system and systemic risk.

• Though deposit insurance reduces systemic risk in the traditional banking system, there is no equivalent insurance for short-term lending in the shadow banking system.

• Shadow banking firms have traditionally not been regulated. In 2010, Congress passed the DoddFrank Act, which contained limited additional regulation of shadow banks.

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• Some shadow banks experienced runs during the 2007-2009 financial crisis and money market funds experienced severe problems in 2020 during the Covid-19 pandemic. Economists and policymakers worry that shadow banks remain vulnerable to runs in a future crisis.



Key Terms and Concepts

Contractual saving institution, p. 374. A financial intermediary such as a pension fund or an insurance company that receives payments from individuals as a result of a contract and uses the funds to make investments.

Finance company, p. 373. A nonbank financial intermediary that raises money through sales of commercial paper and other securities and uses the funds to make small loans to households and firms.

Hedge fund, p. 370. A financial firm organized as a partnership of wealthy investors that make relatively high-risk, speculative investments.

Initial public offering (IPO), p. 351.The first time a firm sells stock to the public.

Insurance company, p. 377. A financial intermediary that specializes in writing contracts to protect policyholders from the risk of financial loss associated with particular events.

Investment banking, p. 351. Financial activities that involve underwriting new security issues and providing advice and financial services to clients, particularly with respect to mergers and acquisitions.

Investment institution, p. 366. A financial firm, such as a mutual fund or a hedge fund, that raises funds to invest in loans and securities.



Market maker, p. 355. A firm that holds an inventory of a security and serves as an intermediary between buyers and sellers of the security.

Money market mutual fund, p. 368. A mutual fund that invests exclusively in short-term assets, such as Treasury bills, negotiable certificates of deposit, and commercial paper.

Mutual fund, p. 367. A financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of financial assets, such as stocks, bonds, mortgages, and money market securities.

Pension fund, p. 374. A financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide for pension benefit payments during workers’ retirements.

Syndicate, p. 351. A group of investment banks that jointly underwrite a security issue.

Systemic risk, p. 381. Risk to the entire financial system rather than to individual firms or investors.

Underwriting, p. 351. An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit.

Chapter Outline

When Is a Bank Not a Bank? When It’s a Shadow Bank!

During the financial crisis of 2007-2009, the general public came to realize that commercial banks no longer played a dominant role in routing funds from savers to borrowers. A variety of “nonbank” financial institutions were acquiring funds that had previously been deposited in commercial banks, and they were using the funds to provide credit that banks had previously provided. The “nonbank banks” eventually began to be referred to collectively as the “shadow banking system.” By 2008, the shadow banking system had grown to be 50% larger than the commercial banking system. Problems with nonbanks made dealing with the financial crisis more difficult because U.S. policymaking and regulation assumed that commercial banks were the most important financial firms. The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System (the Fed) were established to assist commercial banks. The FDIC does not insure short-term borrowing by

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shadow banks, and shadow banks are not normally eligible for loans from the Fed. As a result, the shadow banking system can be subject to the same sources of instability that afflicted the commercial banking system before the establishment of the Fed and the FDIC. In 2008 and 2020, the Fed took strong action to support the operations of money market funds. Money market funds aren’t commercial banks, so why was the Fed involved in supporting them? The financial system has evolved over the past few decades, with “nonbank” financial institutions—including money market mutual funds, hedge funds, pension funds, and investment banks—acquiring funds that businesses and households had previously deposited in banks. These nonbanks use the funds to provide credit to businesses and households that banks had previously provided.

Following the 2007–2009 financial crisis, in 2010 Congress passed the Wall Street Reform and Consumer Protection Act, or the Dodd–Frank Act, which to some extent increased federal regulation of the shadow banking system by creating the Federal Stability Oversight Council. But in 2020, when the Fed again had to provide funding for shadow banks, it became clear that shadow banks are a more important source of instability in the financial system than are commercial banks. To economists and policymakers in Congress and at the Fed, stabilizing the financial system requires stabilizing shadow banking.

Teaching Tips Until recently, the “banking” in most money and banking courses was exclusively commercial banking. The financial crisis of 2007-2009 made it clear that so-called shadow banks have played an increasingly important role in the financial system, a role that has only increased in the years since then. This chapter provides a complete yet concise overview of the shadow banking system and gives students a good background on this important sector of the financial system.

11.1 Investment Banking (pages 350-366) Learning Objective: Explain how investment banks operate.

A. What Is an Investment Bank?

The central activities of investment banks include providing advice on new security issues; underwriting new security issues; providing advice and financing for mergers and acquisitions; financial engineering; research; and proprietary trading and market making. Because most firms lack expertise in financial markets, they turn to investment banks for advice on how to raise funds.

Investment banks underwrite new securities by guaranteeing a price, selling the securities in financial markets, and retaining the difference. Investment banks play an active role in mergers and acquisitions by taking the initiative on contacting firms on potential purchases, sales, and mergers.

In recent years, investment banks have also engaged in activities such as financial engineering, including risk management; research; and proprietary trading. Financial engineering typically involves developing new financial securities or investment strategies using sophisticated models.

Critics state that some of the new financial securities increased risk instead of reducing risk as intended. Investment banks conduct research on large firms and industries. This research can be used for investing decisions and to help clients identify possible mergers and acquisition targets.

Beginning in the 1990s, investment banks began to engage in proprietary trading; that is, buying and selling securities for their own accounts rather than trading only for clients.

B. “Repo Financing,” Leverage, and Funding Risk in Investment Banking Investment banks borrow to finance their investments in securities and direct loans to firms. As a result, these banks often have high leverage, which increases the volatility of their profits and losses.

One way that investment banks borrow is through repurchase agreements (repos), which are shortterm loans backed by collateral. Typically, repos involve selling a security to another financial institution while agreeing to buy it back within the next few days at a slightly higher price. In many

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cases, the borrowing is short term while the funds are used for purchasing long-term assets, creating a maturity mismatch. In addition, a counterparty risk exists in that there’s a possibility that the party on the other side of the financial transaction will not fulfill its obligations.

Teaching Tips Figure 11.1 illustrates the differences in leverage ratios between major commercial and investment banks.

Have students discuss the role of leverage in exposing banks to risk. Note that the three investment banks that didn’t survive the crisis–Lehman Brothers, Bear Stearns, and Merrill Lynch–had leverage ratios of between 30 and 35 in 2007. In 2008, Lehman Brothers went bankrupt, Bear Stearns was bought by JPMorgan, and Merrill Lynch was bought by Bank of America.

C. The Investment Banking Industry Congress passed the Glass-Steagall Act during the Great Depression due to concerns about the riskiness of investment banking. This Act separated commercial and investment banking. In 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act. As a result, many investment banks began to engage in commercial banking activities and many commercial banks began to engage in investment banking. Some economists and policymakers think that the repeal of Glass-Steagall was a mistake and that the repeal contributed to the financial crisis of 2007–2009.

D. Where Did All the Investment Banks Go? During the financial crisis of 2007–2009, firms that held large amounts of mortgage-backed securities suffered significant losses. Standalone investment banks had a tough time weathering the crisis. Only two large investment banks survived the crisis–Goldman Sachs and Morgan Stanley–but they became financial holding companies so they could borrow from the Fed and be eligible to receive funds from the U.S. Treasury through the Troubled Asset Relief Program (TARP).

11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies (pages 366–374) Learning Objective: Distinguish between mutual funds and hedge funds and describe their roles in the financial system.

A. Mutual Funds and Exchange-Traded Funds (ETFs) Mutual funds are financial intermediaries that allow savers to purchase shares in a portfolio of financial assets, which helps to reduce transactions costs and offers savers risk sharing. Open-end mutual funds are the most common form of mutual fund. Other mutual funds are closed-end, which means that the mutual fund company issues a fixed number of shares that are then traded among investors just as stocks are. Exchange-traded funds (ETFs) hold portfolios of assets that can trade continually throughout the day. In recent years, money market mutual funds, which hold highquality, short-term assets, have grown rapidly.

B. Hedge Funds Hedge funds are typically organized as partnerships of a small number of investors and are largely unregulated. Hedge funds usually make investments that involve speculating rather than hedging, so their name is misleading. Some analysts blame hedge funds for destabilizing markets through intensive use of short selling; other analysts credit hedge funds for playing a productive role in financial markets by forcing price changes that can correct market inefficiencies.

C. Finance Companies Finance companies are financial intermediaries that raise money through sales of commercial paper and other securities and use the funds to make small loans to households and firms. Consumer finance companies make loans to: enable consumers to buy cars, furniture, and appliances; finance home improvements; and refinance household debts. Finance company customers have higher default risk than do good-quality bank customers and may be charged higher interest rates. Business Copyright © 2022 Pearson Education, Inc.

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finance companies engage in factoring; that is, purchasing at a discount accounts receivables of small firms. Sales finance companies are affiliated with companies that manufacture or sell bigticket goods, such as automobiles.

Teaching Tips Many people have heard of hedge funds without understanding them. The Apply the Concept, “Would You Invest in a Hedge Fund If You Could?” explores various aspects of hedge funds. The related table compares the benefits and drawbacks of hedge funds and mutual funds. Have students read this Apply the Concept and then ask them if they would invest in a hedge fund.

11.3 Contractual Savings Institutions: Pension Funds and Insurance Companies (pages 374–379) Learning Objective: Explain the roles that pension funds and insurance companies play in the financial system.

A. Pension Funds Because retirements are predictable, pension funds can invest the contributions of workers and firms in long-term assets. Employees may prefer to save through pension plans provided by employers rather than through savings accounts for three reasons: (1) lower transactions costs for portfolio management; (2) the availability of life annuities; and (3) favorable tax treatment. Defined contribution plans, such as 401(k) plans, invest contributions but do not guarantee values upon retirement. Defined benefit plans promise employees a particular dollar benefit based on employee earnings and years of service.

B. Insurance Companies Insurance companies are financial intermediaries that specialize in writing contracts to protect their policyholders from the risks of financial loss associated with particular events. Insurance companies attempt to reduce risk through: 1. Risk pooling 2. Reducing adverse selection through screening and risk-based premiums 3. Reducing moral hazard with deductibles, coinsurance, and restrictive covenants 11.4 Risk, Regulation, and the Shadow Banking System (pages 380–384) Learning Objective: Explain the connection between the shadow banking system and systemic risk.

A. Systemic Risk and the Shadow Banking System In the shadow banking system, short-term loans take forms such as repurchase agreements, purchases of commercial paper, and purchases of money market mutual fund shares rather than the form of bank deposits. Though deposit insurance reduces systemic risk in the traditional banking system, there is no equivalent insurance in the shadow banking system.

B. Regulation and the Shadow Banking System Shadow banking firms have traditionally not been regulated because policymakers thought that they were not as important to the financial system as commercial banks and because these financial firms dealt primarily with sophisticated investors who could look out for their own interests. In 2010, Congress passed the Dodd-Frank Act, which contains limited additional regulation of shadow banks.

C. The Fragility of the Shadow Banking System Many firms in the shadow banking system borrow short term but lend long term. Because investors who provide funds to shadow banks are not protected by deposit insurance, these financial firms are more susceptible to runs. Due in part to lack of regulation, investment banks can invest in risky assets and become highly leveraged. During the financial crisis, many investment banks suffered heavy losses due to investments in mortgage-backed securities.

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D. Are Shadow Banks Still Vulnerable to Runs Today?

Following the Financial Crisis of 2007-2009, many economists and policymakers called for extensive regulation of the shadow banking system. However, the Dodd-Frank Act, passed in 2010, contained limited regulation of the shadow banking system, including the following provisions: 1. Trading of some derivatives are to be carried out on exchanges 2. Large hedge funds must register with the SEC 3. Firms selling mortgage-backed securities and similar assets must hold 5% of the credit risk However, the regulations did not address a basic problem the financial crisis revealed: Some shadow banks borrow short term to make highly leveraged long-term investments, which still makes them vulnerable to runs.

Events during the Covd-19 Crisis reinforced concerns about runs on shadow banks, and the Fed once again created funding facilities.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 11.1

Investment Banking Learning objective: Explain how investment banks operate.

Review Questions 1.1

a. Underwriting: an activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit. b. Financial engineering: developing new financial securities or investment strategies, using sophisticated mathematical models developed by people with advanced degrees in economics, finance, and mathematics. c. Proprietary Trading: buying and selling securities for the bank’s own investment accounts. d. Market making: firms hold an inventory of a security and serve as an intermediary between buyers and sellers of the security.

1.2

Retail funding and wholesale funding differ in the source of funds used to finance investments.

Retail funding uses deposits, and wholesale funding uses short-term borrowing. Commercial banks mainly rely on retail funding, while investment banks mainly rely on wholesale funding.

1.3

Leverage is financing investments by borrowing rather than by using capital, or equity. Prior to 2007-2009 investment banks were more leveraged than commercial banks (more than double).

Federal banking regulations put limits on the size of leverage by commercial banks, but these regulations did not apply to investment banks. The large, stand-alone investment banks during the financial crisis either failed, were bought out by other financial firms, or became financial holding companies.

Problems and Applications 1.4

a. Underwriting is where an investment bank guarantees (typically) a price to an issuing firm for new stocks or bonds and then sells those stocks or bonds at a higher price in financial markets or directly to investors. Underwriting is financial intermediation because the investment bank brings together savers and the firms who issue new securities (borrowers).

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b. An investment bank that buys securities with its own capital is not acting as a financial intermediary (unless it is underwriting the securities and plans to resell them). The bank is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers.

1.5

a. An IPO is an initial public offering, the first time that a firm offers stock to the public. b. Morgan Stanley is underwriting the stock issue. That means that Morgan Stanley guarantees Uber a specific price for the stock and then resells the stock to the public, presumably at a profit. c. Uber would like to receive the highest possible (guaranteed) price for its stock. Investors would like to buy Uber stock at the lowest possible price. So Morgan Stanley must balance the desire of Uber to receive a high price, investors’ willingness to pay at a given price, and its own need to make a profit on these transactions.

1.6

Leverage equals the value of assets divided by the value of equity. The leverage values are: $200,000/$200,000 = 1 $200,000/$40,000 = 5 $200,000/$20,000 = 10 $200,000/$10,000 = 20 The return on your investment equals the increase in the price of the house divided by the amount you invested: $20,000/$200,000 = 10% $20,000/$40,000 = 50% $20,000/$20,000 = 100% $20,000/$10,000 = 200%

a. b. c. d.

a. b. c. d.

1.7

If an investment bank goes public, it would have more access to capital. The bank could sell stock to the public and not have to rely entirely on the funds contributed by the partners of the firm. Going public also reduces the risk involved to the top executives, as it is not solely their money that is being invested as would be the case if the firm were a partnership. Although investment banks may take on more risk than commercial banks or most other financial firms, they also can deliver higher returns. Investors who find this trade-off between risk and return to be attractive will buy the investment banks’ stock.

1.8

a. Commercial banks borrow short term by taking deposits from the public, most of which are demand deposits or regular savings accounts (retail funding), and so depositors can withdraw the finds at any time. At the same time, commercial banks invest long, mostly through home mortgages and commercial real estate loans. b. Investment banks borrow short term, often overnight, through repurchase agreements and commercial paper (known as wholesale funding). While investment banks might invest in many types of securities, these banks often use short-term funds to invest in long-term assets including loans and mortgage-backed securities. c. Unlike commercial banks, investment banks have no federal guarantees. Therefore, those who lend to investment banks are subject to counterparty risk. And if assessments of risk change, individual investors or other financial firms may be unwilling to buy the banks’ commercial paper or lend to them through the repo market, which cuts off the banks’ access to short-term funding. d. A standing repo facility created by the Fed would mean that the Fed would be ready to engage in repo transactions whenever financial firms, in this case investment banks, could not obtain shortterm loans elsewhere. Because investment banks would always be able to obtain loans, establishing this facility would solve the banks’ short-term funding problem.

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1.9

Congress’s main goal was the stability of the financial system. Congress did not want banks using federally insured deposits with their implicitly subsidized lower interest rates to engage in what it saw as risky investment banking activities.

1.10

It was not the large banks with combined commercial banking and investment banking activity that caused the most difficulty during the 2007–2009 financial crisis. Bear Stearns and Lehman Brothers, which operated solely as investment banks, and Washington Mutual, which was a large mortgage lender, caused the most difficulty. Large banks with combined commercial banking and investment banking activity helped stabilize the financial system during the crisis with JP Morgan Chase purchasing Bear Stearns and Bank of America purchasing Merrill Lynch. Repealing the GlassSteagall Act did lead to larger banks, which may increase the moral hazard problem resulting from the too-big-to-fail policy where managers of large firms may make more risky investments if they expect that the federal government will save them from failure.

1.11

The advantage of the “up or out” policy to investment banks and other firms is that workers have an incentive to work very hard during their first years with the firm to demonstrate that they are worthy of being promoted. A disadvantage is that risk-averse people may not apply for jobs at investment banks, or other firms using the “up or out” policy because they are concerned about being fired after just a few years. Some of the people who do not apply might be more productive than some people who end up being promoted at these firms. People are willing to work for these firms if they believe that they can quickly demonstrate their high productivity, earn a promotion, and have a secure job at a high salary.

11.2

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies Learning objective: Distinguish between mutual funds and hedge funds and describe their roles in the financial system.

Review Questions 2.1

Investment institutions are similar to commercial banks because they are financial intermediaries that raise funds and invest the funds in loans and securities. Unlike commercial banks, investment institutions do not raise funds through deposits and they can invest in a wider variety of assets.

2.2

Mutual funds differ from hedge funds in that hedge funds are usually partnerships with a relatively small number of investors. Mutual fund activities are more transparent, and mutual funds make public a list of the assets that the fund owns. Hedge funds are generally less regulated, take more risks for higher returns, and are less liquid. Exchange-traded funds hold a (usually fixed) portfolio of financial assets that can be traded during the day, like stocks. This is an advantage over some types of mutual funds and hedge funds in that they can be traded easily during the day (as opposed to, for example, a closed-end mutual fund that can only be traded at end of day or a hedge fund, which is likely to be less liquid).

2.3

Finance companies have an advantage over commercial banks in monitoring the value of collateral, which gives them an advantage in lending for consumer durables, inventories, and business equipment.

Problems and Applications 2.4

Deposits in bank savings accounts are covered by federal deposit insurance, whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500.

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2.5

a. “Lehman paper” is commercial paper that Lehman Brothers had issued to raise funds. The Lehman paper was worthless because Lehman Brothers had gone bankrupt. b. “Breaking the buck” means that the net asset value of the money market fund had fallen below $1 to $0.97. As a result, investors in the mutual fund would take a capital loss of 3% when they redeemed their shares. “Breaking the buck” was significant because it was highly unusual for a money market mutual fund to allow the price of its shares to drop below $1. Investors in money market mutual funds were willing to accept the relatively low interest rates these funds offered relative to some other investments only if they were sure that they would not suffer a capital loss from a decline in the value of the shares. c. A run is a rush to withdraw money before everyone else does. One money market mutual fund breaking the buck signaled that other money market mutual funds might do the same. Investors became worried about the value of the assets in their money market mutual funds and whether they would be able to redeem their shares at the usual value of $1 per share. Given the low interest rates paid on money market mutual fund shares, investors were not willing to risk capital losses on their investments.

2.6. a. An auto finance company is a nonbank financial intermediary that raises money through sales of commercial paper and other securities and uses the funds to make small loans to households and firms to purchase automobiles. b. In general, the longer the loan, the greater the funding risk, the risk that the lender (in this case, the auto finance company) will not be able to finance the long-term loan with short-term borrowing.

Firms make these loans because it allows them to sell more cars, and buyers take these loans out because it lowers monthly payments on the loans and so makes a higher-priced car more affordable (in terms of a monthly budget, although more total interest will be paid over the life of the loan). c. Because finance companies are less regulated than banks, automobile dealers may be better able to offer loans that are tailored to auto buyers and might also be better at assessing the riskiness (and valuing collateral) of these loans. The dealers may also be better able to offer loans to less creditworthy car buyers. These advantages benefit both automobile dealers (who sell more cars) and automobile buyers (who may be better able to get credit).

2.7. a. A hedge fund is a financial firm organized as a partnership of wealthy investors that make relatively high-risk, speculative investments. b. Hedge funds charge much higher fees than do mutual funds. Hedge funds charge a management fee (typically 2% of the value of the fund’s assets) plus a share of any profits the fund earns (typically 20%). Mutual funds only charge a management fee (typically 0.5% of the value of the fund’s assets). c. Hedge funds are more highly leveraged than mutual funds and use more speculative investment strategies. The evidence does not show that hedge funds consistently produce higher returns than mutual funds. The comparison of returns is not completely clear because hedge funds, unlike mutual funds, do not have to provide detailed reports to the Securities and Exchange Commission on their returns. Even if hedge funds make higher returns, not all investors who are eligible to invest in them do so because some investors will not be comfortable with the higher risk, lower liquidity, and less transparency that hedge funds offer compared with mutual funds.

2.8. a. The cost to a firm of raising new capital falls with an increase in the firm’s stock price—because the firm is raising more funds in exchange for selling a given percentage of the firm to investors—and rises with a decrease in stock prices. Investors are providing capital to these firms. b. Hedge funds correct this inefficiency by selling the overhyped growth stocks, thereby putting downward pressure on their prices and by buying the unglamorous value stocks, thereby putting upward pressure on their prices. Some economists argue that by taking actions of this type, hedge funds can improve the efficiency of financial markets.

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2.9. a. An “accredited investor,” as defined by the Securities and Exchange Commission is an investor with a net worth of at least $1 million (not including the value of the investor’s house) or an income of at least $200,000 in the two years prior to making the investment, as well as a reasonable expectation of having the same income in the year of the investment. In 2020, the SEC began allowing people who hold certain credentials, such as an entry-level stockbroker’s license to become accredited investors even if they didn’t meet the income and wealth requirements. To invest in a hedge fund, you must be an accredited investor. b. Leverage, the use of debt rather than equity to finance investments, magnifies returns. Conservative investments financed through high leverage can have high positive returns or high negative returns.

11.3

Contractual Savings Institutions: Pension Funds and Insurance Companies Learning objective: Explain the roles that pension funds and insurance companies play in the financial system.

Review Questions 3.1

Contractual savings institutions are similar to commercial banks because they are financial intermediaries that raise funds and invest the funds in loans and securities. Contractual savings institutions are different from commercial banks in that they do not raise funds through deposits but receive payments from individuals as a result of contracts, and they can invest in a wider range of assets.

3.2

In a defined contribution plan, the firm places contributions from employees (which some employers match up to a certain limit) into investments the employees select. The employees own the funds in the plan. In a defined benefit plan, the firm promises employees a particular dollar benefit payment that is based on each employee’s earnings and years of service. In a 401(k) plan, employees are not taxed on what they contribute to their 401(k) or on the earnings on those investments until the employees withdraw the funds during retirement. (Early withdrawals from a 401(k) account usually can be made only after paying a penalty.)

3.3

Insurance companies are financial intermediaries in that they obtain funds by charging premiums to policyholders and use these funds to make investments in stocks, bonds, mortgages, and direct loans to firms. Life insurance insures against loss of life or disability, and property and casualty insurance insures against loss of property.

Problems and Applications 3.4

In a defined benefit plan, a worker’s retirement payout is determined by a formula so that the worker can plan on receiving a specific pension payment. The worker could, however, lose some of his or her pension benefits if the plan is underfunded or if the employer goes out of business. In a defined contribution plan, the worker’s retirement payout depends on the performance of the invested funds, so it may be riskier than a defined benefit plan. The worker often has some control over how the money is invested and ordinarily has ownership of the funds. From the employer’s point of view, the defined contribution plan involves less risk than the defined benefit plan because the firm is not committed to making specific pension payments.

3.5

a. Traditional pension plans are defined benefit plans under which retirement payouts are fixed by a formula based on the worker’s years on the job and earnings. This feature can be attractive to workers because they know what their retirement benefit will be and can plan more effectively. The same is true for the employer, but the employer faces the risk that the amount in the pension fund will not be sufficient to cover the promised payments, and that the employer may therefore be liable

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for the additional funds. However, it is also possible that the employer may gain if the fund is overfunded rather than underfunded. b. 401(k) plans are defined contribution plans under which payouts depend on the return earned by the plan’s investments. These plans therefore do not provide a guaranteed retirement income to the beneficiaries. c. 401(k) plans might be more desirable to employers because they do not face the risk of having poor investment returns and underfunded pension plans that might require the employers to divert additional revenues to their pension plans. 401(k) plans might be more desirable to employees because they own the value of the funds in the plans, can determine within a set of choices how to invest the funds, and need be less concerned that financial problems of their employers might undermine the solvency of the plans. 401(k) plans might be less desirable to employees because the employees bear the risk of poor investment returns and do not have a guarantee of a particular dollar benefit payment.

3.6

401(k) plans have vesting periods in order to reduce turnover among employees who are not yet vested. By reducing turnover, employers spend less time recruiting and training new employees and more time working with experienced employees. The resulting higher productivity leads to higher profits and higher wages, which benefit both employers and employees.

3.7

a. When state and local pension plans are underfunded, eventually the state or the city will have to make the required payments to beneficiaries. The choices by the state and local governments will be to either significantly raise taxes or cut other spending to fulfill their pension obligations, or, if the underfunding is bad enough, declare bankruptcy. b. The Covid-19 pandemic resulted in many people losing their jobs, at least temporarily, and many firms, particularly restaurants and retail stores, either closing or earning much lower revenue. As a result, the taxes collected by state and local governments declined, causing their pension funds to be even more underfunded. c. As mentioned in the answer to part a., the choices facing state and local governments aren’t good because they involve raising taxes, cutting other spending, or entering bankruptcy in the hope that a court would reduce their required pension payments. In a few cases, state and local governments have been able to negotiate with public employee unions to reduce pension benefits to be received by newly hired workers or, rarely, even benefits received by current workers or retirees.

3.8

Insurance companies will raise premiums on all policies. Doing so will increase adverse selection problems because businesses in areas with high rates of arson will still be willing to pay the higher premiums because they believe the probability of their filing claims is high. Some businesses in safer areas will drop their fire insurance. The pool of insured businesses will include a higher percentage of businesses likely to make claims. Insurance companies may respond with further premium increases, which will further increase adverse selection. Some insurance companies may eventually stop offering fire insurance policies in the state, and it is possible that ultimately fire insurance policies may no longer be available.

3.9

Insurance companies never know the exact amounts of their future payouts, but through risk pooling and using the law of large numbers they can reliably predict future payouts. Life insurance companies can then match the predicted future payouts with the maturities of their long-term bond purchases.

3.10 a. A medical insurance policy guarantees medical services such as doctor visits, medical exams, medical procedures, and hospital stays. b. With medical services always improving and getting more expensive, companies offering medical insurance policies must increase their premiums to cover the increases in the costs of medical services. As premiums rise, adverse selection may also rise as healthier people decide not to buy health insurance.

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Chapter 11

11.4

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Risk, Regulation and the Shadow Banking System Learning objective: Explain the connection between the shadow banking system and systemic risk.

Review Questions 4.1

The shadow banking system is a collection of nonbank financial institutions that channel money from savers to borrowers. The shadow banking system is largely unregulated and can invest in more risky assets and become more highly leveraged than commercial banks. Unlike commercial banks, there is no federal deposit insurance for the investors providing funds to the shadow banking system.

4.2

A run on a financial firm is the attempt by investors to get their money out before the firm fails.

Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC). The shadow banking industry does not have an equivalent to deposit insurance for the investors lending funds to shadow banks, and so there were runs on some nonbank financial firms in both 2008 and 2020.

4.3

Systemic risk is the risk to the entire financial system rather than to individual firms or investors.

Problems and Applications 4.4

The money market mutual fund industry is important because these institutions buy large amounts of commercial paper, which many firms rely on to meet payroll and other operating costs. Problems with money market mutual funds would sharply reduce the access of firms to this source of shortterm funding. People can deposit money in banks rather than buying money market mutual shares, but they will receive a lower return on their funds and, more importantly, the flow of funds to firms through the commercial paper market would be greatly reduced.

4.5

a. Short-term funding markets are the markets in which shadow banks borrow short-term funds.

Shadow banks usually rely heavily on these markets, which include money market mutual funds and repurchase agreements. b. The Fed opened a Commercial Paper Funding Facility to directly purchase commercial paper, restoring the flow of funds that some firms rely on to meet their short-term spending needs.

4.6

Leverage magnifies profits, but it also magnifies losses. Relying too much on short-term borrowing creates a large mismatch between the maturity of assets and the maturity of liabilities, and when lenders become concerned about the quality of the assets of an investment bank, they stop rollingover their short-term loans to the bank. Without access to short-term borrowing, an investment bank may be forced to raise funds by selling assets, possibly at low prices. Falling asset values can force the bank into insolvency.

4.7

a. The author is referring to short-term funding, so-called wholesale funding. The investors are primarily other financial firms. b. During the 2007–2009 financial crisis, a classic bank run occurred when investors became concerned about the quality of the assets of the borrowing firms (such as investment banks). The investors did not renew their short-term loans, which caused severe liquidity problems for the borrowing firms that had used the short-term funds to make long-term investments. Investors understood that they did not have the equivalent of deposit insurance to cover their short-term loans, and they probably understood that the shadow banking firms were highly leveraged. The investors would not have understood fully the systemic risk in the financial system from the interconnections among mortgage-backed securities, credit default swaps, and other derivatives.

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4.8. a. An investment bank can be subject to a run when investors do not renew their repurchase agreements, when investors do not purchase the investment bank’s commercial paper, or when other counterparties want to cash out their investments. b. Government guarantees refer primarily to federal deposit insurance through the FDIC. c. Deposit insurance eliminated the incentive for depositors to create bank runs because their money was insured if their banks failed.

4.9

a. “The short-term funding markets” refer to the markets where shadow banking firms borrow shortterm funds. They include the repo market and the commercial paper market. b. Deposits at commercial banks were insured by FDIC insurance, but there was no equivalent insurance for short-term loans to shadow banking firms. c. There had not been a financial crisis since the Great Depression and deposit insurance had put an end to bank panics among commercial banks. By 2007, the shadow banking system had become larger than the commercial banking system and was vulnerable to a bank panic. There was no equivalent to deposit insurance for short-term lenders, and the shadow banking firms were highly leveraged.

Data Exercises D11.1

a. Retail money market mutual funds are offered primarily to individuals, whereas institutional money market mutual funds are high minimum investment, low expense share funds that are marketed to corporations, pension funds, and other “institutional” investors. Institutional money market mutual funds are often set up so that money is transferred into them overnight from an investor’s checking account. b. The trends in retail and institutional money market mutual funds have been similar other than the steeper increase in institutional money market mutual funds just before and during the 2001 and 2007-2009 recessions. During the Covid-19 crisis, institutional funds fell much more sharply than retail funds.

D11.2

The larger values later in the period mask the changes in the smaller values earlier in the period, so the earlier data has been divided into two periods: 1952 through 1984 and 1985 through the first quarter of 2015. The large FRED graph that follows shows the entire series.

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Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007 February 2020

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Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 Not yet determined as of February 2021

a. The value of mutual fund shares owned by households (and nonprofit organizations) generally increases just before recessions, decreases at first and then increases during recessions, and increases just after recessions. The pattern is similar across the recessions that occurred during this period. b. The value of mutual fund shares owned by households can change due to changes in the value of the securities (stocks and bonds) held in the mutual fund and due to households buying or selling mutual fund shares.

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Chapter 12 Financial Crises and Financial Regulation 

Brief Chapter Summary and Learning Objectives

12.1 The Origins of Financial Crises (pages 393–400) Explain what financial crises are and what causes them.

• Because banks borrow from depositors short term and lend long term to households and firms, banks have a maturity mismatch with the maturity of their liabilities exceeding the maturity of their assets. This mismatch creates liquidity risk.

• Liquidity risk is a particular problem for banks if the government does not provide insurance for deposits and there is no central bank.

• Governments have two main ways they can attempt to avoid bank panics: (1) A central bank can act as a lender of last resort, and (2) the government can insure bank deposits.

• A bank panic can lead to declines in production and employment, either causing a recession or making an existing recession worse.

• Though there are some benefits to having a fixed exchange rate, pegging exchange rates can cause problems, particularly if the pegged exchange rate ends up substantially above the equilibrium rate that would prevail in the absence of the peg.

• A sovereign debt crisis occurs when a country has difficulty making interest or principal payments on its bonds, or when investors expect a country to have this difficulty in the future.

12.2 The Financial Crisis of the Great Depression (pages 401–406) Describe the key elements of the financial crisis that occurred during the Great Depression.

• Although the Great Depression began in response to an increase in interest rates in 1929, several factors increased the severity of the downturn between the fall of 1929 to the fall of 1930, including a stock market crash in October 1929 and the passage of the Smoot-Hawley Tariff Act in June 1930.

• Many economists believe that the series of bank panics that began in the fall of 1930 greatly contributed to the length and severity of the Great Depression.

• The Federal Reserve, which Congress established in 1913 to end bank panics, did not intervene to stabilize the banking system.

12.3 The Financial Crises of 2007–2009 and 2020 (pages 406–411) Describe what caused the financial crises of 2007–2009 and 2020.

• The financial crisis of 2007–2009 began with the bursting of a housing bubble, which led to a credit crunch.

• The collapse of Lehman Brothers set off a financial panic that caused parts of the financial system to be frozen.

• The Federal Reserve, the Treasury, the Congress, and President Bush responded to the crisis with unprecedented government intervention designed to stabilize the financial system.

• The Covid-19 crisis that began in 2020 also required the Federal Reserves, the Treasury, Congress, and the President to intervene to stabilize the financial system.

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12.4 Financial Crises and Financial Regulation (pages 411–426) Discuss the connection between financial crises and financial regulation.

• There is a regular pattern to financial crises and regulation: (1) a crisis occurs; (2) regulation in response to the crisis is enacted; (3) the financial system responds to the new regulations; and (4) regulators respond, for example, by imposing new capital requirements on financial firms.

• Despite its shaky start as a lender of last resort during the Great Depression, the Fed has performed this role well during most of the post-World War II period.

• Over time, the perception arose that some large financial institutions were too big to fail, because their failure would pose a systemic risk to the economy.

• Regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost to the FDIC of bank failures.



Key Terms

Bank panic, p. 394. The situation in which many banks simultaneously experience runs.

Bank run, p. 393. The process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close.

Basel accord, p. 423. An international agreement about bank capital requirements.

Contagion, p. 394. The process by which a run on one bank spreads to other banks, resulting in a bank panic.

Debt-deflation process, p. 403. The process first identified by Irving Fisher in which a cycle of falling asset prices and falling prices of goods and services can increase the severity of an economic downturn.

Disintermediation, p. 420. The exit of savers and borrowers from banks to financial markets.

Federal Deposit Insurance Corporation (FDIC), p. 395. A federal government agency established by Congress in 1934 to insure deposits in commercial banks.

Financial crisis, p. 393. A situation in which serious problems in the financial system result in a significant disruption in the flow of funds from lenders to borrowers.

Insolvent, p. 393. The situation in which a bank or other firm has a negative net worth because the firm’s assets have less value than its liabilities.

Lender of last resort, p. 394. A central bank that acts as the ultimate source of credit to the banking system, making loans to solvent banks against their good, but illiquid, loans.

Too-big-to-fail policy, p. 414. A policy under which the federal government does not allow large financial firms to fail, for fear of damaging

the financial system.



Chapter Outline

Shadow Banking and Financial Crises During 2007–2009, the U.S. and world economies suffered what was frequently called a once-in-a-lifetime financial crisis. Yet in 2020, during the Covid-19 pandemic, the U.S. and world economies suffered another once-in-a-lifetime financial crisis. How can we account for two once in-a-lifetime crises in less than 15 years? One explanation is that two unlikely events caused crises that would not otherwise have occurred. Another explanation is that the financial system has become more fragile, possibly due to the growing importance of the shadow banking system. Shadow banks may be more susceptible to runs because they are not eligible for the equivalent of federal deposit insurance and cannot usually borrow from the Fed.

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The slow recovery after the 2007–2009 financial crisis led most central banks around the world to keep interest rates low for years. Once a recession is over, typically central banks keep interest rates low for only a limited time before allowing them to rise to more normal levels. Did keeping interest rates low for so long cause distortions to the financial system? Some economists and policymakers believe that investors had taken advantage of being able to borrow at very low interest rates to purchase financial assets, as well as real estate and commodities, driving up their prices to unsustainable levels. Low interest rates on conventional assets, such as investment grade corporate bonds, have inspired some investors, including some financial firms, to buy riskier investments, such as non-investment-grade, or junk, bonds or collateralized loan obligations (CLOs), which are securities that package loans issued by large firms with relatively poor credit ratings. These economists and policymakers were worried that, in effect, the markets for these securities were experiencing bubbles (see Chapter 6, Section 6.5). But, were there really bubbles in the prices of financial and other assets at the beginning of 2020? Bubbles are much easier to identify after the fact than before they have burst. Although we now know that house prices in some markets had reached unsustainable levels by 2006, at the time, some industry observers argued that the high prices were justified by zoning restrictions and rising prices for construction supplies that had increased the cost of building new houses. Similarly, while prior to 2020 and the arrival in the United States of Covid-19, some economists and policymakers worried about bubbles in the stock market, the market for securities backed by commercial mortgages, or the markets for other financial securities, other economists argued that high prices in these markets were justified, particularly given the likelihood that interest rates would remain low for many years.

The point to note about these conflicting views is that financial crises are difficult to predict because they happen infrequently. Only people who had lived through the 1930s had experienced a financial crisis as severe as the one that began in 2007, following the collapse in the market for subprime mortgages. Only the very few people who had lived through the 1918 influenza pandemic had experienced the effects of a pandemic on an economy and financial system. Therefore, when financial crises occur, policymakers, managers of financial firms, investors, and households are forced to deal with highly unusual events.

Teaching Tips Prior to 2007, most economists and policymakers believed that financial crises were a thing of the past, at least where the United States was concerned. The events of 2007–2009 caused economists and policymakers to pay more attention to the possibility of financial crises occurring. One of the objectives of this chapter is to provide students with background on the 2007–2009 financial crisis by putting it in the context of other financial crises. Because many economists, policymakers, and journalists have drawn analogies between the 2007-2009 crisis and the crisis of the 1930s, the chapter devotes a section to the financial crisis of the Great Depression.

The chapter also provides a framework for understanding how financial crises lead to changes in regulations that, in turn, lead to innovations among financial firms, which then lead to additional regulations. For example, the failure of the Fed to carry out its role as lender of last resort in the early 1930s led Congress to set up the FDIC and enact restrictions on bank competition. Banks responded with several innovations, including standby letters of credit, negotiable certificates of deposit, and NOW accounts. Congress then responded to these innovations by passing the Depository Institutions Deregulation and Monetary Control Act in 1980 and the Garn-St. Germain Act in 1982. Problems with inadequate capital in the savings-and-loan and commercial banking systems led to the decision by the United States to join the Basel accord, thereby raising capital requirements for U.S. banks. Banks responded by setting up special investment vehicles (SIVs) to hold their most risky assets. Problems with SIVs during the 2007-2009 financial crisis led the United States and other countries to agree to further changes in capital requirements. This regulatory pattern is a continuing feature of the financial system. Understanding regulatory patterns helps students to better understand the ways in which the financial system evolves.

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12.1 The Origins of Financial Crises (pages 393-400) Learning Objective: Explain what financial crises are and what causes them.

A. The Underlying Fragility of Commercial Banking Because banks borrow from depositors short term and lend long term to households and firms, banks have a maturity mismatch with the maturity of their liabilities exceeding the maturity of their assets. Banks, therefore, face liquidity risk because they can have difficulty meeting their depositors’ demands to withdraw their money. If a bank has made loans and bought securities that have declined in value, the bank may be insolvent.

B. Bank Runs, Contagion, and Bank Panics Liquidity risk is a particular problem for banks if the government does not provide insurance for deposits and there is no central bank. The process by which simultaneous withdrawals by a bank’s depositors results in the bank closing is called a bank run. Without a system of government deposit insurance, bad news about one bank can snowball and affect other banks in a process called contagion. If multiple banks experience runs, the result is a bank panic, which may lead many banks in the system to close. A bank panic feeds on a self-fulfilling perception: If depositors believe that their banks are in trouble, those banks are in trouble.

C. Government Intervention to Stop Bank Panics Governments have two main ways they can attempt to avoid bank panics: 1. A central bank can act as a lender of last resort. For example, the Fed was established as an ultimate source of credit to which banks could turn for loans during a panic.

2. The government can insure deposits. By reassuring depositors that they would receive their money back even if their bank failed, deposit insurance effectively ended the era of commercial bank panics in the United States.

D. Bank Panics and Recessions A bank panic can lead to declines in production and employment, either causing a recession or making an existing recession worse. Bank failures can directly affect the ability of households and firms to spend by wiping out some of the wealth they hold as deposits. Typically, in a panic even banks that remain solvent will reduce their lending as they attempt to accumulate reserves to meet deposit withdrawals. As the recession worsens, with the profitability of firms declining and household incomes falling, more borrowers are likely to default on their loans, and the prices of securities held by banks are likely to fall, further undermining the confidence of depositors and leading to increased withdrawals, causing banks to further curtail lending.

E. Exchange-Rate Crises Though there are some benefits to having a fixed exchange rate, pegging exchange rates can cause problems, particularly if the pegged exchange rate ends up substantially above the equilibrium rate that would prevail in the absence of the peg. For instance, in the case of the Korean won, the central bank, which would be responsible for maintaining the peg, must use its previously accumulated reserve of dollars to buy surplus won, or else the peg cannot be maintained. Eventually, the central bank will exhaust its holding of dollars. To maintain the peg as long as possible, central banks must take steps to make the currency more attractive. Often the central bank raises domestic interest rates, with the intention of attracting foreign investors to buy domestic bonds, thereby raising the demand for the domestic currency, and, potentially, preserving the peg. Unfortunately, higher domestic interest rates also discourage domestic firms from engaging in real capital investment and domestic households from borrowing to finance spending on houses and consumer durables. The result can be a recession.

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F. Sovereign Debt Crises A sovereign debt crisis occurs when a country’s government has difficulty making interest or principal payments on its bonds, or when investors expect a country to have this difficulty in the future. Even if the government avoids default, it will probably have to pay much higher interest rates when it issues bonds. Sovereign debt crises occur frequently and typically result from either of two circumstances: 1. Chronic government budget deficits that eventually result in the interest payments paid on government bonds taking up an unsustainably large fraction of government spending.

2. A severe recession that increases government spending and reduces tax revenues, resulting in soaring budget deficits.

Extra Apply the Concept Greece Experiences a “Bank Jog” Before the United States enacted federal deposit insurance in 1934, commercial banks were subject to bank runs. In a bank run, depositors withdrew their funds because they were afraid that if their bank closed, they would not get back all the money in their accounts. Typically, once a run on a bank began, the bank was quickly forced to close because large numbers of its depositors demanded their money back at the same time. In 2012, Greek banks also experienced something like a bank run, but in this case, depositors withdrew their money at a relatively slow pace, so some journalists described Greek banks as undergoing a “bank jog” rather than a bank run.

After June 2002, all countries adopting the euro, including Greece, had removed their individual currencies from circulation. After that date, all deposits in Greek banks were in euros, rather than in drachmas, the previous Greek currency. The period from 2001 until the beginning of the global economic recession and financial crisis in 2007 was one of relative economic stability in most of Europe. With low interest rates, low inflation rates, and expanding employment and production, the advantages of the euro seemed obvious. The countries using the euro no longer had to deal with problems caused by fluctuating exchange rates. Having a common currency also makes it easier for consumers and firms to buy and sell across borders.

The recession and financial crisis of 2007–2009 resulted in falling real GDP and higher unemployment. The recession caused large increases in government spending and reductions in tax revenues as incomes and profits declined. Governments in a number of European countries, particularly Greece, Ireland, Spain, Portugal, and Italy, paid for the resulting budget deficits by selling bonds to investors. By the spring of 2010, many investors began to doubt the ability of some countries, particularly Greece, to make the interest payments on the bonds. If Greece defaulted, investors would be likely to stop buying bonds issued by several other European governments and would question whether the euro would survive.

The European Central Bank (ECB) helped Greece avoid a default by directly buying its bonds. The central bank extended similar help to Spain, Ireland, and Italy. The International Monetary Fund and the European Union put together aid packages meant to keep Greece and other countries from defaulting. In exchange for the aid, these countries were required to adopt an austerity policy of cutting government spending and raising taxes even though doing so resulted in significant protests from unions, students, and other groups.

In 2012, discontent over spending cuts and higher taxes, along with continuing high unemployment, led Greek voters to elect politicians who vowed to reverse the austerity policy. As a result, speculation increased that Greece would abandon the euro. Many Greeks were afraid that the government might decide to exchange their euro bank deposits for drachmas at a rate of one for one. If the drachma then depreciated— as was widely expected—bank depositors would suffer heavy losses. In response, beginning in May, Greek banks began to lose deposits. Depositors either held their withdrawals as cash or deposited them in foreign

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banks. Unlike with a normal bank run, however, Greek depositors believed that they had ample time to withdraw their money because the ECB was willing to provide euro currency to Greek banks to meet withdrawals and because it was unclear whether Greece actually would stop using the euro.

The Greek bank jog indicated a potential new source of instability in the global financial system: Not only might depositors in euro countries lose faith in banks because of actions by the banks—for instance, making bad loans—depositors could also become concerned that their country might leave the euro or that the ECB would not be willing to supply an unlimited amount of euros to local banks.

Sources: David Enrich, Sara Schaefer Muñoz, and Charles Forelle, “Europe Banks Fear Flight of Deposits,” Wall Street Journal, May 20, 2012; Matthew O’Brien, “End of the Marathon: The Meaning of Greece’s ‘Bank Jog,’” Atlantic, May 17, 2012; and Damien McElroy, “Greeks Withdraw Savings in National ‘Bank Jog,’” (UK) Telegraph, May 20, 2012.

Teaching Tips In the Apply the Concept,“Why Was the Severity of the 2007–2009 Recession So Difficult to Predict?,” the authors cite the work of Reinhart and Rogoff, who explain why recessions caused by financial crises tend to be deeper and longer than other recessions. Have students discuss why financial crises have an effect that extends beyond the financial system. Ask them to discuss why the recovery from a recession caused by a financial crisis is generally slower than the recovery following a typical recession.

12.2 The Financial Crisis of the Great Depression (pages 401–406) Learning Objective: Describe the key elements of the financial crisis that occurred during the Great Depression.

A. The Start of the Great Depression Although many people think the Great Depression started with the stock market crash of October 1929, the National Bureau of Economic Research (NBER) dates the Depression as starting in August 1929. By 1928, the Federal Reserve had become concerned by rapid increases in stock prices. As the Federal Reserve increased interest rates to reduce what it saw as a speculative bubble in the stock market, growth in the U.S. economy slowed during early 1929, and the economy eventually entered a recession. Several factors helped to increase the severity of the downturn, including the stock market crash in October 1929 and the passage of the SmootHawley Tariff Act in 1930.

B. The Bank Panics of the Early 1930s Many economists believe that the series of bank panics that began in the fall of 1930 greatly contributed to the length and severity of the Great Depression. The bank panics fed a debtdeflation process; as banks were forced to sell assets, the prices of those assets declined, causing other banks and investors holding similar assets to suffer declines in net worth, leading to additional bank failures and to investors going bankrupt. In addition, as the economic downturn worsened, the price level fell, resulting in: 1 An increase in real interest rates.

2. A decrease in the real value of debts.

C. The Failure of Federal Reserve Policy During the Great Depression The Federal Reserve, which Congress established in 1913 to end bank panics, did not intervene to stabilize the banking system. Economists have pointed to four possible explanations for this lack of intervention: 1. No one was in charge of the Federal Reserve because authority within the system was much more divided than is true today.

2. The Fed was reluctant to rescue insolvent banks.

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3. The Fed failed to recognize the difference between nominal and real interest rates.

4. The Fed wanted to “purge speculative excess” by allowing the price level to fall and weak banks to fail in order to prepare the way for a recovery.

Teaching Tips Ask students to review the four reasons cited for the failure of the Federal Reserve during the Great Depression. Discuss whether the lessons of the Great Depression helped shape the Fed’s response to the financial crisis of 2007–2009.

12.3 The Financial Crises of 2007–2009 and 2020 (pages 406–411) Learning Objective: Describe the events of the financial crises of 2007–2009 and 2020.

A. The Housing Bubble and the Financial Crisis of 2007–2009 After rising rapidly between 2000 and 2005, sales and prices of new homes began to decline in 2006, causing some homeowners to have trouble paying their loans. When lenders foreclosed on some of these loans, the lenders sold the homes, causing housing prices to decline further.

Mortgage lenders that had concentrated on making subprime loans suffered heavy losses, and some went out of business. Banks and other lenders tightened their lending requirements, resulting in a credit crunch, which further depressed the housing market. As a result, spending declined on housing-related products and homeowners had a more difficult time borrowing against the value of their homes.

B. Bank Runs at Bear Stearns and Lehman Brothers In the fall of 2007 and the spring of 2008, credit conditions worsened. Many lenders became reluctant to lend to financial firms for more than very short terms and often insisted on government bonds as collateral. Three key events occurred during 2008: • Lenders became concerned that Bear Stearns’ investments in mortgage-backed securities had declined in value to the extent that the investment bank was insolvent. With the aid of the Federal Reserve, JP Morgan Chase acquired Bear Stearns in March.

• On September 15, Lehman Brothers investment bank filed for bankruptcy protection after the Treasury and Federal Reserve declined to commit the funds necessary to entice a private buyer to purchase the firm.  On September 16, Reserve Primary Fund, a large money market mutual fund, announced that because it had suffered heavy losses on its holdings of Lehman Brothers commercial paper, it would “break the buck” by allowing the price of shares in the fund to fall to $0.97.

This led to a run on money market mutual funds as investors cashed in their shares. Many parts of the financial system became frozen as trading in securitized loans largely stopped.

Large and small firms had difficulty arranging even short-term loans.

C. The Federal Government’s Extraordinary Response to the 2007–2009 Financial Crisis The Federal Reserve, the Treasury, Congress, and President Bush responded to the crisis with unprecedented government intervention including: o Reducing the federal funds rate to near zero o Effectively nationalizing Fannie Mae and Freddie Mac o Introducing a $50 billion plan to insure money market deposits o Introducing the commercial paper funding facility o Creating the Troubled Asset Relief Program (TARP) Most economists and policymakers believe these measures stabilized the financial system during the fall of 2008 and the spring of 2009. A stress test administered by the Treasury to 19 large financial firms during early 2009 assured many investors that these firms would need to raise

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about $100 billion to deal with a severe economic downturn. After the crisis had passed, Congress turned to the task of examining whether regulations governing the financial system needed to be overhauled. In July 2010, Congress passed, and President Barack Obama signed, the Wall Street Reform and Consumer Protection Act, or Dodd–Frank Act, which we will discuss in Section 12.4.

D. The Covid-19 Pandemic and the 2020 Financial Crisis In response to the worst economic downturn since the Great Depression, the Fed and the federal government took action. The Fed returned the fed funds rate target to the 0–25% range. Congress passed the CARES Act, which provided $2 trillion in aid in the form of direct payments to households, supplemental unemployment benefits, loans and grants to businesses, and aid to state and local governments. The Fed also created liquidity facilities (to act as a lender of last resort for shadow banks) and credit facilities (to lend to businesses outside the financial sector and governments) 12.4 Financial Crises and Financial Regulation (pages 411–426) Learning Objective: Discuss the connection between financial crises and financial regulation.

New government financial regulations typically occur in response to a crisis. Looking at different types of regulations that the government has enacted over the years, we can see that there is a regular pattern: 1. A crisis in the financial system occurs.

2. The government responds to the crisis by adopting new regulations.

3. Financial firms respond to the new regulations.

4. Government regulators adapt policies as financial firms try to evade regulations.

A. Lender of Last Resort After the Fed failed its first test during the Great Depression, Congress reorganized the Fed, helping to centralize decision making by having the chair of the board also chair the FOMC. The Fed has performed well during most of the post-World War II period. Over time, the perception arose that some large financial institutions were too big to fail, because failure would pose a systemic risk to the economy. The Dodd-Frank Act of 2010 allows the Fed, FDIC, and Treasury to seize and “wind down” large financial firms, which means that the firms’ assets are sold off in a way that will not destabilize financial markets. Whether the act has actually put an end to the “too-big-to-fail” policy remained to be seen. But during 2020, when the financial markets began to experience the effects of the Covid-19 pandemic on the economy, it appeared that the optimists were right that Dodd–Frank would not be a serious obstacle to the Fed’s engaging in a program of aggressive lending to a wide variety of financial firms.

B. Reducing Bank Instability One way that Congress attempted to increase stability in the banking system following the Great Depression was by reducing competition. Regulation Q prohibited banks from paying interest on demand deposits and restricted interest paid on time and savings deposits. Congress believed such regulation would increase the profitability of banks and discourage banks from making risky investments. However, in the long run, anticompetitive regulations create incentives for unregulated financial institutions and markets to compete with banks by offering close substitutes for bank deposits and loans. For example, the development of money market mutual funds provided depositors with a means of earning higher interest rates and provided borrowers with a greater ability to raise funds by selling commercial paper. The exit of savers and borrowers from banks to financial markets is known as disintermediation, which costs banks lost revenue from not having enough savers’ funds to loan. To circumvent Regulation Q, banks developed new financial instruments for savers. Regulatory changes in the early 1980s phased out regulation Q.

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C. Capital Requirements One way the federal government attempts to promote stability in the banking system is by sending examiners from the FDIC, the Fed, and the Office of the Comptroller of the Currency to banks to check that they are following regulations. After an examination, a bank receives a grade in the form of a CAMELS rating based on the following: Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Of the CAMELS categories, along with asset quality, capital adequacy has received the most attention. Regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost to the FDIC of bank failures. Under the Basel accord, developed by the Bank for International Settlements, bank assets are grouped into four categories based on their degree of risk. Bank regulators determine a bank’s capital adequacy by calculating two ratios: the bank’s Tier 1 capital relative to its risk-adjusted assets and the bank’s total capital (Tier 1 plus Tier 2) relative to its risk-adjusted assets.

D. The 2007–2009 Financial Crisis and the Pattern of Crisis and Response The financial crisis of 2007–2009 has followed a pattern of crisis and response. The financial crisis, which began with the housing bubble, has led to major regulatory changes. If history is a guide, we can be certain that financial firms will respond with innovations intended to reduce the effect of the new rules on their activities.

Extra Apply the Concept The Consumer Financial Protection Bureau: The New Sheriff of Financial Town In July 2010, Congress passed the Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act. One of the act’s provisions was the creation of the Consumer Financial Protection Bureau (CFPB), in response to complaints about deceptive practices by banks, credit card companies, and mortgage brokers before and during the financial crisis. Many policymakers believed that thousands of Americans had lost their homes because they had taken out mortgage loans that they had either not understood or could not afford.

The CFPB was charged with consolidating responsibilities that had resided with several other federal agencies, and in July 2011, it took over enforcement of 18 existing consumer laws. Since then, the CFPB has used a range of powers to restrict what it considers problem lending, misleading marketing, and secret deals among companies that raise the costs of loans to consumers. The CFPB has a powerful enforcement tool: the threat of civil charges against violators of laws involving money transfers, foreclosures, and many other financial products and services.

The CFPB is part of, and funded by, the Federal Reserve System, but it is responsible for hiring its own personnel and setting its own rules. Although supporters welcomed the new bureau as an advocate for consumers, critics worried about the costs and complexity of additional regulation. Critics also saw the bureau’s unusual level of independence as exempting it from the typical checks on the activities of government agencies. In its first year of existence, the CFPB carried out investigations of credit card companies, for-profit colleges, and mortgage lenders, as well as dozens of other firms. One of its most significant actions was an agreement it reached with Capital One Financial to refund $150 million in fees to over 2.5 million customers who, it was charged, purchased credit card protection and other services as a result of misleading marketing.

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Critics questioned whether the gains for consumers from the bureau’s activities were worth the costs. One rule issued by the CFPB for mortgage simplification was over 1,000 pages long. By comparison, the entire Federal Reserve Act is only 32 pages long. Small banks in particular have complained that following complex rules makes it more costly to offer their services, and these costs are then passed through to consumers. Other costs include legal bills for firms subject to CFPB investigations. Jonathan Pompa, an attorney whose firm represents companies that have been investigated, claimed that the CFPB aggressively examines firms that offer financial products that it believes might harm consumers. As Pompa explains, “They’re not messing around. . . . A year ago, we said there was a new sheriff in town. It’s not just a sheriff—it’s an army.”

The CFPB also came under criticism for establishing a Web site devoted to consumer complaints about credit card companies. The American Bankers Association argued that because the Web site provides publicity for allegations that have not yet been verified, the action “raises serious questions about the balanced review we expect from our government agencies.”

Supporters of the CFPB argue, though, that the 2007–2009 financial crisis revealed that more regulation of consumer lending and related financial services was necessary and that effective regulation could make another financial crisis less likely. Supporters argue that criticism of the bureau comes mainly from financial firms that would rather not comply with new regulations.

Economists and policymakers continue to debate whether the CFPB is supplying needed regulation of financial firms or whether it is unnecessarily increasing the costs and reducing the efficiency of the services those firms provide.

Sources: Mary Kissel, “Ripoffreport.gov,” Wall Street Journal, June 25, 2012; “Too Big Not to Fail,” Economist, February 18, 2012; “Consumer Financial Protection Bureau’s Impact Has Come as a Surprise,” Associated Press, September 16, 2012; Jenna Greene, “One Year In, Consumer Financial Agency Has Had ‘Extraordinary’ Impact,” BLT: The Blog of Legal Times, July 20, 2012; and “Bureau of Consumer Financial Protection (C.F.P.B.),” New York Times, August 10, 2012.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 12.1

The Origins of Financial Crises Learning objective: Explain what financial crises are and what causes them.

Review Questions 1.1

A financial crisis typically results in a recession because households and firms no longer have access to the loans they need to fund some of their spending. Households and firms also decrease spending as bank failures wipe out some of the wealth they hold as deposits and shareholders of banks suffer losses. There can also be a negative feedback between a financial crisis and a recession with each making the other worse.

1.2

Banks take in short-term deposits and make long-term loans. So, banks have a maturity mismatch that makes them subject to liquidity risk if depositors suddenly withdraw funds. A bank does not have to be insolvent to experience a bank run. Depositors may mistakenly believe that a bank has experienced losses and start to withdraw their funds, even though the bank is, in fact, still solvent. Contagion can also cause a solvent bank to experience a bank run.

1.3

Contagion is the process by which a run on one bank spreads to other banks. Negative information about one bank can make depositors believe that other banks are risky as well, and so depositors may withdraw funds not just from a single bank but from many. This reaction can result in a bank panic, a situation in which many banks experience runs at the same time.

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1.4

A currency peg is when a currency is tied (“pegged”) to the value of some other currency, fixing the exchange rate. Currency crises can occur when a pegged (or fixed) exchange rate ends up substantially above or below the equilibrium rate that would prevail in the absence of the peg.

Pegged exchange rates substantially above the equilibrium rate pose a particularly acute threat of a currency crisis because the country may have insufficient foreign exchange reserves to maintain the pegged exchange rate. Some European countries have been suffering from a sovereign debt crisis because they experienced recessions and financial crises during 2007-2009 and beyond that increased government spending and reduced tax revenues, resulting in soaring budget deficits. The subsequent slow recoveries, along with high budget deficits, caused investors to doubt the ability of these governments to pay the interest or principal payments on their bonds, leading to higher interest rates when the governments issued new bonds.

1.5

A sovereign debt crisis occurs when the government that issued a bond has difficulty paying the interest payment or the principal on that bond, or when investors expect the government to have difficulty in the future making these payments. If the sovereign debt crisis leads to a default, the government will not be able to issue bonds for some time. Even if the government does not default, it will have to pay higher interest rates when issuing new bonds. A sovereign debt crisis usually results (1) when the interest on government debt accounts for a significant portion of the government budget (and budget deficit), or (2) during recessions that lead to a reduction in tax revenues and therefore an increase in budget deficits.

Problems and Applications 1.6

a. A contagion of fear means that a run or failure of one bank or several banks can cause depositors in other banks to fear that their bank will suffer a bank run and that they will not be able to withdraw their deposited funds unless they are first in line at the bank. As a result, problems at one bank can spread to other banks, even to banks that are profitable and solvent. b. Because FDIC insurance did not exist in the early 1930s, if a bank failed, then depositors would potentially lose some, or even all, of their deposited money. Bank depositors today do not face similar fears because of FDIC insurance that protects deposits up to $250,000. c. The bank panics started in agricultural areas but the fear that causes bank runs quickly spread to banks in non-agricultural areas. During the time before federal deposit insurance, once people became concerned about problems in the banking system, any bank might experience a run.

1.7

a. “By solvent under normal conditions,” former Fed Chair Bernanke means that the net worth (assets – liabilities) of the bank was positive when the bank was not experiencing a sustained bank run. b. By “sustained run,” Bernanke means a bank run that lasts for a significant period of time. A bank cannot by itself survive a sustained run because it does not have enough reserves to match the deposit withdrawals and its assets (loans and securities) are long term and not easily liquidated.

1.8

a. Bad news about one bank can snowball and affect other banks in a process called contagion.

Once one bank has experienced a run, depositors of other banks may become concerned that their banks might also have problems. b. Two ways the government can keep one bank failure from leading to a panic are: (1) by having a lender of last resort extend loans to banks and (2) by providing insurance for bank deposits.

1.9

If a bank failed it would have 100% of its deposit liabilities on hand, so there would be no possibility of its customers losing their deposits. There would be no need for FDIC insurance.

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1.10

A recession accompanied by a financial crisis generally has more severe consequences, such as decreasing asset prices and lending, which affects the economy for a longer time period than a traditional recession. When financial institutions fail, credit markets can be damaged, and the amount of borrowing, and therefore economic activity, can decrease, further decreasing real output.

1.11

Similar to what Reinhart and Rogoff did, you could gather data from periods in the history of United States and other countries when they experienced recessions with slow recoveries along with a housing bust and uncertainty over changes in fiscal and regulatory policy. It would be difficult to definitively identify the causes of the slow recovery given the size and complexity of the world’s economies.

1.12

The country is afraid of losing the confidence of investors who would buy new issues of their debt. The consequences would be that the investors would either not buy new issues of the sovereign debt or would require significantly higher interest rates.

1.13

An indebted country is afraid of losing the confidence of its debtors, banks and other investors who have loaned money to the country. If it loses the confidence of investors, it will be unable to issue more bonds (and will have to rely on tax revenues to finance government spending) or will have to pay higher interest rates.

12.2

The Financial Crisis of the Great Depression Learning objective: Describe the key elements of the financial crisis that occurred during the Great Depression.

Review Questions 2.1

Bank panics made the Great Depression much more severe. Bank failures wiped out some of the wealth that households and firms held in bank deposits and shareholders held in bank equity, thereby reducing spending. In addition, as some banks failed and most others became more cautious in the loans they made, households and firms had to reduce spending financed by borrowing. The bank panics fueled a debt-deflation process with a cycle of falling asset prices and falling prices of goods and services. This increased the severity of the economic downturn.

2.2

As a result of bank runs, banks were forced to sell assets, causing the prices of the assets to decline. The decline in asset prices caused other banks and investors holding the assets to suffer losses, leading to additional bank failures and investors going bankrupt. With the economic downturn worsening, declines in spending led to a decline in the price level. This deflation increased the real interest rate and the real value of debts, increasing the burden on borrowers and leading to more loan defaults.

2.3

The four reasons the Fed failed to intervene in the banking system in the early 1930s are: First, power within the Federal Reserve was more divided than today, making it difficult for the Fed to act. Second, the Fed was reluctant to rescue insolvent banks, believing that doing so would encourage risky behavior by bank managers (the moral hazard problem). Third, the Fed failed to understand that because of deflation low nominal interest rates did not imply low real interest rates.

Fourth, the Fed wanted to purge speculative excess, believing that it was necessary for the price level to fall and weak banks and weak firms to fail before a recovery could begin.

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Problems and Applications 2.4

The Great Depression began in August 1929. President Hoover did not foresee the bank panics that would magnify the severity of the recession. Hoover expected that the recession that began in August 1929 would have a length typical of other recessions, which means that it would have been reasonable to expect it to be over by June 1930. The Great Depression continued longer than Hoover expected because of: (1) bank panics; (2) policy mistakes by Congress and the president, including raising tariffs and taxes; (3) the decline in stock prices that destroyed household wealth and increased the cost to firms of raising capital; and (4) policy mistakes by the Federal Reserve, including a failure to stop the bank panics.

2.5

a. Bank lending is “information sensitive” because banks acquire information often through relationship banking (as discussed in Chapter 9, Section 9.2) to decide if borrowers will pay back their loans. Lenders who lack information that banks acquire on households and firms may be unwilling to make loans to these borrowers. b. “Nonbank forms of credit” refer to credit from providers other than banks. For example, buyers of commercial paper provide short-term credit to firms. Banks have advantages over other lenders in acquiring information on households and small- and medium-sized firms. The advantages of banks arise from relationship banking, specialization, and economies of scale.

Other providers of credit have greater trouble assessing the riskiness of loans to small borrowers, which makes them reluctant to extend credit to bank customers during times when banks are unable or unwilling to make loans to these borrowers. c. Yes. When thousands of banks failed, it became difficult for their customers to obtain credit, thereby increasing the severity of the Great Depression.

2.6

a. Liquidate means to let prices fall to their equilibrium level and to let firms go out of business. b. The policy advice of the Treasury Secretary at the beginning of the Great Depression helps to explain the Fed’s actions to an extent because the Fed was acting on the predominant economic model of the time, which said that the economy will self-adjust and any attempt by the government to intervene either will have no effect or will have the negative consequence of prolonging the downturn. The Fed seems to have been particularly concerned about what it saw as “speculative excesses” in the stock market during the late 1920s. a. Deflation decreases both prices and incomes. In the short run, deflation could benefit consumers whose incomes did not fall. Consumers who were borrowers would be hurt by the higher real interest rates and higher real value of debts that deflation causes. The deflation during the Great Depression also caused the debt-deflation process, which increased the severity of the economic downturn. b. Real interest rates rise when inflation falls (real rate = nominal rate – inflation, so if inflation is negative, the real rate is higher). c. Financial firms as lenders would have benefitted from the higher real interest rates received on their loans and securities, but nonfinancial firms would have suffered as borrowers from the higher real interest rates and higher real value of their debts. Though not mentioned in the text, deflation tends to cause consumers to postpone spending waiting for further price declines, which reduces sales by firms. Also, the debt-deflation process magnifies the downturn.

2.7

2.8

a. Easy monetary policy means a policy of increasing the money supply and lowering interest rates.

The intent of an easy monetary policy is to make credit readily available to borrowers. b. No. Real interest rates, not nominal interest rates, are the key interest rate for economic decisions, and the deflation of the early 1930s made real interest rates high and above nominal interest rates. In the Fed’s view, low nominal interest rates indicated that the demand for loans was low, implying there was no shortage of available loans to borrowers.

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a. The Fed’s role of lender of last resort refers to the Fed providing banks with loans during bank runs. With these loans, banks can meet the cash demands of its depositors who withdraw their funds. Banks can thereby avoid having to sell illiquid long-term assets. b. The Fed could have served as a lender of last resort. Once depositors knew they could get their funds, the contagion of bank runs would have ended. c. The Fed was reluctant to rescue insolvent banks because they were concerned that it would encourage risky behavior by banks (a moral hazard problem). The Fed also wanted to “purge speculative excess,” which they believed caused the Great Depression.

2.10 a. The causes of the Great Depression were numerous and were compounded by policy mistakes by both the federal government and the Fed (which are discussed in the answer to Problem 2.4).

Less was known about the functioning of the economy, and the actions of the federal government and the Fed were less transparent. In contrast, the cause of the 2020 crisis was clearly the Covid-19 pandemic and the response of fiscal and monetary authorities was transparent to the public. b. The choices of firms and households affect the length and severity of a downturn. When firms and household experience less uncertainty, they are better able to make consumption and investment decisions. Less uncertainty should result in a smaller decline in investment and consumption, reducing the length and severity of a downturn.

2.11 a. The Bank of United States was located in New York City and was one of the largest banks in the country. The managers of the bank had invested heavily in real estate mortgages. The bank failed in December 1930 because falling real estate prices and mortgage defaults left the bank at or close to insolvency. b. Friedman and Schwartz argue that the Bank of United States was so large and so well-known that letting this bank fail led, through the mechanism of contagion, to a cascade of other bank failures. c. Yes. Some economists argue that the failure of the Bank of United States was not as important as Friedman and Schwartz argued because the evidence is unclear as to whether the failure of the Bank of United States led to other bank failures. However, because Friedman and Schwartz’s argument was so influential, Rolnick may well be correct that later Fed policymakers saw the failure of the Bank of United States as an example of the negative consequences for the financial system of letting a large bank fail.

12.3

The Financial Crises of 2007-2009 and 2020 Learning Objective: Describe the events of the financial crisis of 2007-2009 and 2020.

Review Questions 3.1

A bubble means that the price of an asset has increased far beyond the fundamental value of the asset. During the housing bubble, many lenders granted mortgages to subprime and Alt-A borrowers. These mortgages were bundled into mortgage-back securities (MBS), collateralized debt obligations (CDOs), and similar securities, and sold to investors. Once housing prices started to fall, many borrowers began to default on their mortgages, causing rapid declines in the value of mortgage-backed securities. Banks and other financial firms that owned these securities experienced losses. Eventually, a full-blown financial crisis developed, significantly worsening the recession that began in December 2007.

3.2

Investment banks fund long-term investments with short-term borrowing from banks and other financial firms. The short-term loans to investment banks are similar to bank deposits to commercial banks. The investment banks are subject to runs when lenders decline to renew their Copyright © 2022 Pearson Education, Inc.

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short-term loans. To repay the short-term loans, the investment banks have to liquidate long-term assets. The run on Bear Stearns was an early sign that problems with mortgage-backed securities might spill over into the financial system as a whole. The run on Lehman Brothers forced it into bankruptcy and caused the Reserve Primary Fund, which suffered heavy losses on its holdings of Lehman Brothers commercial paper, to “break the buck” by allowing the price of shares to fall below $1.00. The announcement by Reserve Primary Fund led to a run on money market mutual funds. Many parts of the financial system became frozen as trading in securitized loans largely stopped and large firms as well as small ones had difficulty arranging for even short-term loans.

3.3

The 2007–2009 crisis began in financial markets and resulted in a disruption of the flow of funds from lenders to borrowers. The events of 2020 began with a pandemic, not an event in financial markets, and due to the actions of the Fed, the flow of funds from lenders to borrowers was not disrupted.

3.4

The six policy actions by the Federal Reserve and the Treasury during the 2007–2009 were the following: (1) The Federal Reserve lowered the federal funds rate to almost zero; (2) the federal government through the Treasury nationalized Fannie Mae and Freddie Mac to ensure the continued securitization of mortgage loans; (3) the Treasury stopped runs on money market mutual funds by insuring fund shares; (4) the Federal Reserve made loans directly to corporations by buying three-month commercial paper issued by nonfinancial corporations; (5) the Federal Reserve and the Treasury unveiled plans for Congress through the Troubled Asset Relief Program (TARP) to buy preferred stock in banks to increase bank capital and to provide funds to automobile firms that were in danger of failing; and (6) the Treasury administered a stress test on 19 large financial firms to gauge how well these firms would fare if the recession deepened. During the 2020 crisis, the Fed and the Treasury conducted similar policies, including reducing the target range for the federal funds rate to 0–25% and creating a large number of liquidity and credit facilities as well as extending unemployment benefits and making direct payments to households.

Problems and Applications 3.5

a. A house price bubble is when house prices move beyond their fundamental values, which can be approximated by the present value of future rents. b. When households purchase houses, they borrow at the mortgage interest rate, which is a longterm interest rate. As we saw in the discussion of the term structure of interest rates in Chapter 5, long-term interest rates are typically higher than short-term interest rates. In particular, the mortgage interest rate is typically above the federal funds rate. c. Greenspan, along with his colleagues at the Fed, has been criticized for helping to cause the housing bubble by keeping short-term interest rates low in the years leading up to the bubble.

Greenspan is arguing that Fed policy is not solely to blame for the housing bubble because the bubble was caused by low long-term interest rates and the Fed does not directly control longterm interest rates.

3.6

a. Bear Stearns almost failed because lenders became concerned that Bear Stearns’ investments in mortgage-backed securities had declined in value so much that the investment bank was insolvent. Bear’s lenders lost faith in its ability to pay back its short-term loans, so the lenders declined to renew their short-term loans. Bear Stearns had to liquidate assets in order to pay back these short-term loans. b. In March 2008, the Federal Reserve arranged a buyout of Bear Stearns by JP Morgan Chase, a commercial bank. The Fed provided crucial aid to JP Morgan Chase to induce them to purchase Bear.

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c. The debt-deflation process would occur if Bear Stearns went bankrupt and had to sell its assets.

The selling of assets would have pushed down the price of the assets, which other investment banks were also holding. The lower asset prices would have worsened the balance sheets of the other investment banks, which could have led to bankruptcies at these investment banks.

3.7

a. The broad-based loss of confidence in banks causes bank runs—depositors in commercial banks withdrawing their funds or short-term lenders to shadow banks not renewing their short-term loans. Bank runs often force banks to sell their long-term illiquid assets at prices below normal market prices, which weakens the banks’ balance sheets, causing some to become insolvent.

With less short-term funds and weakening economic conditions, banks cut back on their loans, which disrupts credit flows. b. Each of the four elements occurred during the 2007–2009 financial crisis. The bursting of the housing bubble caused deep losses for banks and investment banks that held mortgage-backed securities, resulting in a broad-based loss of confidence in investment banks. With a loss of confidence, lenders of short-term loans to investment banks did not renew their loans, causing investments banks to try to quickly sell their illiquid long-term assets to repay the short-term loans. The lack of short-term funds and worsening economic conditions caused banks and shadow banks to substantially cut back on their loans.

3.8

a. Shadow banks are less regulated than commercial banks. Many investment banks were more highly leveraged than commercial banks were, and there is no protection for lenders to shadow banks similar to the protection that FDIC deposit insurance provides for commercial bank deposits. b. In order to compensate for the risk shadow banks faced, Greenspan believes that shadow banks should have increased their capital (or have been obliged to do so by regulators). Increased capital would have reduced the banks’ leverage and have provided them with the ability to better withstand losses without becoming insolvent.

3.9

a. Fischer was referring to the shadow banking system of investments banks, hedge funds, insurance companies, and money market mutual funds. b. Fischer was referring to the interconnection between banks and nonbanks of financial assets such as mortgage-backed securities and commercial paper, and financial derivatives such as credit default swaps. c. Fischer meant that the interconnections among banks and nonbanks can magnify the negative effect of shocks on the economy. The shocks were the bursting of the housing bubble and the subsequent collapse of the subprime mortgage market, which caused deep losses for holders of mortgage-back securities and the locking up of the mortgage-backed securities market.

3.10

The recession of 2020 occurred because of the spread of Covid-19, the disease caused by the coronavirus. The pandemic was the first to significantly affect the U.S. economy since the 1918 influenza pandemic. Such an unusual event was difficult to predict.

3.11

A liquidity facility allows the Fed to act as a lender of last resort to the shadow banking system.

A credit facility allows the Fed to make loans to nonfinancial firms and state and local governments. The severity of the 2020 crisis required that the Fed be able to make loans and ease credit conditions in both of these areas.

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12.4

Financial Crises and Financial Regulation Learning Objective: Discuss the connection between financial crises and financial regulation.

Review Questions 4.1

The lender of last resort seeks to stop a bank failure from turning into a bank panic by making sure solvent institutions can meet their depositors’ withdrawal demands. The too-big-to-fail policy and the lender of last resort strive to prevent systemic risk, where the failure of a few firms can lead to the widespread failure of solvent banks.

4.2

Innovations to circumvent ceilings on deposit interest rates included the development of negotiable certificates of deposit (CDs), automatic transfer system (ATS) accounts, money market deposit accounts (MMDA), and negotiable order of withdrawal (NOW) accounts.

4.3

Banks can increase the riskiness of their loans and investments without worrying about whether depositors will withdraw their funds. With deposit insurance, depositors have little incentive to monitor the behavior of bank managers or to withdraw their deposits or demand higher interest rates if the managers make reckless investments. Deposit insurance is not a bad idea because deposit insurance has substantially decreased systemic risk in the commercial banking system in the United States by eliminating commercial bank runs.

4.4

Because the Fed had used emergency lending facilities twice in less than 15 years, some economists argued that firms might expect that if risky investments left them vulnerable to failure in the next crisis, the Fed would bail them out, thereby increasing moral hazard. Despite that concern, the benefits of the Fed’s actions in stabilizing financial markets are likely to outweigh the problems of an increase in moral hazard.

4.5

Capital requirements are regulations concerning the amount (as a percentage of assets) and type of capital that banks must hold.

Problems and Applications 4.6

a. Regulatory capital requirements are the minimum amounts of capital that banks are required by regulation to hold as a percentage of their assets. b. The lower the ratio of capital to assets, the higher the financial leverage. Low capital to asset ratios imply that banks are buying assets with large amounts of debt. c. High leverage magnifies both gains and losses. The losses during the financial crisis were magnified by the high leverage of many financial firms.

4.7

a. A hedge fund’s trades “moving against it” means that the hedge fund has placed a bet—either directly by buying a security or indirectly by using derivative contracts—that the price of a security will increase, but the price of the security declined instead, or that the hedge fund has placed a bet that the price of the security will fall, but the price of the security has increased instead. b. Hedge funds are usually highly leveraged, so a relatively small adverse movement in the prices of a hedge fund’s investments can wipe out its capital. c. Leverage is measured as the ratio of assets to capital. So, a hedge fund that is highly leveraged has little capital relative to its assets. d. “Dumping its positions” means a hedge fund is selling either the securities it owns or the derivative contracts upon which the securities are based. e. If a hedge fund owns a large amount of a security or derivatives based on the security, selling its investments can cause a large decline in the price of the security.

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4.8

a. SIFI stands for a systemically important financial institution, which the Financial Stability Oversight Council has identified as a firm whose failure would potentially cause a financial crisis. The Dodd-Frank Act requires SIFIs to hold more capital to increase the ability of the firm to remain solvent after it incurs losses. This requirement will also reduce moral hazard. b. Firms buy assets with either capital or debt. Requiring more capital relative to debt to buy assets reduces financial leverage and reduces the return on equity (profitability) for a given return on assets.

4.9

a. Debt leverage means borrowing and purchasing assets with the borrowed funds. b. If short-term debt is not renewed, or rolled over, the firm may have to sell its investments, as happened with investment banks holding mortgage-backed securities. c. If Greenspan believes that most bubbles burst without severe economic consequences, then, yes, his analysis would help to explain the Fed’s actions.

4.10 a. “Lending into continuing runs” means that the Fed makes loans to banks during a bank run.

Central banks lend into runs at financial firms as they serve as a lender of last resort to prevent contagion and bank panics. b. The Federal Reserve Act required the Fed to lend against sufficient collateral in order to be reasonably sure it could be fully repaid. Requiring sufficient collateral was economically important to prevent further moral hazard in banks’ behavior. c. There is a legal reason and an economic reason why the Fed didn’t lend to Lehman Brothers in the days before its bankruptcy. The legal reason was that Fed Chair Ben Bernanke and Treasury Secretary Henry Paulson claimed that Lehman was deeply insolvent and lacked adequate collateral. That Lehman was actually insolvent has been disputed by economist Laurence Ball of Johns Hopkins University. The economic reason for the Fed’s failing to lend to Lehman was the fear that doing so would increase moral hazard in the financial system.

4.11 a. The Dodd-Frank Act included provisions intended to end the too-big-to-fail policy. Congress included the requirement of living wills in the Act as one of the mechanisms for allowing large financial firms to fail without disrupting the financial system. b. The requirement of large financial firms having living wills was related to Congress in the Dodd-Frank Act rewriting Section 13(3) to not allow the Federal Reserve to make loans for the purpose of assisting a single and specific firm to avoid bankruptcy.

4.12 a. Then Treasury Secretary Paulson wanted Bear Stearns to sell for a low price because it was important that the firm’s owners and managers should suffer significant financial losses. Paulson believed that otherwise the action to save Bear Stearns had the potential to increase the extent of moral hazard in the financial system. b. Ordinarily, the federal government does not intervene to save firms, except for commercial banks on the brink of failure. In a market system, the owners of a firm are entitled to the profits if the firm is successful and suffer the losses if the firm fails. The Treasury and Federal Reserve intervened to save Bear Stearns because they believed the firm’s failure would result in systemic risk to the financial system. Some economists and policymakers were concerned that saving a failing financial firm would increase moral hazard in the financial system.

4.13 a. Section 13(3) of the Federal Reserve Act authorizes the Board of Governors under “unusual and exigent circumstances” to lend to “any individual, partnership, or corporation.” Congress in 1991 amended the Federal Reserve Act to make explicit that in an emergency the Fed could lend directly to nonbank firms. The Fed used this power to create liquidity and credit facilities.

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b. Congress did not want the Fed to act as a lender under normal circumstances. Instead, the Fed’s role was to be as a lender of last resort. c. As we have seen in examining both the 2007–2009 and 2020 crises, not all events are predictable, and the effects of events are not always clear. The Fed cannot perfectly predict or determine when circumstances are unusual and exigent, and it is often even more difficult to determine when these conditions have completely resolved and Fed assistance is no longer needed.

Data Exercises D12.1

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007 February 2020

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 Not known in March 2021

The unemployment rate generally goes down just before a recession, goes up during a recession, and goes down after a recession. The pattern of the 2007–2009 recession is similar to the other recent recessions— 1990–1991 and 2001—in that the unemployment rate continued to go up for a time after the recession had formally ended. In earlier recessions, the unemployment rate began to decline either at the end of the recession or very shortly thereafter.

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D12.2

Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007 February 2020

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 Not known in March 2021

a. The interest rate on the Baa-rated corporate bonds generally goes down just before a recession, up and then down during a recession, and down just after a recession. b. The pattern during the 2007–2009 recession for the interest rate on the Baa-rated corporate bonds was the same, but with a much higher spike in the interest rate during the recession. c. On the basis of movements in the interest rate on Baa-rated corporate bonds, you would date the financial crisis as beginning in October 2008, when the rate spikes, and ending in May 2009, when the rate begins to decline significantly. You would date the 2020 crisis as beginning in March 2020, when the Baa corporate bond rate spikes.

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Chapter 13 The Federal Reserve and Central Banking 

Brief Chapter Summary and Learning Objectives

13.1 The Structure of the Federal Reserve System (pages 435–450) Explain the Structure of the Federal Reserve.

• The Federal Reserve Act established the Federal Reserve System as the central bank of the United States in 1913.

• As part of its plan to decentralize authority within the Federal Reserve System, Congress divided the United States into 12 Federal Reserve districts, each of which has a Federal Reserve Bank that carries out duties related to the Fed’s roles in the payments system, control of the money supply, and financial regulation.

• The president appoints and the Senate confirms the Board of Governors. This board administers monetary policy and is also responsible for some financial regulation.

• The 12-member Federal Open Market Committee (FOMC) oversees the Fed’s open market operations.

• Though the Board of Governors and the FOMC exert most of the Fed’s formal influence on monetary policy, many Fed watchers believe that the informal authority of the chairman, the staff of the board, and the FOMC predominates.

• The severity of the financial crisis of 2007–2009 and some of the unprecedented policy actions the Fed took during that time led many economists and policymakers to reconsider the role of the Fed in the financial system. However, when the Wall Street Reform and Consumer Protection Act, also known as the Dodd–Frank Act, passed in July 2010, it contained none of the more extensive changes to the Fed that had been proposed.

13.2 The Fed’s Relationship with the Government (pages 450–456) Explain the Fed’s relationship to the government and the arguments for and against its independence.

• Congress intended the Federal Reserve System to operate largely independently of external pressures from the president, Congress, the banking industry, and business groups.

• Some policymakers and economists debate the arguments in favor of central bank independence.

13.3 Central Bank Independence Outside the United States (pages 457–460) Compare the extent of central bank independence in other countries.

• Though central bank independence from the political process has increased around the world, in practice, the degree of actual independence in the conduct of monetary policy varies across countries.

• In principle, the European Central Bank (ECB) has a high degree of overall independence, with a clear mandate to emphasize price stability. But aggressive monetary policies following the slow recovery from the 2007–2009 financial crisis and again during the Covid-19 pandemic resulted in criticism of the ECB’s actions by some member governments.

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Key Terms

Board of Governors, p. 442. The governing board of the Federal Reserve System, consisting of seven members appointed by the president of the United States.

Principal–agent view, p. 453. A theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public.

Federal Open Market Committee (FOMC), p.

443. The 12-member Federal Reserve committee that directs open market operations.

Public interest view, p. 452. A theory of central bank decision making that holds that officials act in the best interest of the public.

Federal Reserve Bank, p. 437. One of 12 district banks of the Federal Reserve system that, among other activities, conducts discount lending.

Federal Reserve System, p. 436. The central bank of the United States.

Political business cycle, p. 453. The theory that policymakers will urge the Fed to lower interest rates to stimulate the economy prior to an election.

Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), p. 449. Legislation passed in 2010 that was intended to reform regulation of the financial system.



Chapter Outline

Wells Fargo Owns Part of the Fed. Does It Matter?

The Board of Governors that controls the Federal Reserve System is a federal agency. However, the 12 regional Federal Reserve Banks are legally the equivalent of private corporations, although Banks are not operated to maximize profits. The boards of directors of the Reserve Banks appoint the Banks’s presidents and are responsible for supervising and regulating member banks in their regions. There is a Federal Reserve Bank in San Francisco. Wells Fargo, which is headquartered in San Francisco, is part owner of the Federal Reserve Bank of San Francisco. Although Wells Fargo and other member banks have few ownership rights that stockholders typically have in private corporations, some politicians have criticized the influence that member banks have on operation of the Reserve Banks. The Dodd-Frank Act of 2010 amended the Federal Reserve Act to exclude bankers who serve on a Reserve Bank’s board of directors from participating in the appointment of the Bank’s president. This debate is one example of the interest that some policymakers have in changing the structure of the Fed. These critics are concerned that the Fed, which is financially independent of the federal government, may be too politically independent.

Teaching Tips This chapter highlights the difference between the high degree of decentralization of the Federal Reserve that exists on paper and the high degree of centralization that exists in practice. The chapter also discusses the public-interest view of Fed motivation—which holds that the Fed acts in the interests of the general public—and the principal-agent view—which holds that the Fed acts to increase its power, influence, and prestige as an organization, subject to constraints placed on it by the president and Congress. The chapter presents the arguments for and against the Fed remaining independent of the president and Congress. The chapter also compares central bank independence in other countries.

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13.1 The Structure of the Federal Reserve System (pages 435–450) Learning Objective: Explain the Structure of the Federal Reserve System.

A. Creation of the Federal Reserve System The Federal Reserve Act established the Federal Reserve System as the central bank of the United States in 1913. The act and subsequent legislation created four groups within the system, each empowered, in theory, to perform separate duties: 1. The Federal Reserve Banks 2. Private commercial member banks 3. The Board of Governors 4. The Federal Open Market Committee (FOMC) B. Federal Reserve Banks To decentralize authority within the Federal Reserve System, Congress divided the United States into 12 Federal Reserve districts, each of which has a Federal Reserve Bank in one city (and, in most cases, additional branches in other cities in the district). The 12 Federal Reserve District Banks: (1) manage check clearing; (2) issue new Federal Reserve notes and withdraw damage notes from circulation; (3) conduct discount lending to banks within their districts; (4) perform supervisory and regulatory functions; (5) provide services to businesses and the general public; and (6) serve on the Federal Open Market Committee.

C. Member Banks Although the Federal Reserve Act required all national banks to become member banks of the Federal Reserve System, state banks were given the option to join, and many chose not to.

About 38% of commercial banks in the United States belong to the Federal Reserve System, although these banks hold a majority of all bank deposits.

D. Board of Governors The Board of Governors has seven members that are appointed by the President of the United States and confirmed by the U.S. Senate. To provide for central bank independence, the terms of board members are set so that governors serve staggered nonrenewable terms of 14 years. The president chooses one member of the Board of Governors to serve as chair for a four-year term that can be renewed. The Board of Governors administers monetary policy to influence the nation’s money supply and interest rates through open market operations, reserve requirements, and discount lending, and is responsible for some financial regulation.

E. The Federal Open Market Committee The 12-member Federal Open Market Committee (FOMC) oversees the Fed’s open market operations. Voting members of the FOMC are: • The chair of the Board of Governors • The other Fed governors • The president of the Federal Reserve Bank of New York • The presidents of 4 of the other 11 Federal Reserve Banks (who serve rotating one-year terms)

Teaching Tips Ask students to read the latest monetary policy statement released by the Federal Reserve. The statements are available on the Board of Governors’ Web site: http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm. Have students consider how the statement reflects the FOMC’s views on the economy and how it provides a justification for its monetary policy decision. Ask students whether the statement is written clearly enough that they were able to understand what the FOMC intends to do and why they intend to do it.

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F. Power and Authority Within the Fed Banking legislation during the 1930s gave the Board of Governors the authority to set reserve requirements and the FOMC the authority to conduct open market operations, while also giving the Board of Governors a majority on the FOMC. Although the Board of Governors and the FOMC have formal control over monetary policy, many Fed watchers believe that the informal authority of the chairman, the staff of the board, and the FOMC predominates.

G. Changes to the Fed under the Dodd-Frank Act The Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), passed in July 2010, authorized the following changes: • The Fed was made a member of the new Financial Stability Oversight Council and the new Consumer Financial Protection Bureau (CFPB) was housed at the Fed. The Fed was given no managerial oversight of the CFPB. • The Government Accountability Office (GAO) was authorized to conduct an audit of the emergency lending programs undertaken by the Fed during the crisis.

• The Fed was ordered to release the names of financial institutions it makes loans to and buys and sells securities from.

13.2 The Fed’s Relationship with the Government (pages 450–456) Learning Objective: Explain the Fed’s relationship to the government and the arguments for and against its independence.

A. Handling External Pressure Congress intended the Federal Reserve System to operate largely independently of external pressures from the president, Congress, the banking industry, and business groups. The Fed’s financial independence allows it to resist external pressure. However, the Fed isn’t completely insulated from external pressure. First, the president can exercise control over the membership of the Board of Governors. Second, although the Fed’s earnings on its holdings of bonds and other securities exempt it from requesting money from Congress, the Fed remains a creation of Congress, which can change how it operates by amending the Federal Reserve Act. The DoddFrank Act changed some of the Fed’s organization and procedures, which in turn changed the way in which the Fed was able to act during the Covid-19 crisis.

B. Examples of Conflict Between the Fed and the Treasury During World War II, the Fed agreed to hold interest rates on Treasury securities at low levels to help finance wartime budget deficits. On March 4, 1951, the policy of fixing the interest rates on Treasury securities was abandoned with the Treasury–Federal Reserve Accord, which reestablished the ability of the Fed to operate independently of the Treasury. During the financial crises of 2007–2009 and 2020, the Fed worked closely with the Treasury, raising concern among some economists and policymakers that the Fed was sacrificing some of its independence.

C. Factors That Motivate the Fed The public interest view of Fed motivation holds that the Fed acts in the interest of its primary constituency (the general public) and seeks to achieve economic goals that are in the public interest. Proponents of the principal–agent view argue that the Fed avoids conflicts with groups that could limit its power, influence, and prestige. One implication of the latter view is the possibility of a political business cycle in which the Fed would lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection. The facts for the United States don’t generally support the idea of a political business cycle.

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D. Fed Independence The main argument for Fed independence is that monetary policy—which affects inflation, interest rates, exchange rates, and economic growth—is too important and technical to be determined by politicians, who may be concerned with short-term benefits and disregard longterm costs. Another argument for Fed independence is that complete control of the Fed by elected officials increases the likelihood of a political business cycle. Opponents of the Fed’s independence claim that in a democracy, elected officials should make public policy because voters can hold them responsible. Those who argue for greater Congressional control of monetary policy argue that the Fed has not always used its independence well.

Extra Apply the Concept Fedspeak vs. Transparency Alan Greenspan, who served as chairman of the Federal Reserve Board from 1987–2006, earned a reputation for what financial reporters called “Fedspeak.” In his statements to Congress and the general public, Greenspan often used ambiguous and vague language that was difficult for people to understand. One reason for Greenspan’s cautious statements was a concern that securities traders were listening for hints that the Fed would take actions to affect interest rates and stock prices—and the traders’ profits.

When Ben Bernanke became chairman, he made a commitment to avoid Fedspeak. The television program 60 Minutes interviewed Bernanke in April 2011, and he became the first Fed chairman to hold a news conference following a meeting of the Federal Open Market Committee. In an October 2012 speech, Bernanke explained that: “One of my principal objectives as Chairman has been to make monetary policy . . . as transparent as possible . . . the Federal Open Market Committee explains the reasons for its policy decisions . . . after each regularly scheduled meeting . . .” Perhaps reacting to the Fed’s example, Mario Draghi, who was then president of the European Central Bank (ECB), announced his own commitment to transparency by endorsing a proposal to publish the minutes of the ECB’s monetary policy meetings.

Economists have generally welcomed the Fed’s moves toward greater transparency. Knowing the central bank’s policy intentions can help households and firms make better saving, investment, and spending decisions. However, some critics argue that the Fed’s push for transparency may go too far and the Fed’s decision-makers would have more leeway to respond to changes in the economy if they did not commit to particular courses of action. The Fed may have to agree with these critics – to some degree. For example, in September 2012, the Fed announced that it would pursue an expansionary monetary policy until the labor market improved “substantially.” But the Fed did not set a time limit on how long the policy might continue or state an explicit goal for the increase in employment that would represent “substantial” improvement in the labor market. A columnist in the Wall Street Journal applauded the Fed’s approach, arguing that: “While Bernanke welcomes making the Fed more open, less transparency isn’t necessarily a bad development.”

Still some critics continued to argue that the Fed was providing more information than investors, firms, or households could interpret. One critic argued in regard to a particular Fed policy that: “The Fed’s action would have a better chance of producing the sustained positive market reaction the Fed apparently is after, if the Fed had simply taken the action and shut-up.” In the end, though, when faced with sustained political criticism of many of its actions, the Fed may have little choice but to be more transparent than in the days of Alan Greenspan and Fedspeak.

Sources: Ben S. Bernanke, “Five Questions about the Federal Reserve and Monetary Policy,” Address before the Economic Club of Indiana, Indianapolis, Indiana, October 1, 2012; Christopher Lawton, “ECB to Publish Minutes From Its Monetary Policy Meetings?” Wall Street Journal, September 20, 2012; Gary Crosse and Jan Paschal, “Timeline: Federal Reserve’s Transparency Steps,” Reuters, January 25, 2012; Kathleen Madigan, “In Future, QE Could Stand for ‘Quit Explaining’,” Wall Street Journal, September 17, 2012; and Sy Harding, “Enough with the Fed’s Transparency Already,” Forbes, September 14, 2012.

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13.3 Central Bank Independence Outside the United States (pages 457–460) Learning Objective: Compare the extent of central bank independence in other countries.

The degree of central bank independence in the conduct of monetary policy varies across countries.

An independent central bank is free to pursue its goals without direct interference from other government officials and legislators. Most economists believe that an independent central bank can more freely focus on keeping inflation low.

A. The Bank of England The Bank of England obtained the power to set interest rates independently in 1997. The government can overrule the Bank of England in “extreme circumstances” but has not yet done so. The Chancellor of the Exchequer, however, does set the Bank of England’s inflation target.

Monetary policy focuses on the bank rate, which is the interest rate the Bank of England pays commercial banks on their reserves.

B. The Bank of Japan The Bank of Japan’s Policy Board includes the governor, two deputy governors, and six outside members named by the cabinet and confirmed by Japan’s national legislature. Government representatives do not vote at meetings of the Policy Board. The Bank of Japan Law (1998) gives the Policy Board more autonomy to pursue price stability.

C. The Bank of Canada The Bank of Canada has an inflation target, but the target is set jointly by the Bank and the government. Although the government has had final responsibility for monetary policy since 1967, the Bank of Canada has generally controlled monetary policy. In 2016, Bank of Canada Governor Stephen Poloz argued that while there was a need to coordinate the country’s monetary and fiscal policies, coordination need not undermine the independence of the Bank of Canada.

D. The European Central Bank The European Central Bank (ECB) is charged with conducting monetary policy for the 19 countries that participate in the European Monetary Union and use the euro as their currency.

The ECB’s executive board has six members who are appointed by the heads of state and government based on recommendations by the Council of Ministers of Economics and Finance.

In principle, the European Central Bank (ECB) has a high degree of overall independence, with a clear mandate to emphasize price stability, and it is free to conduct policy without interference from the European Union or from national governments. But unlike the Fed, the ECB is responsible for the monetary policy of 19 sovereign countries. As the ECB has had to take aggressive policies to deal with the financial crisis of 2007–2009, difficulties some member countries had in selling government bonds (sovereign debt), and the Covid-19 pandemic of 2020, it has been criticized by the governments of some member countries.

E. Conclusions on Central Bank Independence The degree of independence in the conduct of monetary policy varies across countries. Many analysts believe that an independent central bank improves an economy’s performance by lowering inflation without increasing fluctuations in output and employment. To have a meaningful degree of independence, a central bank must be able to conduct policy without direct interference from the government. The central bank must also be held accountable for the goals it sets.

Teaching Tips Ask students to consider the pros and cons of Fed independence. Have them consider why the global trend has been to increase the independence of central banks. A useful classroom experience is to have a 10 to 15-minute debate between two groups of students; one group arguing to preserve the Fed’s independence as it now is and the other group arguing that Congress and the president should exert greater control over monetary policy.

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Solutions to the End-of-Chapter Questions, Problems, and Data Exercises

13.1 The Structure of the Federal Reserve System Learning Objective: Explain the Structure of the Federal Reserve System.

Review Questions 1.1

The United States had no central bank between 1836 and 1913 because of a political struggle between advocates of strong financial institutions and those who feared that such strong institutions would abuse their power. Congress had established the first Bank of the United States, which served as a central bank, in 1791 with a 20-year charter. When the charter expired in 1811, Congress did not renew it. In 1816, Congress established the second Bank of the United States, again with a 20-year charter. Advocates of a limited federal government distrusted the Bank because the Constitution did not expressly provide Congress with the authority to establish a central bank, and the Bank had made enemies when it attempted to stabilize the financial system by taking steps to ensure that local banks did not extend too many loans relative to their capital. Local banks resented the Bank’s supervision, and farmers and owners of small businesses, particularly in the West and South, resented the Bank’s interfering with their ability to obtain loans from their local banks. In 1832, the populist President Andrew Jackson vetoed a bill to renew the Bank’s charter. Congress established the Federal Reserve System in 1913 because it feared that the U.S. financial system was unstable. The country had no official lender of last resort for banks and had suffered severe nationwide financial panics and accompanying economic recessions in 1873, 1884, 1893, and 1907.

1.2

Congress split the Federal Reserve System into 12 districts in an attempt to decentralize the system rather than have a single central bank based in Washington, DC.

1.3

During the Great Depression, the Fed failed to help banks experiencing runs—substantial deposit withdrawals. During the early years of the Fed, there was little central control, and the Governor’s Conference competed with the Federal Reserve Board for control. The Fed could therefore not adequately respond to a national crisis like the Great Depression.

1.4

During normal times, the Federal Open Market Committee is the more important body because it directs open market operations and sets the target for the federal funds rate. During the financial crisis of 2007–2009, the Fed needed to make decisions rapidly and use new policy tools. During that period, certain members of the Board of Governors (part of the “four musketeers”) became more important than the Federal Open Market Committee. The Board of Governors also plays a larger role than the Federal Open Market Committee in maintaining the stability of financial markets and institutions.

1.5

The changes that the Dodd-Frank Act made to the Fed include: 1. Barring class A directors of the Federal Reserve banks from participating in the election of bank presidents 2. Making the Fed a member of the new Financial Stability Oversight Council (FSOC) with the authority to increase capital requirements at systemically important financial firms (SIFIs) and to require the SIFIs to develop living wills 3. Designating a Fed vice chair for regulatory supervision 4. Ordering the Government Accountability Office (GAO) to audit the emergency lending programs the Fed carried out during the financial crisis 5. Requiring the Fed to be more transparent about the parties to whom it lends and with whom it buys and sells securities

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6. Establishing the Consumer Financial Protection Bureau, which took over some of the Fed’s responsibilities for administering consumer protection statutes that apply to all financial firms 7. Revising Section 13(3) of the Federal Reserve Act to remove the Fed’s authority to lend to individual financial firms outside broadly based lending programs Problems and Applications 1.6

a. The Federal Reserve System is a “public-private partnership” in the sense that the member banks in each district own the Federal Reserve Banks, but the member banks do not have the rights and privileges of ordinary shareholders. Member banks cannot sell or trade their stock and do not have a legal claim on the profits of the Federal Reserve Banks. Each Federal Reserve Bank is a private-government joint venture. b. The Federal Reserve is accountable to the government in that the Chair of the Board of Governors serves only a four-year term and, like all members of the Board of Governors, must be confirmed by the Senate and the Chair also is required to testify before Congress twice a year.

The Fed also knows that Congress has the authority to modify the Federal Reserve Act to expand or limit the Fed’s powers. The Fed is independent of government in that it is free to set monetary policy without approval of the government, the Board of Governors serve 14-year nonrenewable terms, and the Fed does not require that Congress provide funds for it to operate.

1.7

a. Congress created the tension between the Federal Reserve Banks and the Federal Reserve Board as part of an organizational plan intended to prevent one faction within the Federal Reserve System from having too much power. b. The Board of Governors now has undisputed control over the Federal Reserve System, so the tension has been mostly resolved. The 12 Federal Reserve Banks have interests that sometimes diverge from the interests of the Board of Governors, so some tension can still arise.

1.8

a. A regional Federal Reserve Bank acting independently can move quickly to address regional issues, but Federal Reserve Banks acting independently would undermine the Board of Governor’s centralized control of the system. Federal Reserve Banks operating independently could also cause confusion among the public as to what the Fed’s policy actually is. b. No. In the modern Fed, a Reserve Bank cannot conduct an independent monetary policy.

1.9

The commission should look to distribute the Federal Reserve Banks so as to achieve a balance with regards to population and economic factors similar to that achieved when the system was founded. The boundaries likely would be different because of shifts in population and commerce to states such as Texas, Florida, and California. It does not matter as much today where the district boundaries lie given the information-gathering and information-storing computer technologies available to the financial system and given that the Reserve Banks do not operate independently of the Board of Governors and the FOMC.

1.10 a. Given a 10% required reserve ratio, Bank of America would have to hold $100 in reserves (10% × $1,000) and will be able to make loans totaling $900 (= $1,000 − $100). Bank of America will earn $900 × 0.07 = $63 on its loans and $100 × 0.005 = $0.50 on its reserves at the Fed. Without having to hold reserves, the bank would have earned $1,000 × 0.07 = $70. The 10% reserve requirement reduces the amount Bank of America can earn on $1,000 by $70 − $63.50 = $6.50.

These calculations assume that Bank of America would hold zero reserves in the absence of reserve requirements. But since 2008, the Fed has paid banks interest on their reserve balances, which has given banks an incentive to hold substantial reserve balances.

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b. The opportunity cost to banks of reserve requirements would likely be higher during a period of high inflation when nominal interest rates on loans are high.

1.11

The Sunshine Act required government agencies to post notices of meetings before they happened so that the public would have increased knowledge of when and how policymakers were formulating new policies or regulations. Because the financial crisis was unfolding so quickly, one could argue strongly that Bernanke was justified in evading the letter of the Sunshine Act.

1.12 a. By “hybrid governance model,” Lacker means the public-private ownership of the Federal Reserve Banks with the member banks owning, but not controlling, the Reserve Banks. b. A politically independent Fed comes under less political pressure from voters than do the president and the Congress. During election years, the president and Congress may be more concerned about stimulating economic growth and lowering unemployment than keeping inflation low and stable.

1.13 a. Class A directors are the three bankers elected by the member banks of a Federal Reserve District to serve on the Federal Reserve Bank’s board of directors. b. Having Class A directors who are bankers participate in electing the president of the Federal Reserve Bank might be a conflict of interest because the Federal Reserve Banks supervise member banks in their districts. c. Prior to the Federal Reserve System, clearinghouses provided check-clearing services and shortterm loans for banks dealing with liquidity problems. When Congress established the Federal Reserve, it basically amounted to the “nationalization of the private clearinghouse system,” which banks established and operated.

1.14 a. Currently the Class B and Class C directors elect the presidents of the district banks. These directors are not political appointees. The FOMC consists of district bank presidents and the Board of Governors. The Board of Governors (and the Chair of the Fed) are appointed by the President and confirmed by Congress, so they are political appointees, but because members of the Board of Governors serve long terms, it is unlikely that any president would be able to exert direct political influence over the FOMC. b. The FOMC is insulated from political business cycles. Congress and the President, who need to be concerned with reelection, have an incentive to push for expansionary policies prior to elections even if those actions would not be in the best interest of the economy in the long run. c. Controlling inflation and supporting economic growth are long-term rather than short-term goals.

Generally, neither can be changed quickly, and so achieving these goals requires the FOMC to make decisions that lead to levels of inflation and employment that are desirable in the long run.

As in part (b), politicians are likely to have much more short-term goals, and so if allowed to interfere in FOMC decisions, these politicians would likely make short-term choices that benefit themselves and their reelection prospects rather than the long-term good of the economy.

13.2

The Fed’s Relationship with the Government Learning Objective: Explain the Fed’s relationship to the government and the arguments for and against its independence.

Review Questions 2.1

When Congress first established the Fed, its main responsibilities were to provide short-run liquidity to banks (act as a lender of last resort), oversee some aspects of the banking system, and manage the money supply. Since then, the Fed’s role has expanded considerably, and its main responsibilities now include setting monetary policy in accordance with its dual mandate.

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2.2

The president can exercise control over the membership of the Board of Governors and appoint a new chair every four years, and the Congress can amend the Federal Reserve Act to change how the Fed operates or even abolish it entirely.

2.3

The public interest view holds that officials act in the best interest of the public, while the principal-agent view holds that officials maximize their personal well-being rather than that of the general public. The political business cycle is the theory that policymakers running for reelection will urge the Fed to lower interest rates to stimulate the economy prior to an election.

If the Fed is more concerned with preserving its power, influence, and prestige, as the principalagent view holds, then it would be more likely to take actions resulting in a political business cycle as it attempts to avoid conflict with groups that could limit its power and influence.

2.4

The main argument for Fed independence is that monetary policy is too important and technical to be determined by politicians who may be shortsighted and concerned with short-term benefits with little regard for potential long-term costs. Another argument for Fed independence is that control of the Fed by elected officials increases the likelihood of a political business cycle, which would destabilize the economy and make attaining long-run economic goals more difficult. Arguments against Fed independence include the view that in a democracy elected officials should make monetary policy because they are accountable to the voters, unlike appointed officials who do not face election. Another argument against Fed independence is that placing the central bank under the control of elected officials would lead to better coordination and integration of monetary policy with fiscal policy.

Problems and Applications 2.5

The Fed did not operate independently of the Treasury during the 1942–1951 period, but instead pegged interest rates on Treasury securities at low levels, initially to help finance the large budget deficits the federal government ran during World War II. Pegging interest rates required the Fed to purchase any Treasury bonds not purchased by the public. In that sense, the Fed was under Treasury control even though the Treasury did not formally control the actions of the Fed.

2.6

a. It is true that Fed officials are not elected, so in some sense the quote is correct. b. The debate over whether the Fed is constitutional has gone on for a very long time. The U.S. Constitution does not explicitly give Congress the authority to establish a central bank.

However, the Constitution gives Congress the power to coin money and regulate its value, which Congress in turn has delegated to the Fed. c. Congress could amend the Federal Reserve Act to change how the Fed operates or Congress could even abolish the Fed.

2.7

Having the Government Accountability Office (GAO) give an independent opinion of whether a particular monetary policy action was the right decision would be a “nightmare scenario” because: (1) the GAO could severely slow down the response of monetary policy to changing economic conditions, and (2) the GAO could make monetary policy actions too political. Rather than making decisions on the basis of what the members of the FOMC consider to be in the best interests of the economy, the committee might feel that they need to act cautiously so as not to be second-guessed as the result of a GAO audit. a. A principal-agent problem occurs when managers (agents) take actions that are not in the interests of the owners (principals).

2.8

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b. The economist is thinking of the president as the principal and the Fed as the agent. In this sense, there is a principal-agent problem, because the Fed does not necessarily act in the interests of the president. However, this conflict is actually helpful in preventing political business cycles. The Fed might argue that it acts in the interest of the public rather than in the interests of the president—making the public rather than the president the principal—even though the president appoints members of the Board of Governors.

2.9

The McAvoy and Wheelock explanation of how the Federal Reserve regional banks were created fits more with the public interest view. For instance, Missouri has two regional banks and the speaker of the House of Representatives at the time was from Missouri, but in 1913 the choices of cities reflected the geographical distribution of the population.

2.10

The principal-agent view better explains the stated positions of the Reserve Bank presidents.

These presidents were not making an argument about the effectiveness and efficiency of the Reserve Bank employees in supervising state banks, which would support the public interest view. Instead, the presidents were arguing for saving the jobs of their employees, which supports the view that the Fed attempted to maximize the interests of the Federal Reserve System rather than the interests of the public.

2.11

Members of Congress may feel that they do not have the expertise or time to oversee the financial system and to set monetary policy. Congress may also want to separate the power to spend money (government spending) from the power to control the growth of the money supply, thinking that the power to do both could lead to too much government spending and inflation.

2.12

The amendment would decrease some external pressure on the Fed from threats by Congress to abolish it and would quiet dissenters who don’t believe the Fed is constitutional. Otherwise, the amendment would likely have little effect on the Fed.

13.3

Central Bank Independence Outside the United States Learning Objective: Compare the extent of central bank independence in other countries.

Review Questions 3.1

Among the Federal Reserve, the European Central Bank (ECB), and the central banks in Canada, England, and Japan, the Federal Reserve has the shortest term of office for the central bank head (4 years) and the longest term of office for the members of the central bank governing boards (14 years).

3.2

When a country has a less independent central bank, it tends to also have a higher rate of inflation. An independent central bank can more easily take into account the long-run economic interest of a country, which generally requires keeping inflation rates low.

3.3

The Governing Council of the European Central Bank (ECB) is the main decision-making body of the ECB. The Council consist of the six executive board members, with one of the members serving as president, and the governors of the member national central banks. The decentralized organization of the ECB with the governors of the national central banks holding a majority of the votes makes it difficult to achieve a consensus during a crisis. During the financial crisis of 2007– 2009, the ECB encountered difficulty conducting a common monetary policy for countries experiencing different economic conditions. During the subsequent sovereign debt crisis, the ECB faced the dilemma of whether to buy the sovereign debt of struggling governments. Buying the sovereign debt would allow struggling governments to raise funds by selling bonds and would protect the solvency of European banks with large holdings of these government bonds. On the

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downside, the ECB bond purchases risk raising expectations of higher future inflation and moral hazard among the governments. In July 2020, the ECB started selling common bonds (rather than bonds issued by individual countries) to help support the recovery from the Covid-19 crisis.

Problems and Applications 3.4

Low-income (less-developed) countries often have more trouble selling government debt to investors than do high-income countries. As a result, it is often difficult for a central bank to act independently in a less-developed country. When the government of a less-developed country runs a deficit, the country’s central bank is often under great pressure to buy some, or even all, of the bonds the government must issue to fund the deficit. Research has shown that the more independent a central bank, the lower the inflation rate will be. Therefore, we would expect the average inflation rate in low-income countries to be higher than in high-income countries.

3.5

The countries of the Eurozone experience different economic conditions. To achieve high employment, some of the countries would need accommodative monetary policy while other countries would not. Focusing on the single goal of price stability across the Eurozone is more doable.

3.6

a. When central banks engage in purchases of corporate bonds, they influence the bond market, by changing the bonds’ prices and yields. Buying corporate bonds also influences the allocation of financial capital between asset markets by making bonds relatively more attractive. Buying corporate bonds can also have a direct influence on particular sectors of the economy, if the central bank chooses to favor some types of firms over others. (See also the original Wall Street Journal article that this quote references, which discusses the ECB and the possibility of favoring green firms rather than firms involved with fossil fuels.) b. When central banks purchase corporate bonds or other financial assets, politicians may well think that they should support particular sectors of the economy or particular political agendas.

For example, a government that favored green initiatives might push the central bank to buy assets only in those sectors.

3.7

a. When the central bank purchases government debt, it serves as a way for the government to spend money without having to raise taxes. This approach to financing government spending is sometimes referred to as “paying for spending by ‘printing money.’” b. A central bank needs to be able to say no to actions that would harm the economy, such as excessive inflation resulting from rapid increases in the money supply that can result from the bank buying government bonds, and yes to actions that would help the economy. An example of the latter occurred in 2010, as the Federal Reserve undertook quantitative easing, which was the purchase of long-term government debt. By flooding banks with reserves, the central bank can lower the cost of government and private borrowing in bad economic times.

3.8

The British approach with a representative of the Treasury Department present at the central bank meetings could help coordinate economic policy between the government and the central bank.

The disadvantage could be less independence of the central bank in conducting monetary policy.

3.9

a. This reference to Zimbabwe and Weimar Germany refers to cases in which the government essentially used the central bank to print large amounts of money to finance government spending, creating hyperinflation. b. This phrase ‘under the thumb’ means that the finance ministry controls central bank policies and actions. c. If investors lose confidence in a country’s sovereign debt, we would expect to see falling bond prices and rising interest rates.

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Data Exercises D13.1

Greece grew faster than Germany over most of the 2001 through 2006 period. Both countries suffered declines in real GDP from late 2008 through 2009. Germany grew significantly faster than Greece from 2010 through the first half of 2014 with Greece experiencing negative real GDP growth over most of the 2008 through 2013 period. The divergence in growth rates between Germany and Greece and other countries in the euro-zone posed the challenge to the ECB of whether to continue aggressive accommodative monetary policy to stimulate the Greek and other struggling economies or to slow down on the accommodate policy to prevent future inflation. Since 2014, Greek and German growth rates have been more similar than in the previous periods and have at least moved in roughly the same direction, which makes the ECB’s task somewhat easier.

D13.2

For the third quarter of 2020, the euro-zone debt/GDP ratio was 97.3% and the deficit/GDP ratio was –5%. The high debt/GDP ratio presents the challenge to the ECB to avoid increases in interest rates that can result from an increased supply of government debt. The large deficits would raise the debt/GDP ratio and lead to concerns of default for some Eurozone countries.

The high debt/GDP ratio also means that if interest rates rise, the interest expense on the high level of debt would increase.

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Chapter 14 The Federal Reserve’s Balance Sheet and the Money Supply Process 

Brief Chapter Summary and Learning Objectives

14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 469–477) Explain the relationship between the Fed’s balance sheet and the monetary base.

• The Fed’s balance sheet lists the Fed’s assets and liabilities. There is a close connection between the monetary base and the Fed’s balance sheet.

• The monetary base is the sum of the Fed’s two major liabilities: currency in circulation and bank reserves.

• The most direct method the Fed uses to change the monetary base is open market operations, which involve buying or selling securities, generally U.S. Treasury securities.

• Though less commonly used, the Fed can also increase or decrease reserves by making discount loans to commercial banks.

• Although open market operations and discount loans both change the monetary base, the Fed has greater control over open market operations than over discount loans.

14.2 The Simple Deposit Multiplier (pages 477–482) Derive the equation for the simple deposit multiplier and use T-accounts to illustrate multiple deposit creation.

• An increase in bank reserves results in rounds of bank loans, creation of checkable deposits, and an increase in the money supply. These rounds of deposit creation multiply the initial increase in reserves.

• The simple deposit multiplier relates the initial change in reserves to the change in the money supply and equals 1 divided by the required reserve ratio.

14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 482–493) Explain how the actions of banks and the nonbank public affect the money multiplier.

• Increases in currency holdings or excess reserves reduce the multiple deposit creation process.

• The money multiplier is the ratio of the money supply to the monetary base.

• A realistic money multiplier (m) is: 𝐶𝐶 � �+1 𝐷𝐷 𝑚𝑚 = , 𝐸𝐸𝐸𝐸 𝐶𝐶 �𝐷𝐷 � + 𝑟𝑟𝑟𝑟𝐷𝐷 + � 𝐷𝐷 �

where (C/D) is the currency-to-deposit ratio, (ER/D) is the excess reserves-to-deposit ratio, and rrD is the required reserve ratio, which as of March 2020 is 0.

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• Beginning in the fall of 2008 the value of the money multiplier declined and remained below 1 until May 2018, nearly nine years after the end of the 2007–2009 financial crisis.

14.A Appendix: The Money Supply Process for M2 (pages 501–502) • Describe the money supply process for M2.

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Key Terms

Bank reserves, p. 471. Bank deposits with the Fed plus vault cash.

Currency-to-deposit ratio (C/D), p. 484. The nonbank public’s holdings of currency, C, relative to their holdings of checkable deposits, D. Currency in circulation, p. 471. Paper money circulating outside of the Fed. Currency in M1, p.471. Currency held by the nonbank public.

Discount loan, p. 474. A loan made by the Federal Reserve, typically to a commercial bank.

Discount rate, p. 475. The interest rate the Federal Reserve charges on discount loans.

Excess reserves, p. 472. Any reserves banks hold above those necessary to meet reserve requirements; as of March 2020, all bank reserves are excess reserves because the Fed had eliminated reserve requirements.

Monetary base (or high-powered money), p.

469. The sum of bank reserves and currency in circulation.

Multiple deposit creation, p. 480. Part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits and an increase in the money supply that is a multiple of the initial increase in reserves.

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Open market operations, p. 473. The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

Open market purchase, p. 473. The Federal Reserve’s purchase of securities, usually U.S. Treasury securities.

Open market sale, p. 473. The Fed’s sale of securities, usually Treasury securities.

Required reserve ratio, p. 472. The percentage of checkable deposits that the Fed specifies that banks must hold as reserves; note that as of March 2020, the required reserve ratio equals 0.

Required reserves, p. 472. Reserves that the Fed requires banks to hold against demand deposit and NOW account balances; note that as of March 2020, banks are no longer required to hold reserves.

Simple deposit multiplier, p. 481. The ratio of the amount of deposits created by banks to the amount of new reserves.

Vault cash, p. 471. Currency held by banks.

Chapter Outline

Gold: The Perfect Hedge Against Economic Chaos?

During uncertain financial times, many people view gold as a safe haven. It’s therefore not surprising that sales of gold coins soared from the beginning of the financial crisis in 2008 and again in 2020 during the Covid-19 pandemic. There was a similar surge in gold buying in 2016 following the U.K. vote to leave the European Union (referred to as Brexit). Some investors bet on gold by buying exchange-traded funds that track the price of gold. Gold prices increased from late 2008 to the end of 2012, but they fell sharply in 2013 before rising again during 2020. Many investors buy gold out of

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fear that inflation may increase. Even though inflation remained low through the fall of 2020, some investors predicted soaring inflation in the years to come and saw holding gold as the best way to hedge that risk.

Teaching Tips This chapter integrates material sometimes treated separately: the money supply process and the effect of changes in the Fed’s balance sheet on the money supply process. The chapter starts with the Fed’s balance sheet and uses the balance sheet to explain the money supply process. This approach has the advantage of keeping the Fed’s role at the center of the analysis and makes it easier for students to keep track of the main purpose of the discussion. Many students have difficulty understanding the deposit creation process, so it may be a good idea to devote significant class time to explaining that process. To appreciate the money multiplier material, students need to have a firm grasp of the deposit creation process. Students should find interesting the discussion near the end of the chapter of how the 2007–2009 financial crisis turned the money multiplier into a money divider.

14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 469–477) Learning Objective: Explain the relationship between the Fed’s balance sheet and the monetary base.

A. The Federal Reserve’s Balance Sheet There is a close connection between the monetary base and the Fed’s balance sheet, which lists the Fed’s assets and liabilities. The Fed’s primary assets are government securities and discount loans, while its primary liabilities are currency in circulation and reserves.

B. The Monetary Base The monetary base is the sum of the Fed’s two major liabilities: 1. Currency in M1, which equals currency outstanding minus vault cash.

2. Bank reserves, which equals commercial bank deposits at the Fed plus vault cash. Reserves include required reserves and excess reserves.

C. How the Fed Changes the Monetary Base The most direct method the Fed uses to change the monetary base is open market operations, which involve buying or selling securities—generally U.S. Treasury securities. In an open market purchase, the Fed buys Treasury securities and increases the monetary base by the amount of the purchase. Similarly, the Fed can reduce the monetary base through an open market sale of Treasury securities. T-accounts help illustrate the effect of the Fed’s actions on the balance sheets of the banking system as a whole, the nonbank public, and the Fed. Though less commonly used, the Fed can also increase or decrease reserves by making discount loans to commercial banks. This change in bank reserves changes the monetary base D. Comparing Open Market Operations and Discount Loans Although open market operations and discount loans both change the monetary base, the Fed has greater control over open market operations than over discount loans. Economists think of the monetary base as having two components: 1. The nonborrowed monetary base, Bnon (which the Fed controls) 2. Borrowed reserves, BR, another name for discount loans

Teaching Tips Students may have heard how the Fed’s balance sheet expanded during and after the 2007–2009 financial crisis and during the Covid-19 pandemic. Have students read the Apply the Concept, “Explaining the

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Explosion in the Monetary Base,” in the text, and ask them how and why Fed policy changed beginning in 2008 and how the Fed’s action differed from its traditional policy.

14.2 The Simple Deposit Multiplier (pages 477–482) Learning Objective: Derive the equation for the simple deposit multiplier and use T-accounts to illustrate multiple deposit creation.

A. Multiple Deposit Creation An open market purchase increases the excess reserves of the banking system. Normally, banks use the excess reserves to make loans. The funds from loans are deposited into the banking system after being used to purchase goods and services. The bank that receives new deposits holds some funds in the form of required reserves and loans the rest to borrowers (households and firms). This process continues in rounds of loans and bank deposits, resulting in an increase in the money supply that is a multiple of the initial increase in reserves.

B. Calculating the Simple Deposit Multiplier The simple deposit multiplier relates the initial change in reserves to the change in the money supply and equals 1 divided by the required reserve ratio.

14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 482–493) Learning Objective: Explain how the actions of banks and the nonbank public affect the money multiplier.

The simple deposit multiplier assumes that banks hold no excess reserves and the nonbank public does not change its currency holdings.

A. The Effect of Increases in Currency Holdings and Increases in Excess Reserves Funds deposited in banks are subject to the multiple deposit creation process, while funds held as currency are not. Therefore, an increase in currency holdings relative to deposits reduces the multiple deposit creation process. If banks hold more excess reserves relative to deposits, the multiple deposit creation is reduced.

B. Deriving a Realistic Money Multiplier A realistic money multiplier links the monetary base to the money supply. The money multiplier is the ratio of the money supply to the monetary base. The expression for a realistic money multiplier is: 𝐶𝐶 �𝐷𝐷 � + 1 𝑚𝑚 = , 𝐸𝐸𝐸𝐸 𝐶𝐶 �𝐷𝐷 � + 𝑟𝑟𝑟𝑟𝐷𝐷 + � 𝐷𝐷 � where (C/D) is the currency-to-deposit ratio, (ER/D) is the excess reserves-to-deposit ratio, and rrD is the required reserve ratio. Because the money supply equals the money multiplier multiplied by the monetary base, the money supply can increase due to either an increase in the money multiplier or an increase in the monetary base. Increases in the currency-to-deposit ratio, excess reserves-to-deposit ratio, or required reserve ratio reduce the money multiplier, and, therefore, the money supply (assuming no change in the monetary base).

Because since March 2020, the required reserve ratio has equaled 0, we can further simplify the expression for the money multiplier to:

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𝐶𝐶 �𝐷𝐷 � + 1 𝑚𝑚 = . 𝐸𝐸𝐸𝐸 𝐶𝐶 �𝐷𝐷 � + � 𝐷𝐷 �

C. The Money Supply, the Money Multiplier, and the Monetary Base Since the Beginning of the 2007–2009 Financial Crisis During the financial crisis of 2007–2009, the currency-to-deposit ratio declined slightly, but the excess reserves-to-deposit ratio soared, leading to a 50% decline in the money multiplier.

Reasons for the dramatic increase in the excess reserves-to-deposit ratio include: 1. The desire of banks for increased liquidity as they sought to rebuild their capital.

2. Tighter lending standards due to uncertainty about the credit worthiness of borrowers.

3. The Fed’s payment of interest on bank reserves.

The Fed’s actions in response to the economic effects of the Covid-19 pandemic resulted in banks’ already large holdings of reserves more than doubling between September 2019 and June 2020. Some investors, policymakers, and economists were concerned about the implications for future inflation.

Teaching Tips Have students read the Apply the Concept, “Did the Fed’s Worry about Excess Reserves Cause the Recession of 1937-1938?” in the text, and ask them to (1) describe the parallels between the economic events of the 1930s and the period during and after the 2007-2009 financial crisis; (2) discuss the concerns related to high levels of excess reserves in the mid-1930s and the Fed’s response at that time; and (3) explain how policymakers in the Fed can apply the lessons learned from this period to current monetary policy.

14.A Appendix: The Money Supply Process for M2 (pages 501-502) Learning Objective: Describe the money supply process for M2.

Many economists and policymakers pay more attention to M2 than M1. M2 includes everything in M1 plus nontransaction accounts such as small savings and time deposit accounts (N) and money market deposit accounts (MM). We can derive an expression for the M2 multiplier similar to the expression we derived for the M1 multiplier. The result is: 𝐌𝐌𝐌𝐌 𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦𝐦 =

𝑪𝑪 𝑵𝑵 𝑴𝑴𝑴𝑴 � 𝑫𝑫 𝑫𝑫 𝑫𝑫 𝑪𝑪 𝑬𝑬𝑬𝑬 � �+𝒓𝒓𝒓𝒓𝑫𝑫 +� � 𝑫𝑫 𝑫𝑫

𝟏𝟏+� �+� �+�

.

Increases in the required reserve ratio and the currency-to-deposit ratio reduce deposit creation, thereby reducing the M2 multiplier. An increase in the nonbank public’s preference for nontransaction or money market–type accounts relative to checkable deposits would increase the multiplier.

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Solutions to the End-of-Chapter Questions, Problems, and Data Exercises The Federal Reserve’s Balance Sheet and the Monetary Base Learning Objective: Explain the relationship between the Fed’s balance sheet and the monetary base.

Review Questions 1.1

a. The monetary base is the sum of bank reserves and currency in M1. The money supply is the sum of currency in M1 plus checkable deposits and equals the monetary base multiplied by the money multiplier. b. The monetary base is measured as currency plus total reserve balances. Banks still hold reserves, which are now technically entirely excess reserves, although some large banks must maintain them to meet liquidity requirements under the Basel accord. So, there is no difference in the calculation of the monetary base. c. The Fed, the banking system, and the nonbank public are the three groups included in the money supply process. d. The Fed must be able to control the amount of reserves that banks hold (and the amount of currency in circulation).

1.2

The two most important assets on the Fed’s balance sheet are U.S. Treasury securities and discount loans. The two most important liabilities are currency in circulation and reserve balances of banks. Currency in circulation is currency circulating in the economy; it is not currency held by the Fed. The Fed issues Federal Reserve Notes (currency) and is required by law to redeem them. During the period that the United States was on the gold standard, the Fed was obliged to redeem currency for gold or silver. Although the Fed no longer redeems Federal Reserve Notes for gold or silver, the notes remain liabilities of the Fed.

1.3 Wells Fargo Assets

Liabilities

Securities

−$1 million

Reserves

+$1 million Federal Reserve Assets

Securities

Liabilities

+$1 million

Reserves

+$1 million

Problems and Applications 1.4

a. The article is referring to purchases of Treasury bills and bonds as well as mortgage-backed securities. b. When the Fed purchases an asset, it increases the monetary base by either increasing the reserve accounts of banks or the amount of currency in circulation. A slower rate of asset purchases will therefore decrease the growth rate of the monetary base.

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The monetary base is equal to currency plus reserves. When the Fed makes an open market purchase of assets or lends money to a bank, the action increases the Fed’s liabilities (currency or reserves) and also increases the Fed’s assets. An increase in currency or reserves increases the monetary base. For example, a $1 billion purchase of securities will increase the monetary base by $1 billion.

Federal Reserve Assets Liabilities Securities +$1 billion Reserves +$1 billion a.

Banking System Assets Reserves

Liabilities

+$2 billion

Assets Discount Loans +$2 billion

Borrowings (Discount Loans) +$2 billion Federal Reserve Liabilities Reserves +$2 billion

b.

Banking System Liabilities

Assets Securities

+$2 billion

Reserves

−$2 billion Federal Reserve Assets

Securities

Liabilities

−$2 billion

Reserves

−$2 billion

c.

Banking System Assets Reserves

Liabilities

+$100 million

Checkable Deposits (DeShawn’s Computing Services) +$100 million

Federal Reserve Assets Liabilities Other Assets (Information Reserves +$100 million Technology System) +$100 million

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a. Asset purchases by the Fed increase the monetary base, which in turn will increase the money supply, keeping financial market conditions easy by making it easier for households and firms to borrow at low interest rates. b. The purchases of Treasuries and mortgage-backed securities appear on the asset side of the Fed’s balance sheet as an increase in securities and appear on the liabilities side as an increase in bank reserves. The result is that the balance sheet expands. c. The monetary base consists of currency plus reserves, so the expansion in reserves will increase the monetary base.

The likeliest explanation for the monetary base expanding in Argentina with the arrival of Covid-19 is that the Argentine central bank has increased the monetary base by making asset purchases, similar to those carried out by the Fed in the United States.

1.8

14.2

The Simple Deposit Multiplier Learning Objective: Derive the equation for the simple deposit multiplier and use T-accounts to illustrate multiple deposit creation.

Review Questions 2.1

PNC Bank Securities Reserves Loans

Assets −$1 million +$1 million +$1 million

Liabilities Checkable Deposits +$1 million

When PNC sells the securities to the Fed, the Fed pays the bank by increasing its reserve account. The funds are then lent out—increasing “Loans” in the T-account—with PNC Bank extending the loan by increasing the borrower’s checking account.

2.2

The Fed’s purchase of Treasury bills increases bank reserves. A bank with increased reserves typically loans out its excess reserves and creates a corresponding checking account deposit where the amount of the loan is deposited. The individual bank creating a loan loses the excess reserves when the checking deposit is spent and the funds are deposited in another bank. The bank with the new checking deposit gains reserves and makes a loan of its excess reserves. As before, when the checking deposit is spent the bank loses the excess reserves and the bank with the new checking deposit gains the reserves and loans out the excess reserves. The initial increase in bank reserves from the Fed’s purchase of Treasury bills results in subsequent rounds of bank loans and the creation of checkable deposits, resulting in an increase in the money supply that is a multiple of the initial increase in reserves.

2.3

Simple deposit multiplier = 1/rrD = 1/0.10 = 10, with the 10% reserve requirement. With an 8% reserve requirement, the multiplier would increase to 1/.08 = 12.5.

Problems and Applications 2.4

The $100,000 loan to Jamal’s Jerseys increases Wells Fargo’s assets by $100,000. Because the funds are deposited into the firm’s checking account, the bank’s liabilities also increase by $100,000:

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Wells Fargo Assets Loans

+$100,000

Liabilities Checkable Deposits + $100,000

The $100,000 check spent by Jamal’s Jerseys and deposited in PNC Bank decreases Wells Fargo’s reserves by $100,000 and Jamal’s Jerseys checking account by $100,000 once the check has been cleared: Wells Fargo Assets Reserves

−$100,000

Loans

+$100,000

Liabilities Checkable Deposits

$0

The total change in Wells Fargo’s assets equals zero with an additional $100,000 in loans and a loss of $100,000 of reserves. The total change in liabilities equals zero with the $100,000 initially deposited into Jamal’s Jersey’s checking account having been spent.

2.5

2.6

The bank can lend out only its excess reserves, which are 90% of the $10,000, or $9,000. The bank has to assume that the funds from the loan will be deposited in another bank, which will cause the bank to lose $9,000 in reserves. Losing $9,000 in reserves will leave the bank with just the $1,000 in required reserves that it needs to hold on the $10,000 checking deposit. a.

Securities Reserves

JP Morgan Chase Bank: sells securities to Fed Assets Liabilities −$100 million +$100 million

Federal Reserve: open market purchase from JP Morgan Chase Bank Assets Liabilities Securities

+$100 million

Reserves

+$100 million

b. Note that JP Morgan can lend out the entire amount of the loan because it has not acquired any new checkable deposits, so its required reserves have not increased.

JP Morgan: Granted $100 million loan but the borrower has not yet spent the proceeds of the loan Assets Liabilities Securities

−$100 million

Reserves

+$100 million

Loans

+$100 million

Checkable Deposits +$100 million

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c.

JP Morgan after loan proceeds have been spent Assets Liabilities Securities −$100 million Loans +$100 million Reserves $0

Checkable Deposits

$0

Wells Fargo after receiving new deposit of $100 million Assets Liabilities Reserves: +$100 million

Checkable Deposits

+$100 million

d. The maximum increase in the money supply that can result from the Fed purchase of $100 million in Treasury bills from JPMorgan Chase is $500 million, as we can see from the equation for the simple deposit multiplier: ΔD = ΔR/rrD, $100 million × 1/0.20 = $100 million × 5 = $500 million.

2.7

a. Required reserves = (0.03 × $30 million) + (0.12 × $150 million) = $18.9 million Excess reserves = Total reserves − required reserves = $18.9 − $18.9 = $0. b. As a result of the sale, the bank’s reserves increase to $23.9 million and its securities fall to $26.1 million. The other entries on the balance sheet remain the same. Total reserves are now $23.9 million, while required reserves are still equal $18.9 million. Excess reserves now equal $5 million.

Assets

Liabilities

Reserves

$23.9

Checkable deposits

Loans

150.0

Net worth

Securities Total

$180.0 20.0

26.1 $200.0

Total

$200.0

c. Loans increase to $155 million, while checkable deposits increase to $185 million. Total assets and total liabilities rise to $205 million. Required reserves rise to $19.5 million. So with reserves of $23.9 million, excess reserves equal $4.4 million.

Assets

Liabilities

Reserves

$23.9

Checkable deposits

Loans

155.0

Net worth

Securities Total

$185.0 20.0

26.1 $205.0

Total

$205.0

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d. Reserves decline by $5 million to $18.9 million, and checkable deposits decline by $5 million to $180 million.

Everything else is the same as in part (c), other than that total assets and total liabilities fall to $200 million. As in part (a), required reserves equal $18.9 million, so excess reserves again equal $0.

Reserves Loans Securities Total

Assets $18.9 155.0 26.1 $200.0

Liabilities Checkable deposits $180.0 Net worth 20.0 Total

$200.0

2.8 a. People asked the goldsmiths to store gold for them in return for receipts that could be exchanged for gold at a later time. Today, we ask banks to store our paychecks and portions of our savings in the form of checking and savings accounts. Unlike the goldsmiths, today’s banks have no obligation to exchange their customers’ deposits for commodity money. The goldsmiths became more like modern banks when (1) the goldsmiths’ receipts, instead of the gold itself, were used as a medium of exchange, and (2) the goldsmiths began to make loans based on their holdings of gold. b. Multiple deposit creation was possible if goldsmiths issued more receipts than they had gold reserves to redeem the receipts with, and if the public and other goldsmiths were willing to accept the gold receipts as deposits. Under these circumstances, the gold deposits and the receipts for them would function like modern checking accounts.

2.9

a. The operation of the Suffolk System, in effect, meant that the United States had a “note multiplier,” as long as banks were willing to accept the notes of other banks. The size of the note multiplier would depend on the amount of gold banks needed to hold. That, in turn, was likely determined by how often banks were called on to redeem their notes for gold. The less gold banks needed to hold, the larger the multiplier, just as in the modern banking system, the lower the amount of reserves banks hold, the larger the deposit multiplier. b. The Suffolk System banks would experience a greater increase in notes because other banks in the system are willing to accept each other’s bank notes at full face value. Banks outside the system couldn’t count on other banks be willing to accept their notes except at a discount to face value.

2.10 a. The process of the multiple creation of deposits shows the essence of commercial banking with the granting of loans, the creation of checking deposits, and the transfer of reserves from bank to bank as the loaned funds are spent and deposited in other banks. The response of the banking system to a change in reserves is far greater than the response of a single bank loaning out its excess reserves. b. When an individual bank makes a loan and creates the accompanying checking deposit, the individual bank loses the reserves when the checking deposit is spent and deposited in another bank. The reserves, however, stay in the banking system and lead to a multiple deposit creation process.

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14.3

Banks, the Nonbank Public, and the Money Multiplier Learning Objective: Explain how the actions of banks and the nonbank public affect the money multiplier.

Review Questions 3.1

3.2

3.3

The simple deposit multiplier assumes that banks hold no excess reserves and that the nonbank public does not change its holdings of currency. The money multiplier links the monetary base to the money supply, while the simple deposit multiplier links reserves to deposits. The money multiplier includes the effects on the money supply process of changes in the public’s desire to hold currency relative to checkable deposits and includes the effects of changes in banks’ desire to hold excess reserves relative to checkable deposits. a. The higher the currency-to-deposit ratio (C/D), the lower the money multiplier. b. The higher the excess reserves-to-deposit ratio (ER/D), the lower the money multiplier. c. The higher the required reserve ratio (rrD), the lower the money multiplier.

The currency-to-deposit ratio (C/D) fell, and the excess reserves-to-deposit ratio (ER/D) soared during the 2007–2009 financial crisis. The increase in ER/D was significantly larger than the decrease in C/D, causing the value of the money multiplier to decline. Following the financial crisis, banks continued to hold levels of excess reserves that kept the excess reserve ratio higher than the currency-to-deposit ratio until 2018. From 2018 to early 2020, the excess reserve ratio fell while the currency-to-deposit ratio stayed about the same, so the money multiplier rose.

Since the onset of the Covid-19 crisis, excess reserves (now total reserves) have again risen, though not as dramatically as in 2007–2009, and the currency-to-deposit ratio fell, again reducing the money multiplier.

Problems and Applications 3.4

a. The assumption means that the money multiplier does not change when the Fed changes the monetary base by buying or selling government securities or granting discount loans. b. If the money multiplier changes when the Fed changes the monetary base, then the Fed could not be sure how much the money supply would change. If the change in the money multiplier is small or predictable, then the Fed can determine the approximate change of the money supply. If the change in the money multiplier is large and erratic, then the Fed cannot determine how much the money supply would change.

3.5

Disagree. If the required reserve ratio equaled zero, the simple deposit multiplier would equal infinity, implying that multiple deposit creation would go on forever. However, the money multiplier, which includes currency and excess reserve holdings, would not equal infinity even if the required reserve ratio equaled zero, so multiple deposit creation would not go on forever.

3.6

3.7

a. m = [(C/D) + 1]/[(C/D) + rrD + (ER/D)] = (1 + 1)/ (1 + 1 + 0) = 1 b. m = [(C/D) + 1]/[(C/D) + rrD + (ER/D)] = (0.5 + 1)/ (0.5 + 1 + 0) = 1 c. m = [(C/D) + 1]/[(C/D) + rrD + (ER/D)] = (0.5 + 1)/ (0.5 + 0.5 + 0) = 1.5 When the Fed buys bonds, it creates new reserves and increases the monetary base. An increase in the monetary base will increase the money supply (creating new money) by the change in reserves times the money multiplier.

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3.8

Both the decrease in the required reserve ratio and the decrease in the currency/deposit ratio (relying less on currency to settle transactions) increase the money multiplier, causing the money supply in China to grow faster than the monetary base.

3.9

Currency-to-deposit ratio (C/D) = $100 billion/$800 billion = 0.125 Total reserves-to-deposits ratio = $200 billion/$800 billion = 0.25 Monetary base (B) = $100 billion + $200 billion = $300 billion Money multiplier, m: The excess reserves-to-deposit ratio (ER/D) = $40 billion/$800 billion = 0.05 The required reserve ratio, rrD, = $160 billion/$800 billion = 0.20 So, m = (0.125 + 1)/(0.125 + 0.2 + 0.05) = 1.125/0.375 = 3 Alternatively, m = M1/B = $900 billion/$300 billion = 3.

M1 = $100 billion + $800 billion = $900 billion (or, M1 = $300 billion × 3 = $900 billion).

201

3.10 a. Currency-to-deposit ratio = $850 billion/$700 billion = 1.214 Total reserves-to-deposit ratio = $700 billion/$700 billion = 1 Monetary base (B) = $850 billion + $700 billion = $1,550 billion Money multiplier = (1.214 + 1)/(1.214 + 1) = 1 (using the fact that rrD + ER/D = total reserves to deposits) Alternatively, m = M1/B = $1,550 billion/$1,550 billion = 1 M1 = $850 billion + $700 billion = $1,550 billion (or, M1 = $1,550 × 1 = $1,550 billion) b. (1.214 + 1) / (1.214 + 2) = 0.69 3.11

1930 1931 1932

Currency-todeposit ratio (C/D)

Total reserves-todeposits ratio (R/D)

Monetary Money M1 Money Base Multiplier Supply

$3.681/21.612 = 0.17

$3.227/21.612 = 0.15

$6.908

3.7

$25.293

3.995/19.888 = 0.20

3.307/19.888 = 0.166

7.302

3.3

23.883

4.959/15.490 = 0.32

2.829/15.490 = 0.183

7.788

2.6

20.449

Currency increased relative to deposits because depositors withdrew their funds in response to the bank panic at the beginning of the Great Depression. Reserves rose relative to deposits as banks attempted to protect themselves against runs and as both interest rates on loans and the creditworthiness of borrowers declined.

3.12 a. Many banks had suffered severe losses, had experienced runs, and had seen the creditworthiness of borrowers deteriorate. As a result, they had a strong desire to retain excess reserves rather than loan them out. b. Meltzer was referring to the multiple deposit creation process that would occur if the banks had decided to begin loaning out their excess reserves with the resulting increase in the money supply. c. Because banks did not intend to loan out their excess reserves, the Fed overestimated the size of the money multiplier, the multiple deposit creation process, and the increase in the money supply.

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d. To restore previous holdings of excess reserves, banks made fewer loans and thereby held fewer demand deposits. Meltzer said that the Fed didn’t understand that banks planned to hold their excess reserves for safety. Some members of the Board of Governors were also afraid that increasing stock prices might result in a bubble similar to the one that had preceded the great stock market crash of October 1929. They were afraid that bank loans might fuel further stock buying. In addition, the Fed overestimated the likelihood that inflation would accelerate in an economy suffering from 14% unemployment.

3.13

Both the safe haven aspect and low interest rates on other investments help account for the surge in demand for gold coins in 2020. Concerns about the global pandemic increased the demand for gold coins, plus concerns about the international financial system and large central bank asset holdings caused concerns about higher future inflation, both of which lead some investors to buy gold as a safe haven. Low interest rates on bonds also led to further investment in gold because the opportunity cost of holding gold—the interest rate on bonds—had declined.

3.14 a. A hedge against inflation is something that is likely to hold its value in the event of inflation, for instance, by having its price increase as rapidly as inflation increases. In 2020, central banks greatly increased their asset purchases, which raised concerns about increases in the size of the money supply in those countries. And, the money supply might increase even more in the future if banks decided to hold fewer excess reserves and make more loans. These increases in the money supply caused investors to worry about increases in future inflation. Investors often believe that gold is a good inflation hedge because they expect that its price will rise as the prices of other goods and services rise. However, although this has been true in some periods, in general the real price of gold has fallen over some long periods. In other words, the price of gold has often risen more slowly than the general rate of inflation, which indicates that gold has generally been a poor inflation hedge. b. The rate of return on gold is the capital gain, or the percentage change in the price of gold. One reason gold might be a particularly poor investment in a period following a time of significant gold price increases is that the price increase were likely to have been driven in part by speculation. At a higher price, fewer investors will speculate on future increases in the price of gold, reducing the demand for gold and moderating its price.

Data Exercises D14.1 a. In December 2020, the M1 money stock was $6,621.2 billion and the monetary base was $5,206.6 billion. The simple money multiplier equals the money supply divided by the monetary base, so the M1 money multiplier was: $6,621.2/$5,206.6 = 1.27. b. The M1 measure of the money supply would increase by: $400 million × 0.926 = $508.7 million.

D14.2 a. In December 2020, the Currency Component of M1 was $1,974.2 billion and Total Checkable Deposits were $4,789.2 billion. The currency-to-deposit ratio was: $1,974.2 billion/$4,789.2 billion = 0.41. b. The Fed has discontinued the excess reserves series, because at this time, there are no reserve requirements, so all reserves are excess reserves. A good substitute is total reserves of depository institutions (TOTRESNS). In December 2020, total reserves were $3,135.0 billion.

The excess reserve-to-deposit ratio was: $3,135.0 billion/$4,789.2 billion = 0.65. c. The formula for the money multiplier is: m = [(C/D) + 1]/[(C/D) + rrD + (ER/D)].

Using the values above,

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m = [0.41 + 1]/[0.41 + 0 + 0.73] = 1.24.

D14.3 a. The Fed has discontinued the excess reserves series, because at this time, there are no reserve requirements, so all reserves are excess reserves. A good substitute is total reserves of depository institutions (TOTRESNS). In December 2020, total reserves were $3,135.0 billion.

Total reserves were $1,698.3 billion in December 2019. Excess reserves over the year increased by 85%. b. The 85% increase in excess reserves, holding all other factors constant that affect the money supply, would have decreased the money supply.

D14.4

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Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007 February 2020

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 Not known as of February 2021

a. The trend in the level of the monetary base has been upward, with a steep spike upward that began during the 2007—2009 financial crisis and continued through October 2015. The monetary base fell from November 2015 to December 2019 but spiked again in early 2020. b. The monetary base generally increased throughout the entire period until November 2015. In the 1960—1961 recession, the monetary base decreased just before the recession, increased during the recession, and then decreased after the recession, but otherwise the monetary base increased just before, during, and after the other recessions during the 1959—2020 period. However, after the 2007-2009 crisis, the monetary base continued to increase for some period of time as the Fed continued its accommodative stance due to the slow recovery. c. By far the most volatility in the monetary base occurred during and following the 2007—2009 financial crisis, with the 2020 Covid-19 crisis a close second.

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Chapter 15 Monetary Policy 

Brief Chapter Summary and Chapter Objectives

15.1 The Goals of Monetary Policy (pages 505–511) Describe the Goals of Monetary Policy.

• The Fed has several goals for monetary policy, including price stability, high employment, economic growth, stability of financial markets and institutions, interest rate stability, and foreign exchange market stability.

15.2 Monetary Policy Tools and the Federal Funds Rate (pages 511–521) Understand how the Fed uses monetary policy tools to influence the federal funds rate.

• Although the Fed sets a target for the federal funds rate, the actual rate is determined by the interaction of the demand and supply for bank reserves in the federal funds market, under the usual assumption of scarce reserves.

• To analyze the determinants of the federal funds rate, we need to examine the banking system’s demand for and the Fed’s supply of reserves.

• Until the financial crisis of 2007–2009, the Fed primarily relied on the following three monetary policy tools: open market operations, discount policy, and reserve requirements.

• During the 2007–2009 financial crisis, the Fed introduced two new policy tools—quantitative easing and forward guidance—to deal with the zero lower bound problem.

15.3 The Fed’s Monetary Policy Tools and Its New Approach to Managing the Federal Funds Rate (pages 521–531) Trace how the Fed has changed its use of monetary policy tools over time.

• Open market operations have traditionally been the Fed’s preferred tool in conducting monetary policy.

• Discount policy was used extensively in response to the financial crisis of 2007–2009.

• The Fed currently manages the federal funds rate by setting a target range, bounded by the interest rate on excess reserves and the interest rate on overnight reverse repurchase agreements.

15.4 Monetary Targeting and Monetary Policy (pages 531–547) Explain the role of monetary targeting in monetary policy.

• Traditionally, the Fed has relied on two types of targets: 1. Policy instruments, sometimes called operating targets 2. Intermediate targets Targeting is no longer the Fed’s favored approach.

• The Taylor rule summarizes the variables typically used in setting a target for the federal funds rate.

• Inflation targeting has become an increasingly popular approach to monetary policy, particularly before the recent financial crisis. In 2012, the Fed announced an inflation target of 2%. In 2020, the Fed adjusted this target to be an average inflation rate of 2%, beginning a new policy of Copyright © 2022 Pearson Education, Inc.

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average-inflation targeting. During the Covid-19 pandemic, some economists and policymakers suggested the Fed raise the target to 4%.

• Although there are institutional differences in the ways in which central banks conduct monetary policy, most central banks use short-term interest rates as a policy instrument to achieve an ultimate goal such as low inflation.



Key Terms

Discount policy, p. 511. The policy tool of setting the discount rate and the terms of discount lending.

Discount window, p. 511. The means by which the Fed makes discount loans to banks, serving as the channel for meeting the liquidity needs of banks.

Economic growth, p. 507. Increases in the economy’s output of goods and services over time; a goal of monetary policy.

Federal funds rate, p. 514. The interest rate that banks charge each other on very short-term loans; determined by the demand and supply for reserves in the federal funds market.

Open market operations, p. 511. The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

Primary credit, p. 523. Discount loans available to healthy banks experiencing temporary liquidity problems.

Quantitative easing (QE), p. 513. A central bank policy that attempts to stimulate the economy by buying long-term securities.

Reserve requirement, p. 511. The Fed’s regulation that banks must hold a fraction of checkable deposits as vault cash or deposits with the Fed; in March 2020, the Fed eliminated reserve requirements.

Seasonal credit, p. 524. Discount loans to smaller banks in areas where agriculture or tourism is important.

Secondary credit, p. 523. Discount loans available to banks that are not eligible for primary credit.

Taylor rule, p. 537. A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate.

Chapter Outline The Brave New World of Monetary Policy For decades, Federal Reserve policy was largely a matter of adjusting the target for the federal funds rate, depending on the state of the economy. The Fed would cut the federal funds rate if the economy neared recession and increase the rate if inflation was increasing. To change the federal funds rate, the Fed would use open market operations to increase or decrease bank reserves, which was successful because banks held relatively few excess reserves.

But during the financial crisis of 2007–2009, the Fed took extraordinary actions to keep the financial system from imploding by buying a variety of assets and greatly increasing the amount of reserves in the system. For the first time, the Fed began paying interest on excess reserves. Initially, the Fed and most economists believed that once the crisis was over, the Fed would shrink its balance sheet, and banks would return to holding few excess reserves. Fed officials used the term exit strategy to refer to the steps the Fed would take to return reserves to pre-2008 levels. But the slow recovery from the recession led the Fed to continue rounds of quantitative easing (QE), increasing the balance sheet further. Because reserves were no longer scarce, the Fed needed new procedures beyond open market operations to affect the federal funds rate.

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maturing. As the Fed’s holdings of securities declined, so did bank reserves, shrinking the monetary base.

But this process ended in mid-2019, when U.S. economic growth slowed; Fed Chair Jerome Powell responded by expanding the Fed’s securities purchases. During the 2020 Covid-19 pandemic, the Fed revived some of the lending facilities it had used during the 2007–2009 financial crisis and also started new programs, and bank reserves soared.

Are these permanent policy changes? Many economists believe so, for two reasons. First, low inflation and low interest rates meant that short-term nominal interest rates were likely to be low well into the future. In such circumstances, the Fed would only be able to make relatively small reductions in its target for the federal funds rate before hitting a lower bound of zero. Using a new policy method, such as QE, rather than relying on targeting the federal funds rate will result in the Fed’s balance sheet and bank reserves remaining much higher than they were before 2008. Secondly, changes in banking regulations since the 2007–2009 crisis have required large banks to be more liquid than they typically were prior to 2008, leading the banks to maintain large reserve balances rather than borrow in the overnight market. It seems unlikely that the Fed will face a situation of scarce reserves at any time in the near future.

Some economists and policymakers are concerned that the persistence of unconventional policies might have introduced distortions into the economy and the financial system that could lead to future economic instability. They have three particular concerns: (1) A long period of very low interest rates has resulted in unsustainably high prices of assets such as stocks, corporate and government bonds, and corporate loans; (2) low interest rates have reduced the return to saving and made it more difficult for risk-averse investors to adequately save for retirement using low-risk assets such as bank certificates of deposits (CDs); and (3) the Fed’s continuing to hold trillions of dollars in financial assets on its balance sheet is distorting prices and yields in financial markets, particularly the housing market, by removing from the market securities usually held by private investors.

Teaching Tips This chapter brings together a number of the topics covered in earlier chapters as part of an integrated discussion of monetary policy. The chapter provides an overview of the Fed’s monetary policy tools, including the Fed’s heavy use of discount lending during the financial crises of 2007–2009 and 2020.

Figures such as 15.1, 15.3, and 15.4 show the demand and supply for reserves in the federal funds market and illustrate many key points. The related Apply the Concept features discuss the reasons for the change in the relationship between the growth of the money supply and the inflation rate beginning in the 1980s.

15.1 The Goals of Monetary Policy (pages 505–511) Learning Objective: Describe the Goals of Monetary Policy.

The Fed has six monetary policy goals that are intended to promote economic well-being.

A. Price Stability Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and as a unit of account. In a market economy, prices communicate information about costs and about demand for goods and services to households and firms. Inflation makes prices less useful as signals for resource allocation. Severe inflation inflicts even greater economic costs. As a result, price stability is a key monetary policy goal.

B. High Employment High employment, or a low rate of unemployment, is another key monetary policy goal.

Unemployed workers and underused factories and machines reduce output. Unemployment causes financial distress for workers who lack jobs. The Fed attempts to reduce levels of cyclical unemployment, which is unemployment associated with business cycle recessions.

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C. Economic Growth Economic growth provides the only source of sustained real increases in household incomes.

Policymakers attempt to encourage stable economic growth over time because a stable business environment allows firms and households to plan accurately and encourages the long-term investment needed to sustain growth.

D. Stability of Financial Markets and Institutions The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The 2007–2009 financial crisis led to a renewed debate over whether the Fed should take action to forestall asset price bubbles such as those associated with the dot-com boom on the U.S. stock market in the late 1990s and the U.S. housing market in the 2000s. In 2020, in response to the effects of the Covid-19 pandemic on the economy, the Fed implemented a series of initiatives focused on maintaining the flow of funds through the financial system.

E. Interest Rate Stability Fluctuations in interest rates make planning difficult for households and firms. Sharp interest rate fluctuations also cause problems for banks and other financial firms.

F. Foreign Exchange Market Stability A stable dollar simplifies planning for commercial and financial transactions. Fluctuations in the dollar’s value change the international competitiveness of U.S. industries.

G. The Fed’s Dual Mandate Many economists refer to the Fed’s dual mandate as price stability and maximum employment.

If the Fed can attain these two goals, it will typically also attain its other goals (economic growth, stability of financial markets and institutions, interest-rate stability, and foreign exchange market stability). An open question is whether the mandate is consistent with financial market stability.

15.2 Monetary Policy Tools and the Federal Funds Rate (pages 511–521) Learning Objective: Understand how the Fed uses monetary policy tools to influence the federal funds rate.

The Fed’s traditional policy tools include open market operations, discount policy, and reserve requirements. During the 2007–2009 financial crisis, the Fed added five new policy tools. The Fed used these tools during the 2020 Covid-19 pandemic. Three of the tools are connected with bank reserve accounts and controlling the federal funds rate. The other two tools deal with the zero lower bound problem.

A. New Tools to Manage the Federal Funds Rate The Fed’s new tools for managing the federal funds rate are: (1) Interest on bank reserve balances: In October 2008, the Fed began for the first time to pay interest on banks’ required reserve and excess reserve deposits. This interest rate is called the IOER, (interest rate on excess reserves). By paying interest on reserve balances, the Fed increases its ability to influence banks’ reserve balances.

(2) Overnight reverse repurchase agreement facility: With a repurchase agreement (or repo), the Fed sells a security to a financial firm and promises to buy back the security the next day.

With a reverse repo, the Fed sells a security that it promises to buy back the following day.

The Fed is essentially borrowing funds overnight from the firm that purchases the security.

By raising the interest rate the Fed is willing to pay on these loans, the Fed reduces the willingness of the firms it deals with in these transactions—its counterparties—to lend at a lower rate. The Fed refers to overnight reverse repurchase agreements as ON RRPs and the interest rate on these securities as the ON RRP rate.

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(3) Term deposit facility: In April 2010, the Fed announced that it would offer banks the opportunity to purchase term deposits, which are similar to the certificates of deposit that banks offer to households and firms.

B. New Tools When Facing a Zero Lower Bound on the Federal Funds Rate During the 2007–2009 financial crisis, the Fed introduced two new tools to deal with the zero lower bound problem:

1. Quantitative easing: A central bank policy whose goal is to stimulate the economy by buying long-term securities.

2. Forward guidance: Statements by the Federal Open Market Committee (FOMC) about how it will conduct monetary policy in the future.

C. The Federal Funds Market and the Fed’s Target Federal Funds For several decades, the focus of Fed policy has been setting a target for the federal funds rate, which is the interest rate that banks charge each other on very short-term loans. The target for the federal funds rate is set at meetings of the FOMC. The Fed sets a target for the federal funds rate, but the actual rate is determined by the interaction of the demand and supply for reserves.

Teaching Tips Spend a little extra time in class developing the graph of the federal funds market, Figure 15.1, “Equilibrium in the Federal Funds Market,” because students can easily gloss over this graph and treat it as a standard demand and supply graph. You can help students understand the graph by making it clear that the supply curve is vertical because the Fed controls the volume of reserves, which makes the supply of reserves independent of the federal funds rate. Also, carefully explain the reasoning behind the horizontal portions of each curve to help students understand the unique shapes of the demand and supply curves for reserves.

D. Open Market Operations and the Fed’s Target for the Federal Funds Rate The Fed uses open market operations to hit its target for the federal funds rate. An open market purchase of securities increases the supply of reserves, which decreases the federal funds rate. The lower the cost of funds to banks typically leads to lower interest rates on loans to households and firms. An open market sale of securities increases the federal funds rate.

E. The Effect of Changes in the Discount Rate and in Reserve Requirements Typically, the Fed has raised or lowered the discount rate at the same time that it raises or lowers the target for the federal funds rate. As a result, changes in the discount rate have no independent effect on the federal funds rate. The Fed rarely changes the required reserve ratio. If the other factors underlying the demand and supply curves for reserves are held constant, an increase in the required reserve ratio increases the demand for reserves because banks have to hold more reserves, resulting in a higher federal funds rate.

15.3 The Fed’s Monetary Policy Tools and Its New Approach to Managing the Federal Funds Rate (pages 521–531) Learning Objective: Trace how the Fed has changed its use of monetary policy tools over time.

A. Open Market Operations When the Fed carries out an open market purchase of Treasury securities, the prices of these securities increase which decreases their yields. Because the purchase will increase the monetary base, the money supply will expand. At the end of each of its meetings, the FOMC issues a statement that includes its target for the federal funds rate and its assessment of the economy,

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particularly with respect to its policy goals of price stability and economic growth. The Fed issues a directive to the Federal Reserve System’s account manager, who has the responsibility of implementing open market operations. Open market operations have three key benefits that other policy tools lack: (1) control, (2) flexibility, and (3) ease of implementation. During the 2007– 2009 financial crisis, with the federal funds rate already near zero, the Fed engaged in quantitative easing with the intent of reducing long-term interest rates rather than the federal funds rate.

Teaching Tips Though the first round of quantitative easing was generally supported by most economists, the second and third rounds announced in November 2010 and September 2012, respectively, were more controversial.

Opponents of quantitative easing see it as a new approach to monetary policy with the risk of significantly increasing inflation without effectively stimulating economic growth. Supporters of quantitative easing argue that it is an extension of the traditional use of open market operations that the Fed routinely uses to stimulate the economy when it is perceived to be too weak. Open market operations usually focus on the federal funds rate. But because the federal funds rate was already near zero, the Fed focused on reducing long-term interest rates.

A potentially worthwhile classroom exercise is to have a brief debate between two groups of students: Ask one group to defend quantitative easing and ask the other group to present the opposing case.

B. Discount Policy Since 1980, all depository institutions have had access to the Fed’s discount window. The Fed’s discount loans to banks fall into three categories: 1. Primary credit, which is available to healthy banks with adequate capital and supervisory ratings.

2. Secondary credit, which is intended for banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings.

3. Seasonal credit, which consists of temporary, short-term loans to satisfy seasonal requirements of smaller banks in geographic areas where agriculture or tourism are important.

During both the financial crisis of 2007–2009 and the 2020 crisis caused by the Covid-19 pandemic, the Fed created a large number of liquidity and credit facilities to extend loans or provide liquidity in other sectors of the economy.

C. How the Fed Currently Manages the Federal Funds Rate Because banks maintain very large reserve balances, raising the target for the federal funds rate through open market sales of securities is no longer feasible. Instead, the Fed uses two new monetary policy tools: changes in the interest rate the Fed pays on excess reserves and changes in the interest rate on overnight reverse repurchase agreements, to set a target range for the federal funds rate.

The interest rate the Fed pays on bank reserves sets the top of the Fed’s target range because banks would rarely lend in the federal funds market at a lower interest rate than they could receive on reserve deposits with the Fed. The interest rate the Fed pays on reverse repurchase agreements sets the bottom of the Fed’s target range because financial institutions would rarely lend in the federal funds market at a lower interest rate than they could receive from a loan to the Fed. In order to lower the target for the fed funds rate, the Fed would have to decrease both of the interest rates.

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Extra Apply the Concept A Morning’s Work at the Open Market Trading Desk The following is an overview of activity at the Open Market Trading Desk at the Federal Reserve Bank of New York.

7:00 A.M. The account manager receives from the research staff an estimate of the supply of reserves for that day and for the remaining days of the current maintenance period. The maintenance period is the two-week period over which the Fed calculates banks’ required reserve balances.

8:00 A.M.–9:00 A.M. The account manager begins informal discussions with market participants to assess conditions in the government securities market. From these discussions and from data supplied by the staff of the FOMC, the account manager estimates the demand for reserves and how the prices of government securities will change during the trading day. The account manager’s staff compares forecasts on Treasury deposits and information on the timing of future Treasury sales of securities with the staff of the Office of Government Finance in the Treasury Department. These Treasury activities can affect the level of bank reserves and the monetary base.

9:10 A.M. After reviewing the information from the various staffs, the account manager studies the FOMC’s directive. This directive identifies the level of the federal funds rate desired. The account manager must design dynamic open market operations to implement changes requested by the FOMC and defensive open market operations to offset temporary disturbances to reserves as predicted by the staff. The account manager places the daily conference call to at least two members of the FOMC to discuss trading strategy.

9:30 A.M. On approval of the trading strategy, the traders at the Federal Reserve Bank of New York notify the primary dealers in the government securities market of the Fed’s desired transactions. If traders plan to make open market purchases, they request quotations for asked prices. If traders plan to make open market sales, they request quotations for bid prices. (Recall that the asked price is the price at which a dealer is willing to sell a security, and the bid price is the price at which a dealer is willing to buy a security.)

9:40 A.M. The primary dealers submit their propositions to the trading desk.

9:41 A.M. The trading desk selects the lowest prices offered when making purchases and accepts the highest prices when making sales and returns the results to dealers.

10:30 A.M. By this time, the transactions have been completed and the trading room at the Federal Reserve Bank of New York is less hectic. No long coffee breaks for the account manager and staff, though, because they are busy the rest of the day monitoring conditions in the federal funds market and the level of bank reserves to get ready for the next day of trading.

Source: Adapted from “A Morning at the Desk” from Implementing Monetary Policy: The Federal Reserve in the 21st Century by Christopher Burke, Federal Reserve Bank of New York, January 13, 2010.

15.4 Monetary Targeting and Monetary Policy (pages 531–547) Learning Objective: Explain the role of monetary targeting in monetary policy.

The central bank’s objective in conducting monetary policy is to use its policy tools to achieve monetary policy goals. But the Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high economic growth and low inflation. Although the Fed hopes to encourage economic growth and price stability, it has no direct control over real GDP or the price level. The Fed also faces timing difficulties in using its monetary policy tools.

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A. Using Targets to Meet Goals Targets are variables that the Fed can influence directly that help achieve monetary policy goals.

Traditionally, the Fed has relied on two types of targets: 1. Intermediate targets, which are typically either monetary aggregates or interest rates.

2. Policy instruments, or operating targets, such as the mortgage interest rate or M2, are variables that the Fed controls only indirectly because private sector decisions also influence these variables.

Using targets is no longer the Fed’s favored approach.

B. The Choice between Targeting Reserves and Targeting the Federal Funds Rate Traditionally, the Fed has used three criteria—whether a variable is measurable, controllable, and predictable—when evaluating variables that might be used as policy instruments. The Fed’s main policy instruments have been reserve aggregates, such as total reserves or nonborrowed reserves, and the federal funds rate. A key point to understand is that the Fed can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate—but it cannot choose both.

C. The Taylor Rule: A Summary Measure of Fed Policy Actual Fed deliberations are complex and incorporate many factors about the economy. John Taylor of Stanford University has summarized these factors in the Taylor rule for federal funds rate targeting: Federal funds rate target = Current inflation rate + Equilibrium real federal funds rate

+ (1/2 × Inflation gap) + (1/2 × Output gap).

According to the Taylor rule, the Fed should raise the federal funds rate in response to a positive inflation gap or a positive output gap. The Taylor rule has tracked the actual federal funds rate fairly closely during most years. But during the late 1960s and early to mid-1970s, the federal funds rate predicted by the Taylor rule is above the rate target and the Taylor rule indicates that the federal funds rate should have been negative throughout 2009. That the Taylor rule tracks the federal funds rate fairly closely confirms the view that targeting the federal funds rate has been central to Fed policymaking in recent decades.

D. Inflation Targeting and the Fed’s New Monetary Policy Strategy In 2012, the Fed joined many other central banks by setting an inflation target. With inflation targeting, a central bank publicly sets an explicit target for the inflation rate over a period of time, and the government and the public then judge the performance of the central bank on the basis of its success in hitting the target.

Arguments in favor of the Fed using an explicit inflation target focus on four points: 1. Announcing explicit targets for inflation draws the public’s attention to what the Fed can actually achieve in practice.

2. The establishment of transparent inflation targets for the United States provides an anchor for inflationary expectations.

3. Inflation targets promote accountability for the Fed by providing a yardstick against which its performance can be measured.

4. Inflation targeting potentially provides the Fed with another monetary policy tool.

Opponents of inflation targets make five points: 1. Rigid numerical targets for inflation diminish the flexibility of monetary policy to address other policy goals.

2. Because monetary policy influences inflation with a lag, inflation targeting requires that the Fed depend on forecasts of future inflation, which can be inaccurate.

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3. Holding the Fed accountable only for a goal of low inflation may make it more difficult for elected officials to monitor the Fed’s support for good economic policy overall.

4. Uncertainty about future levels of output and employment can impede economic decision making in the presence of an inflation target.

5. Using the inflation target as a policy tool could be economically destabilizing.

In 2020, the Fed announced a move to an average-inflation target of 2%, allowing the inflation rate to move above and below 2% as long as the longer run average is still 2% E. International Comparisons of Monetary Policy Although there are institutional differences in how central banks conduct monetary policy, there are two important similarities in recent practices. First, most central banks in industrial countries rely on short-term interest rates—similar to the federal funds rate in the United States—as the policy instrument, or operating target, through which goals are pursued. Second, many central banks took extraordinary measures, such as quantitative easing, to deal with slow economic growth following the financial crisis of 2007–2009 and again during the crisis caused by the Covid-19 pandemic.

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Solutions to the End-of-Chapter Questions and Problems

15.1 The Goals of Monetary Policy Learning objective: Describe the goals of monetary policy.

Review Questions 1.1

Monetary policy aims to advance the economic well-being of the population. Economic wellbeing is typically determined by the quantity and quality of goods and services that individuals can enjoy, and arises from efficient employment of labor and capital, steady growth in output, and stable economic conditions. Monetary policy has six goals: price stability, high employment, economic growth, stability of financial markets and institutions, interest rate stability, and foreign-exchange market stability. By achieving just two of the goals – price stability and high employment – it will typically also attain the other goals. In addition, because Congress has made explicit references to price stability and high employment in federal law, these two goals are often referred to as the Fed’s “dual mandate.” It is debatable, however, whether the Fed’s dual mandate is necessarily consistent with financial market stability.

1.2

The Fed seeks to reduce cyclical unemployment. The Fed does not seek to reduce the unemployment rate to zero because the tools of monetary policy affect economic conditions throughout the economy and are ineffective in reducing the levels of frictional and structural unemployment.

1.3

Interest rates represent the cost of borrowing. Fluctuating interest rates make investment decisions by firms and households more difficult because the cost of borrowing becomes more uncertain.

1.4

Large fluctuations in the foreign exchange value of the dollar would make it difficult to determine the prices of output in terms of foreign currencies, the cost of imported intermediate goods used in production, and the dollar value of foreign assets and profits.

Problems and Applications 1.5

Deflation and inflation make it difficult to distinguish overall price changes from relative price changes, which affects resource allocation. Unanticipated deflation redistributes income just as unanticipated inflation does, as when borrowers suffer losses from unanticipated deflation

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because they pay higher than expected real interest rates. Borrowers therefore lose from deflation while creditors gain.

1.6

a. “Extraordinary easing measures” mean expansionary monetary policy and quantitative easing in order to maintain low interest rates and stimulate the economy. b. An expansionary policy of low interest rates would stimulate spending, putting upward pressure on prices. Deflation can be highly damaging as it causes consumers to delay present spending in order to wait for lower future prices. Deflation can lead to an inefficient allocation of resources.

Unanticipated deflation hurts borrowers as it raises the real interest rate above the expected real interest rate. c. Answers will vary. When deflation or high inflation is caused by a demand shock (too little or too much aggregate spending), then the columnist is correct that the single mandate of price stability would encompass the dual mandate of price stability and maximum employment. For example, a decline in spending could cause both deflation and high unemployment, and a decrease in interest rates would stimulate spending, increasing both inflation and employment.

When deflation or inflation is caused by a supply shock, then the Fed faces the policy dilemma of having to choose in the short term between stable prices and maximum employment. A negative supply shock caused by a substantial increase in oil prices increases both inflation and unemployment; if the Fed raises interest rates to lower inflation, unemployment will increase.

With supply shocks, price stability alone is not consistent in the short run with the dual mandate of price stability and maximum employment.

1.7

a. The second part of the Fed’s dual mandate is high employment. b. When the U.S. economy experiences a period of price stability and high employment, it usually also experiences economic growth and stability of financial markets, interest rates, and foreign exchange rates. Congress therefore mandated that the Fed pursue both of these two goals.

1.8

1.9

The unemployment rate for Blacks has consistently been higher than the unemployment rates for Whites or Hispanics. Black unemployment rates are particularly likely to increase significantly during a recession. Likewise, the Black employment–population ratio has been below the ratios for Hispanics and Whites. a. Black unemployment rates begin higher than White or Hispanic rates in more normal times.

During the pandemic, a spike in overall employment rates implies a far larger spike in Black unemployment rates, which generally soar during recessions. b. The Fed has traditionally interpreted its goals as applying to the economy as a whole rather than to any particular sector or group because its monetary policy actions typically affect national economic indicators such as real GDP and the price level.

15.2 Monetary Policy Tools and the Federal Funds Rate

Learning objective: Understand how the Fed uses monetary policy tools to influence the federal funds rate.

Review Questions 2.1

The Fed’s three traditional monetary policy tools are open market operations (buying and selling securities on the open market); discount policy (changes in the discount rate); and reserve requirements (changes in the required reserves that banks must hold). Open market operations is the Fed’s most important traditional monetary policy tool, because the Fed relied on them to reach its target for the federal funds rate.

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2.2

The Fed’s new policy tools for managing the federal funds rate are: the interest rate on bank reserve balances; the interest rate on overnight reserve repurchase agreements (short-term loans backed by collateral); and the interest rate on bank term deposits (time deposits, usually at slightly higher rate than the IOER). The first two tools are more important than the term deposit facility, which the Fed uses less frequently.

2.3

The zero lower bound refers to the fact that nominal interest rates cannot generally fall below zero (although some central banks have been willing to lower interest rates below zero). The Fed has used two tools when the federal funds rate is at the zero lower bound, quantitative easing and forward guidance. Quantitative easing is a central bank policy of buying long-term securities to affect long-term rates. Forward guidance is statements about how the Fed will conduct monetary policy in the future, often designed to influence long-term interest rates.

2.4

The federal funds rate is generally the lowest lending rate in the economy. The Aaa and Baa bond rates move together but are higher than the federal funds rate. A decrease in the federal funds rate will generally decrease the Aaa and Baa bond rates, so the federal funds rate essentially pulls the bond rates up or down. Other factors, such as risk, can also change the bond rates.

2.5

An increase in the federal funds rate decreases the quantity of reserves demanded because borrowing becomes more costly. The demand for reserves is horizontal at the interest rate on excess reserves (IOER).

2.6

The supply of reserves is determined by the Fed supplying nonborrowed reserves through open market operations and borrowed reserves in the form of discount loans. The discount rate sets a ceiling on the federal funds rate, causing the supply curve for reserves to become horizontal.

Banks would not borrow at the federal funds rate if it is higher than the discount rate.

Problems and Applications 2.7

a. The federal funds rate would be likely to hit zero. b. The Fed was not powerless to act when the federal funds rate hit the zero lower bound. The Fed was able to use its new tools, such as quantitative easing and forward guidance.

2.8

This statement is an example of the FOMC using forward guidance to direct expectations about future monetary policy.

2.9

a. A decrease in the required reserve ratio will decrease the demand for reserves because banks would need to hold fewer reserves. The demand curve will shift to the left, from D1 to D2.

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b. A decrease in the discount rate from id1 to id2 would lower the interest rate at which the supply curve for reserves becomes horizontal. As shown on the following graph, the horizontal section of the supply curve shifts down, from S1 to S2.

c.

A decrease in the interest rate paid on reserves from iIOER1 to iIOER2 would lower the interest rate at which the demand curve becomes horizontal. As shown on the following graph, the horizontal section of the demand curve shifts down, from D1 to D2.

d. An open market sale of government securities would decrease the supply of reserves, shifting the supply curve to the left, from S1 to S2.

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∗ The following graph on the left shows that to lower its target for the federal funds rate, from 𝑖𝑖𝑓𝑓𝑓𝑓1 ∗ , the Fed can conduct an open market purchase of securities. The open market purchase to 𝑖𝑖𝑓𝑓𝑓𝑓2 shifts the supply curve for reserves to the right, from S1 to S2. In the graph, we assume that in addition to lowering its target for the federal funds rate, the Fed reduces the discount rate, from id1 to id2. As a result, the horizontal section of the supply curve for reserves shifts down. ∗ ∗ The graph on the right shows that to raise its target for the federal funds rate, from 𝑖𝑖𝑓𝑓𝑓𝑓1 to 𝑖𝑖𝑓𝑓𝑓𝑓2 , the Fed can conduct an open market sale of securities. The open market sale shifts the supply curve for reserves to the left, from S1 to S2. In the graph, we assume that in addition to increasing its target for the federal funds rate, the Fed increases the discount rate, from id1 to id2. As a result, the horizontal section of the supply curve for reserves shifts up. The answers do depend on reserves being scarce. If reserves are not scarce, the Fed would have to use its two new tools of monetary policy—the interest rate on reserve balances and the interest rate on reverse repurchase agreements—to change the federal funds rate.

2.11 a. To raise the federal funds rate, the Fed would sell securities, which shifts the supply curve for reserves to the left, from S1 to S2. The equilibrium federal funds rate rises from 2.00% to 2.25%.

At the same time, the Fed raises the discount rate from 2.50% to 2.75%, as shown by the horizontal section of the supply curve shifting up.

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Banks’ increased demand for reserves shifts the demand curve to the right, from D1 to D2. To offset the effect of the increase in demand on the equilibrium federal funds rate, the Fed would engage in an open market purchase of securities. The open market purchase shifts the supply ∗ curve to the right, from S1 to S2, leaving the equilibrium federal funds rate unchanged at 𝑖𝑖𝑓𝑓𝑓𝑓 .

c. A decrease in the required reserve ratio would shift the demand for reserves, from D1 to D2. To offset the effect of the decrease in demand on the federal funds rate, the Fed would engage in an open market sale of securities. The open market sale shifts the supply curve to the left, from S1 to ∗ .

S2, leaving the equilibrium federal funds rate unchanged at 𝑖𝑖𝑓𝑓𝑓𝑓

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2.12 a. See the following graph.

b. To raise the target for the federal funds rate, the Fed conducted an open market sale of securities.

As shown in the above graph, the sale shifted the supply curve for reserves to the left, from S1 to S2, which increased the equilibrium federal funds rate from 4.00% to 4.25%. The increase in the discount rate from 5.00% to 5.25% is shown by the shifting up of the horizontal section of the supply curve. c. With banks holding large amounts of excess reserves, the Fed could not raise the federal funds rate with an open market sale of securities. Instead, the Fed would raise the federal funds rate by raising the interest rate it paid on bank reserves and the interest it offered on overnight reverse repurchase agreements.

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2.13 a. See the following graph.

b.

To lower the target for the federal funds rate, the Fed conducted an open market purchase of Treasury securities. As shown on the graph in part (a.), the purchase shifted the supply curve for reserves to the right, from S1 to S2, which decreased the equilibrium federal funds rate from 4.25% to 3.50%. The decrease in the discount rate from 4.75% to 4.00% is shown by the shifting down of the horizontal section of the supply curve.

c. With banks holding large amounts of excess reserves, the Fed could not lower the federal funds rate with an open market purchase of securities. Instead, the Fed would lower the federal funds rate by lowering the interest rate it paid on bank reserves and the interest rate it offered on overnight reverse repurchase agreements.

15.3 The Fed’s Monetary Policy Tools and Its New Approach to Managing the Federal Funds Rate Learning objective: Trace how the Fed has changed its use of monetary policy tools over time.

Review Questions 3.1

An open market operation refers to the Fed buying or selling Treasury securities on the open market. The Fed engages in open market operations to influence the federal funds rate. For example, an open market sale of Treasury securities decreases the quantity of reserves available, so the federal funds rate will increase.

3.2

The three categories of discount loans are primary credit, secondary credit, and seasonal credit.

Primary credit refers to discount loans available to healthy banks that have adequate capital and supervisory ratings experiencing temporary liquidity problems. Secondary credit refers to discount loans to banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings. Seasonal credit refers to discount loans to smaller banks to satisfy seasonal

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requirements in geographic areas where agriculture or tourism is important. During the financial crisis of 2007–2009, the Fed’s discount lending expanded to include: (1) temporary lending facilities that made loans to primary dealers (investment banks and large securities firms); (2) financial firms with mortgage-backed securities; (3) nonfinancial corporations that issue commercial paper; and (4) investors who purchase asset-backed securities.

3.3

During the 2007–2009 financial crisis, the Fed expanded its discount lending so that it could lend to a number of types of financial institutions (largely shadow banks) that it does not typically lend to. Depository institutions, such as commercial banks and savings and loans, and financial institutions, such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, are eligible to borrow and lend in the federal funds market. With the new lending facilities, the Fed could now lend to investment banks and nonfinancial firms, that were previously not able to borrow from the Fed.

3.4

Liquidity facilities: Central Bank Liquidity Swap Lines, Municipal Liquidity Facility, Paycheck Protection Program Liquidity Facility, and Money Market Mutual Fund Liquidity Facility Credit facilities: Primary Dealer Credit Facility, Commercial Paper Funding Facility, Money Market Mutual Fund Credit Facility, Primary Market Corporate Credit Facility, Secondary Market Corporate Credit Facility, Term Asset-Backed Securities Loan Facility, Main Street New Loan Facility, and Main Street Expanded Loan Facility

3.5

The Fed now uses the interest rate on excess reserves (IOER) and the overnight reverse repurchase rate (ON RRP) to manage the target range for the federal funds rate. The IOER serves as a ceiling for the federal funds rate, as it is the rate that the Fed pays banks for reserve deposits, and the ON RRP serves as a floor for the federal funds rate, as it is the rate that the Fed offers on borrowing overnight. Raising both rates will result in a rise in the target rate and the federal funds rate.

Problems and Applications 3.6

a. “General credit conditions in the country” mean the availability of loans and the interest rates on those loans. b. The Fed’s purchases of Treasury securities increase bank reserves, giving banks more funds (reserves) with which to make loans.

3.7

a. Agency residential and commercial mortgage-backed securities are securities issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed purchased these securities as part of its quantitative easing program, and it did so in part to help stabilize the markets for these securities and the banks and other financial firms that hold them.

Stabilizing the mortgage market makes it easier for banks to grant the loans that people need to buy houses. b. Smooth market functioning means that sellers of these securities can find buyers and can, therefore, continue to fund their operations. Monetary policy is transmitted to the broader economy through a variety of channels, but particularly through interest rates. If markets do not function smoothly, that interest rate signal can be lost. c. A repurchase agreement is a form of short-term borrowing in which the seller supplies securities, usually overnight and agrees to buy them back the next day. The Fed was engaging in repurchase operations to ensure that financial firms had access to short-term funding and could therefore continue to provide short-term credit nonfinancial firms.

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3.8

Agree. Because reserves are no longer scarce, small changes in reserves have little or no effect on the FFR.

3.9

a. The IOER is the interest rate that is paid on excess reserves that banks hold at the Fed. The ON RPP is the interest rate that the Fed pays on overnight repurchase agreements. b. Only commercial banks, which can hold reserves at the Fed, are eligible to receive the IOER. Many other types of firms, including government-sponsored enterprises like Fannie Mae and Freddie Mac, and investment firms, including mutual fund companies, can borrow and lend in the overnight market, and so they can participate in ON RPP transactions but cannot receive the IOER. c. The IOER does not act as a floor for the effective federal funds rate because not all firms that participate in the overnight market can receive that rate. Therefore, they may make loans in the federal funds market at interest rates that are lower than the IOER. However, with the ability to lend to the Fed at the interest rate offered on reverse repurchase agreements, the over 80 financial institutions that participate in reverse repurchase agreements with the Fed would be unlikely to lend in the federal funds market at a lower interest rate, and so the ON RRP acts as a floor for the federal funds rate.

3.10 a. By saying that “reserves were no longer relatively scarce,” Fed Chair Yellen meant that the level of bank reserves was so large that banks had little need to borrow reserves from other banks. b. To raise the federal funds rate, the Fed typically conducted an open market sale of Treasury securities. With over $2 trillion dollars of excess reserves, to raise the federal funds rate the Fed would need to conduct a massive open market sale of government securities to reduce reserves by several trillion dollars, which would disrupt the financial system.

3.11

The federal funds rate is typically lower than the interest rate the Fed pays banks on reserves because of financial institutions such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, that can borrow and lend in the federal funds market, but are not eligible to receive interest on their deposits with the Fed. If banks were the only borrowers and lenders in the federal funds market, then the actual federal funds rate could not drop below the interest rate the Fed pays on reserve deposits because banks could borrow in the federal funds market and turn around and deposit the funds in their reserve balances at the Fed and earn a risk-free return. Competition among banks to obtain the funds through the federal funds market would drive the federal funds rate up to the interest rate the Fed pays on reserves. (This argument ignores the fact that the actual federal funds rate may be below the interest rate on excess reserves because banks incur costs for the funds they obtain and deposit at the Fed.) The financial institutions that participate in the federal funds market but that do not receive interest of their deposits at the Fed prevent the Fed from setting the interest rate it pays on reserves to equal the actual federal funds rate.

3.12 a. The interest rate the Fed pays on bank reserves sets the top of the Fed’s target range because banks would rarely lend in the federal funds market at a lower interest rate than they could receive on reserve deposits with the Fed. The interest rate the Fed pays on reverse repurchase agreements sets the bottom of the Fed’s target range because financial institutions would rarely lend in the federal funds market at a lower interest rate than they could receive from a loan to the Fed. In order to lower the target for the fed funds rate, the Fed would have to decrease both of the interest rates. b. In the following graph, the actual federal funds rate will usually be between the interest rate the Fed pays on excess reserves, iIOER, and the interest rate the Fed offers on reverse repurchase agreements, iONRRP.

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15.4 Monetary Targeting and Monetary Policy Learning objective: Explain the role of monetary targeting in monetary policy.

Review Questions 4.1

The Fed can face a trade-off between price stability and high employment (or high economic growth). For example, in attempting to achieve high employment and high economic growth, the Fed needs to pursue an expansionary monetary policy, but this same policy could cause higher inflation.

4.2

The two timing difficulties the Fed faces in using its monetary policy tools are the information lag and the impact lag. The information lag is the Fed’s inability to instantaneously observe changes in economic variables such as GDP and the inflation rate. The impact lag is the time required for monetary policy changes to affect output, employment, or inflation.

4.3

Policy tools (Fed has most influence) Policy instruments Intermediate targets Policy goals (Fed has least influence)

4.4

The Taylor rule is a monetary policy guideline that economist John Taylor developed to help analyze how the Fed chooses the target for the federal funds rate. The Taylor rule serves as a summary measure of Fed policy and can be compared to the Fed’s actual target for the federal funds rate to assess whether Fed policy is more expansionary or more contractionary than is indicated by economic conditions. The Taylor rule and the actual federal funds rate have largely moved together closely, although the Taylor rule suggested that the federal funds rate should have been negative at some points. In the period from 2009 until 2016, the federal funds rate was essentially zero, so the Taylor rule did not track the federal funds rate well. Since 2016, the Taylor rule guideline and the federal funds rate target have generally moved together although the interest rate implied by the Taylor rule has often been higher than the federal funds rate.

4.6

The Bank of Japan and the European Central Bank have set at a negative level the interest rate they pay banks on deposits. The negative interest rates are intended to stimulate economic growth and raise the inflation from very low levels by pushing banks to lend out their reserves

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rather than leave them on deposit. The Bank of Japan also wanted lower interest rates to reduce the foreign exchange value of the yen.

Problems and Applications 4.7 a. b. c. d. e. f. g. h. i. j.

4.8

M2: intermediate target Monetary base: intermediate target Unemployment rate: goal Open market purchases: monetary policy tool Federal funds rate: operating target Nonborrowed reserves: operating target M1: intermediate target Real GDP: goal Discount rate: monetary policy tool Inflation rate: goal If the Fed uses the federal funds rate as a policy instrument, then increases in the demand for reserves will lead to an increase in the level of reserves. In the following graph, this result is shown by the supply curve shifting to the right from S1 to S2 as the demand curve shifts to the ∗ . right, from D1 to D2, while the target for the federal funds rate remains unchanged at 𝑖𝑖𝑓𝑓𝑓𝑓1

Conversely, if the Fed uses the level of reserves as a policy instrument, then in the following graph the Fed will keep the supply of reserves constant at S1 when the demand curve shifts to the ∗ ∗ to 𝑖𝑖𝑓𝑓𝑓𝑓2 . right, from D1 to D2. As a result, the equilibrium federal funds rate increases from 𝑖𝑖𝑓𝑓𝑓𝑓1

4.9

The following legislative changes and financial innovations occurred after 1979: 1. Congress authorized NOW (negotiable order of withdrawal) accounts on which banks can pay interest.

2. Banks introduced two innovations: (a) Automated transfer of saving accounts, which move checkable deposit balances into higher-interest CDs (certificate of deposits) each night and then back into checkable deposit balances in the morning.

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(b) Sweep accounts, which move checkable deposits of businesses into money market deposit accounts at the end of each week and then move the funds back into checkable deposits at the beginning of the following week.

4.10

These changes by Congress and the banks caused M1 to become more of a store of value than a pure medium of exchange. The short-run link between M1 and spending and, therefore, M1 and inflation, broke down.

Solving for the inflation rate using the percentage change (growth rate) form of the equation of exchange gives the following equation: Inflation = % change in M + % Change in V – % change in Y, where M denotes the money supply, V denotes the velocity of money, and Y denotes real GDP. For the June 2008 to June 2012 period, the growth rate in real GDP was approximately 1%. For an inflation rate of 1% with the growth rate in the money supply at 12% and the growth rate in real GDP of 2%, the growth rate in the velocity of money must have been about -9%. Over the June 2012 to June 2016 period, the growth rate in real GDP was approximately 2%. For an inflation rate of 2% with the growth rate in the money supply at 9.5% and the growth rate in real GDP of 2%, the growth rate in the velocity of money must have been –5.5%. Prior to 1980, the link between the growth rate in the money supply and the inflation rate was much tighter, so we would have expected inflation rates higher than 2% given growth rates of the money supply of 9.5% and 12.0%.

4.11 a. Kaplan means that the Fed would allow the inflation rate to rise above its 2% target, “overshooting” the target. A higher inflation rate would mean a lower real interest rate, which is expansionary and therefore beneficial when the economy is in a recession. b. A policy of average-inflation targeting will automatically make monetary policy expansionary during recessions and contractionary during periods of unexpectedly high inflation. If households and firms accept that the Fed is following this policy, then during a recession when the inflation rate falls below the target, they would expect that the Fed would take action to increase the inflation rate. A higher inflation rate would result in a lower real interest rate, which would have an expansionary effect on the economy. Similarly, if the inflation rate were above the target, households and firms would expect future inflation rates to be lower, raising the real interest rate, which would have a contractionary effect on the economy.

4.12

The Taylor rule federal funds rate target = 1% + 2% + 0.5(1% – 2%) + 0.5(−1.9%) = 1.55%. The Taylor rule federal funds rate target exceeds the Fed’s actual target range of 0.25 to 0.50%.

4.13 a. The Federal Open Market Committee (FOMC) kept the federal funds rate at levels well below the levels indicated by the Taylor rule in 2003-2005. b. Low interest rates encouraged subprime borrowers (borrowers with flawed credit histories) and Alt-A borrowers (borrowers who did not document their incomes) to acquire mortgage loans.

Low interest rates may also have attracted speculators who bought properties intending to resell them (or “flip” them) rather than live in them. The increased demand from these buyers helped to push housing prices above their fundamental values. Many of the loans these buyers obtained were adjustable rate mortgages and many borrowers made very small down payments. When interest rates later rose and housing prices began to decline, many of these borrowers defaulted on their mortgages, helping to worsen the housing bust.

4.14

Investors might buy a bond with a negative interest rate for a number of reasons, but primarily because there are not many good alternatives for the safe investment of cash. A bond with a

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negative interest rate might be a better alternative than a more risky bond with a positive interest rate.

4.15

Banks will receive less income from their reserve deposits, and so they will be less profitable if they cannot make up for the lost revenue elsewhere. To some extent, banks can pay negative interest rates to some customers (or charge them fees), but negative interest rates at banks will tend to push household and firms to remove deposits from banks and put them into investments like stocks with higher yields (but greater risk).

Data Exercises D15.1

The answers below apply to the Federal Open Market Committee (FOMC) press release of January 27, 2021. a. The FOMC did not change its target range. b. The FOMC appears to be primarily concerned about slow economic growth but is also concerned that inflation is below the 2% target. c. The Fed did not change either of these rates. d. The Fed did not announce any other monetary policy actions.

D15.2

Over the period, the Fed was able to keep the effective federal funds rate within the target range other than the week of January 1, 2016.

D15.3

The Bank of England’s total assets increased from about £575 billion at the beginning of 2020 to nearly £900 billion at the end of 2020, an increase of about 56%. Over the same period, the Federal Reserve’s balance sheet increased from $4,174 billion to $7,363 by the end of 2020, an increase of about 76%. (Answers will vary slightly based on balance sheet versions.)

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D15.4

The series mentioned in the question has been discontinued. A good substitute is Total Borrowings of Depository Institutions (BORROW). Based on this series, the financial crisis appears to have begun about December 2007 and ended around August 2012. The Covid-19 pandemic began to affect the economy in March 2020.

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Chapter 16 The International Financial System and Monetary Policy 

Brief Chapter Summary and Chapter Objectives

16.1 Foreign Exchange Intervention and the Monetary Base (pages 557–559) Analyze how the Fed’s interventions in foreign exchange markets affect the U.S. monetary base.

• International financial transactions affect the money supply when central banks or governments try to influence the foreign exchange values of their currencies.

• Foreign exchange intervention may be unsterilized or sterilized.

16.2 Foreign Exchange Interventions and the Exchange Rate (pages 559–563) Analyze how the Fed’s interventions in foreign exchange markets affect the exchange rate.

• An unsterilized intervention leads to a decrease in international reserves and in the monetary base and an appreciation of the domestic currency.

• With a sterilized intervention, the monetary base is unaffected and domestic interest rates will not change, leaving the exchange rate unaffected.

• Restrictions on capital inflows receive more support from some economists than do restrictions on capital outflows, in part because such inflows often lead to domestic lending booms and increased risk taking by domestic banks.

16.3 The Balance of Payments (pages 564–566) Describe how the balance of payments is calculated.

• The balance-of-payments account measures all flows of private and government funds between a domestic economy and all foreign countries.

• The current account summarizes purchases and sales of currently produced goods and services between a country and its foreign trading partners.

• The financial account measures trade in existing financial or real assets between a domestic economy and foreign countries.

• Official reserve assets are assets that central banks hold and use in making international payments to settle the balance of payments and to conduct international monetary policy.

16.4 Exchange Rate Regimes and the International Financial System (pages 567–587) Discuss the evolution of exchange rate regimes.

• In the past, most exchange rate regimes were fixed exchange rate systems in which exchange rates were set at levels determined and maintained by governments.

• The present international financial system can be described as a managed float regime in which central banks occasionally intervene to affect foreign exchange values.

• With pegging, a country keeps its exchange rate fixed against another country’s currency.

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Key Terms

Balance-of-payments account, p. 564. A measure of all flows of private and government funds between a domestic economy and all foreign countries.

Bretton Woods system, p. 571. An exchange rate system that lasted from 1945 to 1971, under which countries pledged to buy and sell their currencies at fixed rates against the dollar and the United States pledged to convert dollars into gold if foreign central banks requested it to.

Capital controls, p. 563. Government-imposed limits on foreign investors buying domestic assets or on domestic investors buying foreign assets.

Devaluation, p. 573. The lowering of the official value of a country’s currency relative to other currencies.

Euro, p. 578. The common currency of 19 European countries.

European Central Bank (ECB), p. 579.The central bank of the European countries that have adopted the euro.

European Monetary Union, p. 578. A plan drafted as part of the 1992 single European market initiative, in which exchange rates were fixed and eventually a common currency was adopted.

Exchange rate regime, p. 567. A system for adjusting exchange rates and flows of goods and capital among countries.

Fixed exchange rate system, p. 567. A system in which exchange rates are set at levels determined and maintained by governments.

Flexible exchange rate system, p. 575. A system in which the foreign exchange value of a currency is determined in the foreign exchange market.

Gold standard, p. 567. A fixed exchange rate system under which currencies of participating countries are convertible into an agreed-upon amount of gold.

International Monetary Fund (IMF), p. 571. A multinational organization established in 1944 by the Bretton Woods agreement to administer a system of fixed exchange rates and to serve as a lender of last resort to countries undergoing balance-of-payments problems.

International reserves (or foreign reserves), p.

557. Central bank assets that are denominated in a foreign currency and used in international transactions.

Managed float regime, p. 576. An exchange rate system in which central banks occasionally intervene to affect foreign exchange values; also called a dirty float regime.

Pegging, p. 582. The decision by a country to keep the exchange rate fixed between its currency and another country’s currency.

Policy trilemma, p. 585. The hypothesis that it is impossible for a country to have exchange rate stability, monetary policy independence, and free capital flows at the same time.

Revaluation, p. 573. The raising of the official value of a country’s currency relative to other currencies.

Sterilized foreign exchange intervention, p. 559.

A foreign exchange market intervention in which the central bank offsets the effect of the intervention on the monetary base.

Unsterilized foreign exchange intervention, p.

558. A foreign exchange market intervention in which the central bank does not offset the effect of the intervention on the monetary base.

Foreign exchange market intervention, p. 557.

A deliberate action by a central bank to influence the country’s exchange rate.

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Chapter Outline

A Single Currency for Every Country?

The decision in 2002 by 12 sovereign countries to commit to using the same currency was unprecedented.

By 2020, 19 countries had adopted this currency, the euro. The European Central Bank (ECB) determines monetary policy for these countries. For its first five years, this system worked well as businesses and households benefited from the cost savings from exchanging goods and services without having to exchange currencies. But when the financial crisis of 2007-2009 hit, central banks of the individual countries could not respond by allowing their currencies to depreciate or by expanding their monetary bases. Falling government revenues and increases in government spending increased budget deficits and forced countries to sell bonds. Concerns by investors that some governments might default on payments of interest or principal led the ECB to buy the debt of Spain and Italy. And beginning in 2014 the ECB made the interest rate on bank reserves negative. Although the actions of the ECB helped to stabilize the economies of the weakest countries, some economists and policymakers feared that the euro would not be stable in the long run.

During the Covid-19 pandemic of 2020, the euro faced another potential crisis because the virus had a larger economic effect on southern European countries than on northern European countries. Some policymakers and economists proposed funding economic stimulus efforts by, for the first time, issuing government bonds that all members of the European Union (EU) would be responsible for repaying.

Although there was initial opposition, in July 2020 an agreement was reached to issue €750 billion of these bonds. ECB President Christine Lagarde was able to overcome dissent among ECB member countries to start the Pandemic Emergency Purchase Program (PEPP), under which the ECB purchased €1.35 trillion in government and private bonds, as well as corporate commercial paper in order to keep funds flowing through the European financial system and reassure investors that it was safe to buy the bonds issued by all of the governments in Eurozone countries. The issues the eurozone has encountered illustrate why it is unlikely that a single world currency will ever be adopted.

Teaching Tips Most students are interested in the global economy. At least since the 2007–2009 financial crisis, a discussion of monetary policy seems incomplete without considering international financial linkages. The chapter begins with an analysis of the effects of foreign exchange interventions by central banks and uses the simple demand and supply model of exchange rates developed in Chapter 8 to analyze the effects of sterilized and unsterilized interventions. The chapter includes a brief overview of the balance of payments.

The chapter concludes with an account of the evolution of the international financial system. Many students will be interested in the coverage of the gold standard, including the Apply the Concept on the gold standard during the Great Depression.

16.1 Foreign Exchange Intervention and the Monetary Base (pages 557–559) Learning Objective: Analyze how the Fed’s interventions in foreign exchange markets affect the U.S. monetary base.

International financial transactions affect the domestic money supply when central banks or governments try to influence the foreign exchange values of their currencies. If the Federal Reserve wants the foreign exchange value of the dollar to rise (fall), it can increase the demand (supply) for dollars by selling (buying) foreign assets and by buying (selling) dollars in international currency markets. A purchase of foreign assets by a central bank has the same effect on the monetary base as an open market purchase of government bonds. When a central bank allows the monetary base to respond to the sale or purchase of domestic currency in the foreign exchange market, the transaction

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is called an unsterilized foreign exchange intervention. When a foreign exchange intervention is accompanied by offsetting domestic open market operations that leave the monetary base unchanged, it is called a sterilized foreign exchange intervention.

16.2 Foreign Exchange Interventions and the Exchange Rate (pages 559–563) Learning Objective: Analyze how the Fed’s interventions in foreign exchange markets affect the exchange rate.

A. Unsterilized Intervention If nothing else changes, an unsterilized intervention in which the central bank sells foreign assets in exchange for domestic currency leads to a decrease in international reserves and the monetary base and an appreciation of the domestic currency.

B. Sterilized Intervention With a sterilized foreign exchange intervention, the central bank uses open market operations to offset the effects of the intervention on the monetary base. Because the monetary base is unaffected, domestic interest rates will not change. Therefore, the demand curve and supply curve for domestic currency in exchange for foreign currency will also be unaffected, and the exchange rate will not change.

C. Capital Controls Capital controls are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. Capital controls have significant problems. Restrictions on capital inflows receive more support from some economists than do restrictions on capital outflows, in part because such inflows often lead to domestic lending booms and increased risk taking by domestic banks. Other economists point out that problems caused by capital inflows could be made less severe by improving bank regulation and supervision in emerging-market countries.

16.3 The Balance of Payments (pages 567–587) Learning Objective: Describe how the balance of payments is calculated.

The balance-of-payments account measures all flows of private and government funds between a domestic economy and all foreign countries. Inflows of funds are recorded in the accounts as positive numbers and include: • Payments from foreigners for U.S.-produced goods and services (U.S. exports) • Acquisition of U.S. assets (capital inflows) • Gifts to U.S. citizens (unilateral transfers) Outflows of funds are recorded in the accounts as negative numbers and include: • Payments by U.S. households, firms, and governments for foreign goods and services (imports) • Foreign assets by U.S. households and businesses (capital outflows) • Gifts to foreigners, including foreign aid (unilateral transfers) A. The Current Account The current account summarizes transactions between a country and its foreign trading partners for purchases and sales of currently produced goods and services. In general, a current account surplus or deficit must be balanced by international lending or borrowing or by changes in official reserve transactions.

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Teaching Tips Discussion of a global savings glut can improve student understanding of why the United States tends to run current account deficits as well as the interaction between financial flows and international trade. Have students think through why funds may flow into or out of a country and the effect these flows have on the country’s exchange rate and ultimately on its current account.

B. The Financial Account The financial account measures trade in existing financial or real assets among countries. When someone in a country sells (buys) an asset to (from) a foreign investor, the transaction is recorded in the balance-of payments accounts as a capital inflow (outflow) because funds flow into (out of) the country to buy the asset. The financial account balance is the amount of capital inflows minus capital outflows—plus the net value of capital account transactions, which consist mainly of debt forgiveness and transfers of financial assets by migrants when they enter the country.

C. Official Settlements Changes in asset holdings by governments and central banks supplement private capital flows.

Official reserve assets are assets that central banks hold and use in making international payments to settle the balance of payments and to conduct international monetary policy. The official settlements balance is sometimes called the balance-of-payments surplus or deficit (when considering the balance of payments as only the sum of the current and financial accounts).

D. The Relationship Among the Accounts In principle, the current account balance and financial account balance sum to zero. In reality, measurement problems keep this relationship from holding exactly.

16.4 Exchange Rate Regimes and the International Financial System (pages 553–573) Learning Objective: Discuss the evolution of exchange rate regimes.

A. Fixed Exchange Rates and the Gold Standard In the past, most exchange rate regimes were fixed exchange rate systems, in which exchange rates were set at levels that were determined and maintained by governments. Under a gold standard, currencies of participating countries are convertible into an agreed-upon amount of gold. The gold standard had an automatic mechanism, called the price-specie-flow mechanism that caused exchange rates to reflect the underlying gold content of countries’ currencies. One problem with the economic adjustment process under the gold standard was that countries with trade deficits and gold outflows experienced declines in price levels, or deflation. Another consequence of fixed exchange rates under the gold standard was that countries had little control over their domestic monetary policies. The gold standard finally collapsed in the 1930s, during the Great Depression.

Teaching Tips The Apply the Concept,“Did the Gold Standard Make the Depression Worse?” points out that during the Great Depression countries that abandoned the gold standard earlier experienced less severe economic contractions. Discussing this topic can help students understand the role that monetary policy can play in stimulating or hindering an economy during difficult economic times. The Fed’s efforts to defend the value of the dollar by maintaining the gold standard appear to have deepened the Great Depression. You can draw parallels to the state of the economy during and following the 2007–2009 financial crisis regarding the desirability of maintaining a strong currency when the domestic economy is weak. You may be able to base another interesting classroom discussion around whether the United States should consider returning to a gold standard.

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B. Adapting Fixed Exchange Rates: The Bretton Woods System Despite the gold standard’s demise, many countries remained interested in the concept of fixed exchange rates. Under the Bretton Woods system, which was established in 1944, the United States agreed to convert U.S. dollars into gold at a price of $35 per ounce—but only in dealing with foreign central banks. The central banks of all other members of the system pledged to buy and sell their currencies at fixed rates against the dollar. Under this system, exchange rates were supposed to adjust only when a country experienced fundamental disequilibrium—that is, persistent deficits or surpluses in its balance of payments at the fixed exchange rate. In principle, the International Monetary Fund (IMF) was to administer the Bretton Woods system and to be a lender of last resort to ensure that short-term economic dislocations did not undermine the stability of the exchange rate system. In practice, the IMF—which survived the demise of the Bretton Woods system—also encourages domestic economic policies that are consistent with exchange rate stability and gathers and standardizes international economic and financial data to use in monitoring member countries. There is some controversy among policymakers regarding the role and actions of the IMF. Under the Bretton Woods system, a country could defend its exchange rate by buying or selling reserves or changing domestic economic policies, or it could petition the IMF to be allowed to change its exchange rate. When investors came to believe that a government was unable or unwilling to maintain its exchange rate, they attempted to profit by selling a weak currency or buying a strong currency. These actions, known as speculative attacks, could force a devaluation or revaluation of the currency. The system eventually collapsed because the lack of U.S. commitment to price stability and the reluctance of other countries to revalue their currencies against the dollar led to strong market pressures on fixed exchange rates.

C. Central Bank Interventions After Bretton Woods Though the United States and many other countries officially follow a flexible exchange rate system, the present international financial system can be described as a managed float regime, in which central banks occasionally intervene to affect foreign exchange values. A central bank often must decide between actions to achieve its goal for the domestic monetary base and interest rates and actions to achieve its goal for the exchange rate. Because of the traditional role of the dollar as an international reserve currency, U.S. monetary policy hasn’t been severely hampered by foreign exchange market transactions.

D. Fixed Exchange Rates in Europe One benefit of fixed exchange rates is that they reduce the costs of uncertainty about exchange rates in international commercial and financial transactions. The countries that were members of the European Economic Community formed the European Monetary System in 1979. Eight European countries also agreed at that time to participate in an exchange rate mechanism (ERM) to limit fluctuations in the values of their currencies against each other. As part of the 1992 single European market initiative, European Community (EC) countries drafted plans for the European Monetary Union, in which exchange rates would be fixed by using a common currency, the euro. The European Central Bank (ECB), the common central bank for countries that use the euro, commenced operation in January 1999 and is structured along the lines of the Federal Reserve System. In 2020, despite being battered by the sovereign debt crisis, it appeared likely that the euro would survive.

E. Currency Pegging With pegging, a country keeps its exchange rate fixed against another country’s currency.

Countries peg their currencies to gain the following three advantages of a fixed exchange rate: a reduced exchange rate risk, a check against inflation, and protection for firms that have taken out loans in foreign currencies. A currency’s equilibrium exchange rate, as determined by demand and supply, may be significantly different from the pegged exchange rate. The result is that the pegged currency may become overvalued or undervalued against the dollar. Despite the drawbacks to pegging, many developing countries peg their currencies against the dollar or euro.

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F. Does China Manipulate its Exchange Rate?

In 2016, both the Democratic and Republican nominees for president accused the Chinese government of manipulating its exchange rate against the dollar. Pegging the yuan against the dollar ensured that Chinese exporters would face stable dollar prices for the goods they sold in the United States. By the early 2000s, many economists argued that the yuan was undervalued against the dollar. In July 2005, the Chinese government announced that it would switch from pegging the yuan against the dollar to linking the value of the yuan to the average value of a basket of currencies, a policy abandoned temporarily during the financial crisis. The value of the yuan gradually increased from 2005 to 2014. In 2015, the People’s Bank of China announced that it would buy dollars to reduce the yuan’s value in order to increase China’s economic growth rate. Despite the accusations that the Chinese government had manipulated the value of its currency, most economists were skeptical that the value of the yuan was being kept artificially low.

G. The Policy Trilemma A country cannot achieve all of the following goals: exchange rate stability, monetary policy independence, and free capital flows. It is possible to achieve at most two of these goals at the same time. This is referred to as the policy trilemma.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 16.1 Foreign Exchange Intervention and the Monetary Base Learning objective: Analyze how the Fed’s interventions in foreign exchange markets affect the U.S. monetary base.

Review Questions 1.1

A foreign exchange market intervention is a deliberate action by the central bank to influence the country’s exchange rate. A country’s international reserves are central bank assets that are denominated in a foreign currency and used in international transactions.

1.2

Assuming no sterilization, the Fed’s holdings of international reserves decrease by $2 billion and the monetary base decreases by $2 billion.

Federal Reserve Assets Foreign assets −$2 billion (international reserves)

Liabilities Bank reserves at the Fed −$2 billion

1.3

The purchases have the same effect on the monetary base. In either case, the Fed acquires an asset and increases bank reserves or currency in circulation by an equivalent amount.

1.4

With a sterilized foreign exchange intervention, the central bank offsets the effect of the foreign exchange intervention on the monetary base. With an unsterilized foreign exchange intervention, the central bank does not offset the effect on the monetary base. So, the effect of a sterilized intervention is significantly less.

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Problems and Applications 1.5

a. To weaken the currency, the central bank would buy foreign assets, which increases its balance sheet. b. A successful intervention would weaken the dollar, so it would take more dollars to buy one unit of foreign currency, or fewer units of foreign currency to buy a dollar. c. If the value of the currency is reduced, the price of the country’s exports in other countries will be lower in terms of those countries’ currencies.

1.6

a. A sterilized intervention refers to a foreign exchange intervention where the central bank offsets the effect of the intervention on the monetary base. b. If the Fed purchased foreign assets, it would also sell U.S. Treasury securities, or if the Fed sold foreign assets it would also buy U.S. Treasury securities. c. A sterilized intervention will not have any effect on the value of the dollar because a sterilized intervention will not change domestic interest rates.

1.7

The Fed’s international reserves decrease by $5 billion, and the monetary base decreases by $5 billion. The T-account below assumes that the purchasers of the foreign assets sold by the Fed pay with checks drawn on U.S. banks, causing bank reserves at the Fed to fall by $5 billion.

Alternatively, if the Fed purchases U.S. dollars with the proceeds from its sale of foreign assets, currency in circulation would fall by $5 billion. This is an unsterilized intervention because the Fed takes no action to offset the effect of the foreign exchange intervention on the monetary base.

Federal Reserve Assets Foreign assets −$5 billion (international reserves)

1.8

Liabilities Bank reserves at the Fed −$5 billion

The monetary base does not change. The following T-account assumes that the Fed’s purchase of foreign assets and sale of Treasury securities affects bank reserves. Alternatively, the two could affect currency in circulation with the same effect on the monetary base. This is a sterilized intervention because the Fed takes action to offset the effect of the foreign exchange intervention on the monetary base.

Federal Reserve Assets

1.9

Liabilities

Foreign Assets +$2 billion (international reserves)

Bank reserves +$2 billion

Treasury securities −$2 billion

Bank reserves −$2 billion

a. The monetary base increases by $10 billion because bank reserves or currency in circulation will increase by $10 billion. b. The monetary base does not change because the effects of the two actions on the monetary base offset. c. The monetary base does not change because sterilized foreign exchange interventions do not affect the monetary base. d. The monetary base decreases by $20 billion because bank reserves or currency in circulation will fall by $20 billion.

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16.2 Foreign Exchange Interventions and the Exchange Rate Learning objective: Analyze how the Fed’s interventions in foreign exchange markets affect the exchange rate.

Review Questions 2.1

To raise the foreign exchange rate, the central bank would sell foreign assets, which would reduce the monetary base and raise domestic interest rates.

2.2

A sterilized central bank intervention does not affect the demand curve or the supply curve for a country’s currency because domestic interest rates do not change.

2.3

Capital controls are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. Countries may impose capital controls because currency crises are fueled in part by sharp inflows and outflows of financial investments. The disadvantages of imposing capital controls are: 1. They can lead to corruption with government officials demanding bribes to exchange domestic currency for foreign currency.

2. Multinational firms may be reluctant to build factories and other facilities in countries with capital controls because the firms will have difficulty returning any profits they earn to their home countries if they can’t exchange domestic currency for foreign currency.

3. Individuals and firms can evade the capital controls through currency black markets.

Problems and Applications 2.4

On the foreign exchange market, foreign investors demand U.S. dollars. An increase in U.S. interest rates relative to Japanese interest rates increases the demand for dollars because foreign investors typically wish to purchase U.S. financial assets rather than just holding U.S. currency.

2.5

The sale of $5 billion of U.S. Treasury securities by the Bank of Japan will raise interest rates in Japan by reducing the monetary base. The higher Japanese interest rates will increase the demand for yen and decrease the supply of yen, pushing up the exchange value of the yen. In the following graph, the demand curve for yen shifts to the right, from D1 to D2, and the supply curve for yen shifts to the left, from S1 to S2. As a result, the equilibrium exchange rate increases from EX1 to EX2.

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a. The yen reaching an 11-year high means that it would take more dollars to buy the same amount of yen. b. The Bank of Japan could sell yen and buy dollars (buy dollar-denominated assets). The sale of yen increases the supply of yen, reducing the number of dollars required to buy yen. The Japanese monetary base increases, which decreases Japanese interest rates. In the following graph, the decrease in interest rates would decrease the demand for Japanese yen, demand curve to shift to the left, from D1 to D2. The supply of Japanese yen increases, causing the supply curve to shift to the right, from S1 to S2. The result is a decrease in the exchange value of the yen relative to the dollar, with the exchange rate declining from EX1 to EX2.

c. The exchange rate determines the price of imports in the domestic currency and the price of exports in foreign currencies. A weakening of the yen will therefore reduce the price of Japanese exports in the United States and the yen price of Japanese imports from the United States will increase. These effects benefits Japan exporters and hurt U.S. exporters. The Bank of Japan might be concerned about a strengthening yen, but the United States would not favor efforts to weaken the yen.

2.7

a. Because this debt is denominated in foreign currencies (often dollars), a weakening of the Turkish lira would mean that it is more expensive to make payments on this debt. The payment on the debt does not change in dollar terms, but it will now take more lira to buy the same amount of dollars. b. The central bank of Turkey would need to sell dollars (or other foreign currencies) and buy lira, which would increase the value of lira and weaken the dollar. Because the central bank of Turkey must use its holding of dollars (or other currencies) to do this, it will deplete its foreign exchange reserves. c. Capital controls are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. In this case, capital controls might be imposed to prevent domestic investors from buying foreign assets. Capital controls reduce the demand for foreign currencies and therefore increase or stabilize the value of the Turkish lira.

Large capital outflows often occur in response to economies experiencing rapid inflation, currency depreciation or expected devaluation, and recessions. While capital controls can prevent or mitigate these capital flows, there are downsides: (1) increased corruption; (2) multinational firms hesitating to locate in the countries; and (3) black markets developing for currencies.

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16.3 The Balance of Payments Learning objective: Describe how the balance of payments is calculated.

Review Questions 3.1

The current account records transactions of currently produced goods and services, and the financial account records transactions of existing financial or real assets. If a country runs a current account deficit, the value of its exports of goods and services are likely to be smaller than the value of its imports of goods and services.

3.2

Each international transaction represents an exchange of goods, services, or assets among households, businesses, or governments. The two sides of the exchange must always balance.

Suppose the United States runs a current account deficit of $500 billion, meaning that it spent $500 billion more on foreign currently produced goods and services than it received. Every dollar of the $500 billion was used by foreign individuals, firms, or governments to invest in the United States or was added to foreign holding of dollars. There is nowhere else for the dollars to go—they must have been spent on investments in the United States or not spent at all. Dollars that aren’t spent are added to foreign holdings of dollars and included in official reserve transactions. Therefore, a current account deficit must be exactly offset by a financial account surplus.

Similarly, a country that runs a current account surplus must run a financial account deficit of exactly the same amount and, in either case, the balance of payments must equal zero.

In reality, there is often a difference between these accounts, which are called the statistical discrepancy. Economists believe that the statistical discrepancy results from hidden capital flows due to illegal activities or capital flight. The official settlements balance reflects changes in the reserve assets of central banks. When the official settlements balance is excluded from the financial account, a country can either: (1) Run a balance-of-payments surplus, where the country gains international reserves or (2) Run a balance-of-payments deficit, where the country loses international reserves

3.3

Official reserve assets are assets that central banks hold and that they use to make international payments to settle the balance of payments and to conduct international monetary policy.

Problems and Applications 3.4

The financial account balance would be a surplus of $400 billion and would represent a net capital inflow.

3.5

The purchase of the 10 Volkswagen autos would be recorded in the current account as a $300,000 payment to foreigners, which is recorded as a negative number. The purchase of the U.S. Treasury bond would be recorded in the financial account as a $300,000 receipt from foreigners, which is recorded as a positive number.

3.6

The transaction is recorded in the financial account as a $300 million increase in U.S. international reserves.

3.7

a. U.S. exports of services and imports of manufactured goods would appear in the current account. b. The United States can have a balance of payments deficit if the official settlements balance is excluded from the financial account. If the current account balance is less (in absolute value) than the financial account balance, excluding the official settlements balance, then there is a balance of payments deficit, and the United States is losing international reserves.

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a. Capital flight refers to financial capital leaving the country, usually due to political or other perceived risks. b. If there are capital controls, it may not be legal for financial capital to leave the county. In this case, firms and individuals may resort to illegal measures and black markets to exchange currencies and take capital out of the country. These activities are not recorded officially and become part of the statistical discrepancy in the balance-of-payments account.

16.4 Exchange Rate Regimes and the International Financial System Learning objective: Discuss the evolution of exchange rate regimes.

Review Questions 4.1

An exchange rate regime is a system for adjusting exchange rates and flows of capital between countries.

4.2

The gold standard was a fixed exchange rate system under which currencies of participating countries were convertible into an agreed-upon amount of gold. The exchange rates between any two countries’ currencies were fixed by their relative gold weights. For example, if $1 could be exchanged for 1/20 of an ounce of gold, while one French franc (FF1) could be exchanged for 1/80 of an ounce of gold, the exchange rate would be $1 = FF4. Gold served as international reserves. Trade deficits lead to gold outflows and a decrease in the money supply, and trade surpluses lead to gold inflows and an increase in the money supply. The Bretton Woods system of fixed exchange rates was not as tied to gold and had more flexibility. The United States agreed to convert U.S. dollars into gold at a price of $35 per ounce, but only in dealing with foreign central banks. Unlike the gold standard, countries were not willing to redeem their domestic currencies for gold. The money supply of a country was not determined by the quantity of gold it held. Exchange rates could fluctuate within a small range. As with any fixed exchange rate system, countries were not free to pursue independent monetary policy. The U.S. dollar served as the primary reserve currency.

4.3

a. The gold standard was a fixed exchange rate system with exchange rates determined by the relative amounts of gold in different currencies. b. Countries were not able to pursue active monetary policies because gold flows caused changes in the country’s monetary base. c. Countries that ran trade deficits experienced gold outflows because they were importing more than they were exporting. To pay for the difference between their imports and their exports, gold had to flow to other countries. d. A gold inflow would increase a country’s monetary base and its inflation rate. e. During the Great Depression, countries under the gold standard had difficulty pursuing expansionary monetary policy. To remain on the gold standard, some countries had to pursue contractionary monetary policies.

4.4

Devaluations and revaluations refer to the lowering (devaluation) and raising (revaluation) of a country’s official fixed exchange rate. A depreciation refers to a drop in the value of a currency in a flexible exchange rate system, whereas a devaluation refers to a drop in the official fixed exchange rate in a fixed exchange rate system. Under the Bretton Woods system, countries were hesitant to pursue a devaluation because the governments faced political charges that their monetary policies were flawed. Devaluations also increased the domestic currency price of imports, potentially increasing the domestic inflation rate. Countries were even more hesitant to pursue a revaluation because it made domestic goods and services less competitive in world markets and therefore would reduce exports.

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4.5

The eurozone refers to the European countries that use the euro as a common currency. Using a single currency eliminates the transactions costs of currency conversions and exchange rate risk for firms and investors in commercial and financial dealings among the countries in the euro zone. The removal of transactions costs in cross-border trades increases efficiency in production by offering the advantages of economies of scale. When a country’s economic conditions are worse than the euro zone as a whole, using a single currency prevents that country from pursuing an independent monetary policy. In particular, a country cannot benefit from an increase in exports that would result if its currency depreciated.

4.6

Pegging is the decision by a country to keep the exchange rate fixed between its currency and another country’s currency. Countries peg their currencies to gain the following three advantages of a fixed exchange rate: (1) reduced exchange-rate risk; (2) a check against inflation; (3) and protection for firms that have taken out loans in foreign currencies. A peg can run into problems when the pegged currency becomes overvalued or undervalued and then being subject to speculative attacks. The controversy with China’s pegging of the value of the yuan is that it was undervalued, making Chinese exports cheaper and imports into China more expensive.

4.7

The policy trilemma is the hypothesis that it is impossible for a country to have exchange rate stability, monetary policy independence, and free capital flows at the same time. U.S. policymakers choose to have monetary policy independence and free capital flows; therefore, they choose to allow fluctuations in the exchange rate.

Problems and Applications 4.8

Under a gold standard, inflation is possible from: (1) a trade surplus that leads to a gold inflow, which increases the domestic monetary base and leads to inflation, and (2) gold discoveries that increase the world money supply and lead to inflation across countries.

4.9

a. Under a gold standard, currency must be completely backed by gold reserves. Without an increase in gold reserves, the central bank cannot print more money. b. The United States has an independent central bank with a mandate that included price stability.

This implies that the central bank is unlikely to print more money than is consistent with this mandate.

4.10

Leaving the gold standard in the 1930s led to an increase in a country’s output and employment for two reasons. First, the country’s central bank would be free to pursue an expansionary monetary policy and would no longer have to take actions, such as raising interest rates, to remain on the gold standard that might lead to contractions in production and employment.

Second, the decline in the country’s exchange rate would spur its exports.

4.11

The United States left the gold standard in 1933 when the federal government announced that it was no longer willing to exchange domestic currency for gold. When the United States joined the Bretton Woods system, it did not return to the gold standard because the Bretton Woods system did not require countries to redeem their currencies for gold. Under Bretton Woods, the United States agreed to convert U.S. dollars into gold at a price of $35 per ounce only in dealing with foreign central banks.

4.12 a. Speculators would win by selling the currency at the current exchange rate and buying it back at a lower exchange rate after the devaluation, as speculators did in 1967 with the overvalued British pound.

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b. If the country did not devalue, the investors could buy the currency back at the same exchange rate in which they bought the currency. Their only loses would be transactions costs and the opportunity costs of the funds. c. The same reasoning applies to any fixed exchange rate system. When a currency in a fixed exchange rate system experiences a fundamental disequilibrium and becomes clearly overvalued (undervalued), investors will win if the country devalues (revalues), while not losing if it doesn’t devalue (revalue).

4.13 a. The U.S. dollar is the world’s reserve currency since the majority of international reserves are held in dollars. While the dollar is the dominant reserve currency, it is likely that the yen, the euro, and the yuan will become increasingly important as reserve currencies. b. Because many international debts are denominated in dollars, the cost of repaying the debt changes as the value of the dollar changes relative to the value of local currencies. These fluctuations in the exchange rate add additional risk to borrowing funds internationally, as the cost of repayment can change. c. Because of the dollar’s role as a reserve currency, the demand for the dollar is higher than it otherwise would be. That high demand increases the foreign exchange value of the dollar, which raises the domestic currency price of U.S. exports. Countries that import substantial quantities of goods and services from the United States may experience inflation because the prices of imports are included in an importing country’s price level.

4.14

The differential effects of the coronavirus in different countries means that greater amounts of support are likely to be required for some countries than for others. It also makes it difficult for the European Central Bank (ECB) to set a level of interest rates (and related monetary policies) that is suitable for all of the eurozone countries. Countries like Italy that have been hard-hit by the pandemic must issue more government debt to pay for pandemic programs, and without ECB support, this additional debt could increase borrowing costs for Italy to an unsustainable level.

At the same time, issuing substantial amounts of new debt may make investors more reluctant to buy Italian debt, and the flow of funds to Italy could be greatly reduced, disrupting the financial system. The deal negotiated by the ECB (as detailed in the Chapter Opener)—which allows the ECB to buy more bonds from these harder-hit countries—was required to help stabilize those economies, and agreeing to that deal required that all eurozone countries be committed to supporting the euro.

4.15 a. By departing the eurozone, the Greek government could pursue an expansionary monetary policy, including devaluing its currency to stimulate exports. b. There may be long-term advantages of being in the eurozone from the increased international trade and finance with reduced exchange rate risk and there are several short-term drawbacks of leaving the euro. Greek bank deposits in euros would be converted to bank deposits in drachmas.

If euros are exchanged for drachmas at a rate of one-to-one and the drachma subsequently loses value, as is widely expected, the owners of Greek bank deposits would suffer heavy losses. In addition, the Greek government would most likely default on its bonds, forcing it to pay for government spending exclusively with tax revenues. The result could be a dramatic cut in government spending. Further, foreign lenders to Greek banks and companies would likely object to being paid in drachmas, which could undermine the ability of Greek companies to borrow outside of Greece. Lastly, there is considerable uncertainty about the consequences in the short run and the long run of abandoning the euro.

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4.16 a. A currency manipulator is a country whose government intervenes in foreign exchange markets to keep the value of its currency artificially low or high. As the Chinese government moved away from central planning toward a market system, an important part of Chinese economic policy was the decision in 1994 to peg the value of the yuan to the dollar to ensure that Chinese exporters would face stable dollar prices for the goods they sold in the United States. Over the subsequent decade to decade and a half, as the yuan became undervalued relative to the U.S. dollar, Chinese firms gained a competitive advantage over U.S. firms as U.S. exports to China became more expensive and Chinese exports to the United States became cheaper. b. The hard peg of 8.28 yuan per dollar over the 1994-2004 period and the People’s Bank of China accumulating $700 billion of U.S. dollar assets suggest that China intervened in the foreign exchange market to undervalue the yuan. Over most of the 2005-2014 period, the yuan appreciated against the U.S. dollar and by late 2015 the People’s Bank of China was selling U.S. dollar assets to slow down the downward pressure on the yuan. In late 2015 and 2016, the yuan depreciated not from a People’s Bank of China intervention, but from Chinese investors taking advantage of new rules allowing them to invest abroad for the first time. Although the People’s Bank of China intervenes in the foreign exchange market more than central banks of highincome countries, the yuan did not appear to be undervalued in 2020.

4.17 a. By policy trilemma, former Fed Chair Bernanke means that China cannot pursue monetary policy independence and allow free capital flows while at the same time fixing the exchange rate. b. An expansionary monetary policy would lower interest rates and decrease the demand for Chinese financial assets. With free capital flows, the decrease in the demand for Chinese financial assets would decrease the demand for yuan, causing the exchange rate value of the yuan to fall.

Data Exercises D16.1

Over the July 2010 through early 2014 the dollar depreciated almost 11% against the yuan. From early 2014 through early 2017, the dollar appreciated over 14%. The dollar then depreciated again from early 2017 through mid-2018, followed by another rise in the dollar. After some fluctuations in 2019, the yuan reached its peak early in 2020, and since then the dollar has again been appreciating against the yuan. As of this writing (February 2021) the value of the yuan is around its 2011 level.

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D16.2

The U.S. current account balance data series BOPBCA was discontinued as of the first quarter of 2014 and has been replaced with the data series IEABC, which goes from the first quarter of 1999 to the present. To show the current account balance going back to 1960, the following graph uses the BOPBCA series to show more recession periods.

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Business Cycle Peak August 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 March 2001 December 2007 February 2020

Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 Not known as of March 2021

The current account balance in general rises just before a recession, rises during a recession, and falls just after a recession—but the pattern varies across recessions.

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Chapter 17 Monetary Theory I: The Aggregate Demand and Aggregate Supply Model 

Brief Chapter Summary and Chapter Objectives

17.1 The Aggregate Demand Curve (pages 597-601) Explain how the aggregate demand curve is derived.

• Economists analyze the demand for goods and services by households, firms, and the government in terms of aggregate expenditure.

• An increase in the price level reduces real money balances, which drives up interest rates. The result is lower aggregate expenditure and a downward-sloping aggregate demand curve.

• Factors that affect consumer spending, investment, or government purchases cause the aggregate demand curve to shift.

17.2 The Aggregate Supply Curve (pages 601-609) Explain how the aggregate supply curve is derived.

• Firms differ in their reaction to changes in the price level in the short run and the long run.

• There are two views as to why the short-run aggregate supply curve is upward sloping. One view is based on the misperceptions theory, and the other view is based on the short-run stickiness of prices.

• Both views agree that the long-run aggregate supply curve is vertical at potential GDP. • Changes in labor costs, other input costs, and the expected price level cause the short-run aggregate supply to shift.

• The LRAS curve shifts over time to reflect growth in potential GDP, which results from increased inputs and higher productivity.

17.3 Equilibrium in the Aggregate Demand and Aggregate Supply Model (pages 609-616) Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model.

• Short-run equilibrium occurs where the aggregate demand curve intersects the short-run aggregate supply curve, and long-run equilibrium occurs where the aggregate demand curve, the short-run aggregate supply curve, and the long-run aggregate supply curve all intersect.

• The economy will self-correct to return to potential GDP in the long run.

17.4 The Effects of Monetary Policy (pages 616-623) Use the aggregate demand and aggregate supply model to show the effects of monetary policy on the economy.

• Though the economy will eventually self-correct from an adverse demand shock, the Fed may employ expansionary monetary policy to speed up the process.

• Given the difficulties in implementing monetary policy, many economists argue that the Fed should focus on long-run objectives and only implement expansionary policy during severe recessions.

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Key Terms

Aggregate demand (AD) curve, p. 597. A curve that shows the relationship between the price level and aggregate expenditure on goods and services.

Real money balances p. 598. The value of money held by households and firms, adjusted for changes in the price level; M/P.

Aggregate supply, p. 601. The total quantity of output, or GDP, that firms are willing to supply at a given price level.

Short-run aggregate supply (SRAS) curve, p.

603. A curve that shows the relationship in the short run between the price level and the quantity of aggregate output, or real GDP, that firms are willing to supply.

Business cycle, p. 616. Alternating periods of economic expansion and economic recession.

Long-run aggregate supply (LRAS) curve, p.

606. A curve that shows the relationship in the long run between the price level and the quantity of aggregate output, or real GDP, supplied by firms.

Monetary neutrality, p. 612. The proposition that changes in the money supply have no effect on output in the long run because an increase (decrease) in the money supply raises (lowers) the price level in the long run but does not change the equilibrium level of output.



Stabilization policy, p. 616. A monetary policy or fiscal policy intended to reduce the severity of the business cycle and stabilize the economy.

Supply shock, p. 606. An unexpected change in production costs or in technology that causes the short-run aggregate supply curve to shift.

Chapter Outline

Why Have Recent College Graduates Struggled in the Labor Market?

“The Great Recession” that began in December 2007 and ended in June 2009 was the longest and deepest recession since the Great Depression. It wasn’t until late 2015 that the unemployment rate dropped to 5%.

But what many economists found disturbing in 2016 was that the fraction of the population working had not yet returned to pre-recession levels. In addition, the unemployed were staying unemployed for longer periods of time. Ordinarily, as the unemployment rate declines competition for workers causes wages to rise, which would lead to higher inflation. Yet in mid-2016, inflation was below the Fed’s target of 2% every month for four years. The situation raised the question of whether persistent slack in labor markets indicated that expansionary monetary policy should be continued. The long-run decline in the employment-population ratio suggests that structural factors that are unrelated to the overall state of the economy might be involved, such as the retirement of the baby boom generation. However, even for prime-age men, the employment-population ratio never returned to its 2007 level.

A recession began in February 2020 due to the economic effects of the Covid-19 pandemic. During that recession, the employment–population ratio for each of the groups shown in the chart in the text (replicated below) experienced the largest declines on record.

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By April 2020, the pandemic had caused the unemployment rate to spike to 14.7%. In July 2020, the Congressional Budget Office (CBO) forecast that the unemployment rate would not fall below 6% until the fall of 2024 and would remain above 4% as late as 2034. There was a particular concern that the 2020 recession would significantly reduce job prospects for younger workers, including recent college graduates just entering the labor force.

Research that has analyzed the job market experiences of college graduates in different age cohorts has found that if you graduate from college into a weak job market, you may experience labor scarring, which means that if you fail to start your work career immediately after graduation, you are more likely to not be employed even years later. The analysis indicates that (1) the trend of each successive age cohort of college graduates having a lower employment–population ratio began in 2005 and (2) the most recent cohorts have relative employment rates 3 or 4 percentage points lower than what would be expected based on the pre-2005 trend.

Some economists and policymakers argue that workers would have experienced better labor market outcomes in the years since the end of the Great Recession if the Fed had pursued more aggressive expansionary policies. Other economists and policymakers argue that some of the problems in labor markets were due to structural changes in the U.S. economy. Monetary policy is intended to affect the total level of spending in the economy and is not well suited to addressing structural problems.

Teaching Tips This chapter focuses on the derivation of the aggregate demand and aggregate supply curves and on the determination of equilibrium real GDP and the equilibrium price level in the short and long runs. The discussion of short-run aggregate supply focuses on the new classical and new Keynesian approaches. The chapter covers the differences and the similarities of the two approaches.

17.1 The Aggregate Demand Curve (pages 597-601) Learning Objective: Explain how the aggregate demand curve is derived.

Economists analyze the demand for goods and services by households, firms, and the government in terms of aggregate expenditure. The concept of aggregate expenditure is used to develop the aggregate demand (AD) curve, which shows the relationship between the price level and aggregate expenditure on goods and services by households, firms, and the government.

A. The Money Market and the Aggregate Demand Curve The AD curve is downward sloping because, if nothing else changes, an increase in the price level reduces aggregate expenditure on goods and services. An increase in the price level reduces real money balances, which drives up interest rates. Higher interest rates lead to lower spending by households and firms, which results in an inverse relationship between the price level and aggregate expenditure.

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B. Shifts of the Aggregate Demand Curve A shift of the aggregate demand curve to the right is expansionary because each price level is associated with a higher level of aggregate expenditure. A shift of the aggregate demand curve to the left is contractionary because each price level is associated with a lower level of aggregate expenditure. Variables that affect consumer spending, investment, or government purchases cause the aggregate demand curve to shift. These variables are: • Increases and decreases in the money supply • Changes in the household saving rate • Changes in households’ expected future incomes • The expected profitability of capital • Changes in taxes on households and firms • Changes in foreign demand for U.S.-produced goods and services 17.2 The Aggregate Supply Curve (pages 601-609) Learning Objective: Explain how the aggregate supply curve is derived.

Firms differ in their reaction to changes in the price level in the short run and the long run.

Therefore, we divide our analysis of aggregate supply according to the time horizon that firms face.

A. The Short-Run Aggregate Supply (SRAS) Curve There are the two explanations of why the SRAS curve is upward sloping: 1. The new classical view is based on the misperception theory, which emphasizes the difficulty firms have in distinguishing between relative increases in the prices of their products and general increases in the price level. When the actual price level is greater than the expected price level, firms increase output. As a result, output can be higher or lower than the full employment level in the short run—until firms can distinguish changes in relative prices from changes in the general price level.

2. An alternative explanation of why the SRAS curve is upward sloping is that prices take time to adjust to changes in aggregate demand and are therefore sticky in the short run. The new Keynesian view uses characteristics of many real-world markets—rigidity of long-term contracts and imperfect competition—to explain price behavior. When firms have “sticky” prices, an increase in the price level will tend to increase these firms’ profits in the short run and will lead them to increase their outputs.

B. The Long-Run Aggregate Supply (LRAS) Curve In the new classical view, firms eventually distinguish changes in the relative prices of their products from changes in the price level. According to the new Keynesian view, though input costs are sticky in the short run, over time input costs increase in line with the price level, so both firms with flexible prices and firms with sticky prices adjust their prices in response to a change in demand in the long run. According to both views, the LRAS curve is vertical at potential GDP. C. Shifts in the Short-Run Aggregate Supply Curve There are three main reasons the short-run aggregate supply curve shifts: 1. Changes in labor costs 2. Changes in other input costs 3. Changes in the expected price level An increase in any of these three factors leads to higher production costs, causing the SRAS curve to shift to the left.

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D. Shifts in the Long-Run Aggregate Supply (LRAS) Curve The LRAS curve shifts over time to reflect growth in the potential level of output. Sources of this economic growth include: 1. Increases in capital and labor inputs 2. Technological change that increases the growth of in productivity 17.3 Equilibrium in the Aggregate Demand and Aggregate Supply Model (pages 609-616) Learning Objective: Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model.

A. Short-Run Equilibrium The economy’s short-run equilibrium occurs at the intersection of the AD and SRAS curves.

B. Long-Run Equilibrium The economy’s long-run equilibrium occurs at the intersection of the AD, SRAS, and LRAS curves. If aggregate demand expands unexpectedly, shifting the aggregate demand curve to the right, output and the price level both increase in the short run. Over time, as firms learn that the general price level has risen and as input costs rise, the SRAS curve shifts to the left. In the long run, the SRAS curve will shift far enough to intersect AD at potential GDP. Because changes in the money supply only affect AD and not potential GDP, economists generally agree that money is neutral in the long run.

C. Economic Fluctuations in the United States Policies that increase AD without increasing AS result in higher inflation. Economic policy designed to promote investment can affect both AD and AS and so investment incentives are unlikely to be inflationary. The AD-AS model can be used to explain economic fluctuations, including these four episodes of fluctuations in the United States: (1) shocks to aggregate demand, 1964–1969; (2) supply shocks, negative during 1973–1975 and positive after 1995; (3) a credit crunch shock to aggregate demand during and after the 2007–2009 recession; and (4) the Covid-19 pandemic and the recession of 2020.

17.4 The Effects of Monetary Policy (pages 616-623) Learning Objective: Use the aggregate demand and aggregate supply model to show the effects of monetary policy on the economy.

Most economists believe that increases in the money supply and decreases in interest rates can increase short-run output. It may be possible, then, for the Fed to use monetary policies to stabilize the economy by reducing the severity of recessions and smoothing short-run fluctuations in output.

A. Active Monetary Policy If the economy experiences an adverse AD shock, output will decline in the short run. The economy will eventually self-correct and return to potential GDP, but it may take years. The Fed can try to speed up the recovery by using open market operations to lower the target for the federal funds rate. An expansionary monetary policy will shift the AD curve back to the right, enabling GDP to return to its potential level more quickly, although at a higher price level than what would occur if no action was taken. However, precise implementation of such a policy is difficult given lags in policy; therefore, economists generally advocate that policymakers focus on long-run objectives such as low inflation or steady economic growth. Many economists argue that policymakers should restrict the use of activist policy to fighting major downturns in the economy.

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B. Was Monetary Policy Ineffective During and After the 2007–2009 Recession?

In 2016, some economists wondered whether prolonged periods of high unemployment had led to a reduction in the employment-population ratio that would be difficult to reverse. Some economists believe that negative shifts in aggregate demand can reduce the full employment rate of output, a situation known as hysteresis. This situation can result from persistent high rates of unemployment that diminish workers’ skills and discourage some workers from staying in the labor force. In 2016, the Fed faced a dilemma: using expansionary monetary policy would be effective if the economy faces insufficient aggregate demand. But if aggregate supply was the source of the problem, conventional policy would be ineffective.

Teaching Tips Ask students to discuss the supply-side reasons for continued high unemployment (for example, hysteresis and uncertainty) as well as the demand-side reasons (such as weak economic growth). Given this context, have students evaluate the effectiveness of monetary policy during and after the recession of 2007-2009.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 17.1 The Aggregate Demand Curve Learning objective: Explain how the aggregate demand curve is derived.

Review Questions 1.1

Aggregate expenditure consists of: (1) Spending by households on goods and services, C (2) Planned spending by firms on capital goods, such as factories, office buildings, and machine tools and by households on new homes, I (3) Government purchases of goods and services (not including transfer payments such as Social Security payments), G (4) Net exports, which is spending by foreign firms and households on goods and services produced in the United States minus spending by U.S. firms and households on goods and services produced in other countries, NX

1.2

Households and firms demand money to facilitate buying and selling, which economists call the transactions motive. The demand curve for real money balances is downward sloping because the short-term nominal interest rate is the opportunity cost of holding money. As the interest rate increases, the opportunity cost of holding money increases, and households and firms demand a smaller quantity of real money balances.

1.3

The AD curve is downward sloping because an increase in the price level decreases real money balances, which raises the interest rate. The higher interest rate decreases consumption spending, investment spending on capital goods and new homes, and net exports.

1.4

a. Investment spending by firms on plant and equipment would decrease because the cost to firms of borrowing would increase. b. Consumption spending by households would decrease because the incentive to save would increase and the cost to households of borrowing would increase.

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c. Net exports would decrease because a higher interest rate would increase the foreign exchange value of the dollar, thereby increasing the foreign currency prices of U.S. exports and reducing the dollar prices of foreign imports.

1.5

Changes in the money supply shift the aggregate demand curve because interest rates change, which changes investment, interest-sensitive consumption, and net exports.

Changes in the savings rate shift the aggregate demand curve because changes in savings also change consumption.

Changes in households’ expected future income shift the aggregate demand curve because changes in expected income change current consumption.

Changes in the expected profitability of capital shift the aggregate demand curve because investment changes.

Changes in taxes shift the aggregate demand curve because disposable income changes, changing consumption, or the after-tax profitability of firms changes, which changes investment.

Changes in government purchases shift the aggregate demand curve by changing government spending.

Changes in foreign demand for U.S. goods and services shift the aggregate demand curve by changing net exports.

Problems and Applications 1.6

a. The Federal Reserve lowering the target for the federal funds rate would decrease the interest rate, causing the AD curve to shift to the right. b. The federal government spending on highways would directly increase aggregate expenditure, causing the AD curve to shift to the right. c. The cut in the corporate profits tax would increase the after-tax rate of return on investment projects, increasing investment spending, and cause the AD curve to shift to the right. d. An increase in the foreign exchange value of the dollar would increase the foreign currency prices of U.S. exports and decrease the dollar price of foreign imports, causing the AD curve to shift to the left. e. Firms becoming pessimistic about the future profitability of spending on factories and machinery would decrease current investment spending, causing the AD curve to shift to the left.

1.7

A decrease in the price level causes the supply of real money balances to shift to the right, lowering the equilibrium interest rate from i1 to i2. The lower interest rate increases planned investment spending, consumption spending, and net exports.

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1.8

a. If the dollar weakened, it would take fewer units of foreign currency to buy one dollar. b. Holding other factors constant, the weakening of the dollar would increase aggregate demand.

The weaker dollar makes U.S. exports cheaper overseas—because it will take fewer units of foreign currency to buy one dollar—and U.S. imports more expensive in the United States— because it will take more dollars to purchase a unit of foreign currency. So, exports rise, imports fall, and net exports increases, shifting the aggregate demand curve to the right.

1.9

a. Corporate equities are stocks. Households might hold stocks indirectly through pension funds or mutual funds. b. All else equal, the decline in household wealth would be likely to increase the savings rate, which would also reduce consumption spending at any given level of income. c. The reduction in consumption spending would reduce aggregate demand, shifting the curve leftward.

1.10

The policymakers Christina Romer was referring to are the president, Congress, and the Federal Reserve. Increases in government spending directly increase aggregate expenditure and decreases in taxes increase disposable income, which leads to an increase in consumption spending.

17.2

The Aggregate Supply Curve Learning objective: Explain how the aggregate supply curve is derived.

Review Questions 2.1

The slope of the short-run aggregate supply curve is upward sloping, and the slope of the longrun aggregate supply curve is vertical.

2.2

The equation of the new classical aggregate supply curve is: Y = 𝑌𝑌 𝑃𝑃 + 𝑎𝑎(𝑃𝑃 − 𝑃𝑃𝑒𝑒 ),

where 𝑌𝑌 𝑃𝑃 is potential output and 𝑃𝑃𝑒𝑒 is the expected price level. There is an asymmetry because firms have more information on the prices they charge than they do on the general price level in the economy. Firms can easily detect price changes of their products, but it is more difficult in the short run to detect changes in the overall price level.

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2.3

Price stickiness means that prices adjust slowly in the short run in response to changes in aggregate demand. Price stickiness can be explained by: (1) long-run nominal contracts for wages or prices for intermediate goods, and (2) imperfect competition with differentiated products, relatively few sellers, and costs to changing prices.

2.4

Changes in labor costs, other input costs, and the expected price level shift the short-run aggregate supply curve, along with the factors that shift long-run aggregate supply. Changes in the quantity of capital and labor inputs and the productivity of inputs shift the long-run aggregate supply curve.

Problems and Applications 2.5

In the short run, for a particular expected price level, Pe, an increase in the actual price level, P, increases the value of the second term, a(P – Pe), in the aggregate supply equation, thereby raising the aggregate quantity of output supplied. In the long run, firms can distinguish changes in the relative prices of their products from changes in the price level, implying the actual price level will equal the expected price level. With P = Pe, the second term of the equation, a(P – Pe), equals zero and the aggregate quantity of output supplied equals potential GDP, YP.

2.6

a. A decrease in the expected price level reduces wages and other costs of production, shifting the short-run aggregate supply (SRAS) curve to the right. b. A decrease in oil prices reduces firms’ costs of production, shifting the SRAS curve to the right. c. The development of much faster personal computers will increase the productivity of workers, reducing firms’ costs of production and shifting the SRAS curve to the right. d. Higher wages will increase firms’ costs of production, shifting the SRAS curve to the left. e. Severe winter storms will reduce the ability of firms to produce output at any given price level, shifting the SRAS curve to the left.

The following graph on the left illustrates a SRAS curve shifting to the right, as in parts a., b., and c. The graph on the right illustrates a SRAS curve shifting to the left, as in parts d. and e.

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You should agree. When aggregate demand falls, sticky nominal wages slow the reduction in costs (from lower wages) that are needed to shift the short-run aggregate supply curve to the right. The shift of the short-run supply curve is required to restore GDP to its potential level. The recovery of output to potential GDP occurs more quickly if nominal wages are flexible. a. The executive means that if you lay off workers, they will be unhappy—but they are no longer part of the company. If you cut wages, then everyone at the company is unhappy, which might affect the productivity of all workers. b. This would make the short-run supply curve relatively flatter, which in turn would reduce employment further for a given shift in aggregate demand.

2.9

A negative supply shock is something that shifts the short-run aggregate supply curve leftward.

Examples of negative supply shocks include: (1) increases in oil prices; (2) increase in wages (when there is no associated change in labor productivity); and (3) increases in the expected price level. A leftward shift of the short-run aggregate supply curve increases the price level and reduces output, and so the economy will be in a recession if it was originally at full employment.

2.10

If the long-run aggregate supply curve shifts, the short-run aggregate supply curve will also shift, but not vice versa. Changes in productivity and in the quantities of capital and labor will not only increase aggregate supply in the long run, but also in the short run. But shifts in the short-run aggregate supply curve due to changes in labor costs, other input costs, and the expected price level (when these changes are separate from changes in the quantity of capital, labor, and productivity) do not change potential GDP and will not shift long-run aggregate supply.

2.11 a. The industries that are likely to be most directly affected by the cost increases from hydraulic fracturing are manufacturing, utilities, and the long-haul trucking industry. The rising natural gas prices would lead manufacturers of aluminum, glass, and other products, and utilities to switch from natural gas to coal as an energy source. Firms in long-haul trucking have begun to switch from trucks powered by diesel fuel to trucks powered by much cheaper and cleaner natural gas, but that trend could be reversed by an increase in natural gas prices. b. The cost increases would shift the short-run and long-run aggregate supply curves to the right.

The effect would likely be greater in the long run as firms have additional time to fully respond to the cost increases.

17.3

Equilibrium in the Aggregate Demand and Aggregate Supply Model Learning objective: Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model.

Review Questions 3.1

Short-run equilibrium occurs at the intersection of the AD curve and the SRAS curve. Long-run equilibrium occurs at the intersection of the AD, SRAS, and LRAS curves, where the level of output equals potential GDP.

3.2

The short-run aggregate supply curve will shift to the left. With output above potential GDP, wages and other input prices will be bid up and the expected price level will rise as households and firms adjust to the increase in the price level.

3.3

The decrease in aggregate demand shifts the AD curve to the left, from AD1 to AD2. As a result, short-run equilibrium moves from E1 to E2. Over time, as households and firms learn that the

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general price level has fallen and as input costs fall, the SRAS curve will shift to the right, from SRAS1 to SRAS2. In the long run, equilibrium will move from E2 to E3 and output will return to potential GDP.

3.4

No, monetary neutrality only means that changes in the money supply have no effect on output in the long run. Most economists believe that an increase in the money supply can increase output in the short run by lowering interest rates, which results in an increase in spending by households and firms.

Problems and Applications 3.5

The economy will be in a short-run equilibrium without being in a long-run equilibrium when the AD curve and the SRAS curve intersect at an output level different from potential GDP. However, the economy cannot be in a long-run equilibrium without being in a shortrun equilibrium. Long-run equilibrium occurs where the AD, SRAS, and LRAS curves intersect, so it is simultaneously short-run and long-run equilibrium.

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3.6

With both the price level and the output level decreasing, the aggregate demand curve must have shifted to the left. Any other shift of the aggregate demand or aggregate supply curve would have resulted in output or the price level (or both) increasing.

3.7

The increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to AD2. As a result, in the short run the price level increases from P1 to P2 and the level of real GDP increases from YP to Y2. With output above potential GDP, over time households and firms will learn that the general price level has risen and input costs will rise. So, the short-run aggregate supply curve will shift to the left, from SRAS1 to SRAS2. The price level will increase further, from P2 to P3, while output returns to potential GDP.

3.8

The decline in income in Europe decreases U.S. net exports, which causes the aggregate demand curve to shift to the left, from AD1 to AD2. As a result, in the short run the price level falls from P1 to P2 and the level of real GDP falls from YP to Y2. With output below potential GDP, over time households and firms will learn that the general price level has fallen and input costs will fall. So, the short-run aggregate supply curve will shift to the right, from SRAS1 to SRAS2. The price level will decrease further, from P2 to P3, while output returns to potential GDP.

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3.9

a. Decreases in consumption decrease aggregate expenditure, causing the aggregate demand curve to shift to the left. The following graph depicts the economy in a recession with output below potential GDP. A decrease in consumption would shift the aggregate demand curve from AD1 to AD2, causing output to decrease further.

b. The increase in saving will fund investment in new plant and equipment, which will increase potential GDP, shifting the LRAS curve to the right. In the following graph, the increase in investment shifts the aggregate demand curve to the right from AD1 to AD2 and the increase in the stock of capital shifts the long-run aggregate supply curve to the right, from LRAS1 to LRAS2.

For simplicity, the following graph does not show the short-run aggregate supply curve because the focus of this problem is the long run.

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3.10 a. The supply shock was caused by the shutdown of businesses due to the Covid-19 virus. b. The demand shock was caused by the reduction in consumer and business incomes, which reduced consumption and investment, and by the reduction in net exports, caused by the decline in incomes overseas. c. In general, aggregate supply shocks and aggregate demand shocks are not correlated and do not necessarily occur together. The one sense in which the two types of shocks occur together is that, if an aggregate demand shock causes a recession or inflation, there will eventually be a shift in the short-run aggregate supply curve as wages and prices adjust, but this would not typically be characterized as a supply shock.

17.4

The Effects of Monetary Policy Learning objective: Use the aggregate demand and aggregate supply model to show the effects of monetary policy on the economy.

Review Questions 4.1

Business cycles vary both in length and in severity. For example, the recession of 2001 in the United States was both short and mild. The Great Depression of the 1930s and the recession of 2007-2009, on the other hand, were both long and severe.

4.2

Stabilization policy refers to monetary and fiscal policies intended to stabilize the economy and reduce fluctuations due to business cycles. Attempts to fine-tune the economy may be ineffective given the potentially long lag in formulating and implementing stabilization policies and the potentially long lag before the policies affect the level of output and the price level. Economists generally advocate that policymakers focus on long-run objectives such as low inflation or steady economic growth and restrict the use of activist monetary or fiscal policy to fighting major downturns in the economy.

4.3

To counteract a negative demand shock, the Fed can conduct expansionary monetary policy by lowering interest rates. To counteract a positive demand shock, the Fed can conduct contractionary monetary policy by raising interest rates.

4.4

Hysteresis refers to the idea that when high rates of unemployment persist workers lose their skills or are viewed by employers as lacking current skills. Hysteresis raises the natural rate of unemployment and implies that negative shocks to aggregate demand can have long-lasting negative effects on unemployment.

Problems and Applications 4.5

a. The Fed would lower interest rates and cause the aggregate demand curve to shift to the right, from AD1 to AD2. As a result, equilibrium moves from E1 to E2 and output increases from Y1 to YP. The price level also increases from P1 to P2.

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b.

The Fed would raise interest rates and cause the aggregate demand curve to shift to the left, from AD1 to AD2. As a result, equilibrium moves from E1 to E2 and output decreases from Y1 to YP. The price level also decreases from P1 to P2.

4.6

Expansionary monetary policy might more quickly return the economy to full employment than if the Fed did not pursue an expansionary monetary policy and waited for the economy to eventually return to potential GDP by itself. On the other hand, given the lags in the impact of monetary policy actions, expansionary monetary policy could be the wrong policy (or wrong amount of stimulus) by the time the policy fully impacts the economy. In this case, the policy might push real GDP beyond potential GDP, increasing the rate of inflation.

4.7

a. The aggregate demand curve shifts to the right, from AD1 to AD2, and the short-run aggregate supply curve shifts to the left, from SRAS1 to SRAS2. The price level increases from P1 to P2, but the change in the level of output depends on which curve shifts more. In the following graph, the SRAS curve shifts more than the AD curve, causing the level of output to decline from YP to Y2.

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b. With output at Y2 being less than full employment, over time prices and input costs will decrease, shifting the short-run aggregate supply curve in the following graph from SRAS2 to SRAS3, moving the economy back to potential GDP, YP, at a lower price level, P3.

c. The Fed would conduct expansionary monetary policy, shifting the aggregate demand curve in the following graph from AD2 to AD3, and restoring the economy to potential GDP, Yp, at a higher price level, P4.

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4.8

To the extent that negative shocks to aggregate demand lead to extended periods of unemployment, hysteresis can occur and cause the LRAS curve to be to the left of where it would otherwise be, indicating that the level of potential GDP has fallen from what it would have been. To the extent that hysteresis occurs, factors that shift the AD curve would also shift the LRAS curve.

4.9

a. A scarring effect refers to the long-term consequences of unemployment. Workers who are unemployed for long periods may have trouble being rehired or may become discouraged and drop out of the labor force permanently. Non-participation means that workers leave the labor force. Highly persistent means that it takes a long time for these scarring effects to diminish. b. The estimate of how many people might still be brought back into the labor market indicates the excess supply of labor and gives the Federal Reserve an idea of how much more monetary stimulus, if any, it should conduct. It is difficult to make such estimates because of the size and complexity of the economy and because there are alternative explanations for the low employment-to-population ratio (or labor force to population ratio) such as structural changes in the economy, social security disability payments, and regulatory uncertainty. If the estimates of how many people might still be brought back into the labor market are too small, then the Fed may discontinue expansionary monetary policy too soon, or if the estimates are too large, then the Fed may continue expansionary monetary policy too long and increase inflation.

4.10

Hysteresis refers to the idea that when high rates of unemployment persist workers lose their skills or are viewed by employers as lacking current skills. The decline that began in 2005 is unlikely to have been caused by hysteresis, as rates of unemployment were not high at that time.

However, the effects of the 2007-2009 financial crisis would have been likely to cause hysteresis, and so this may have enhanced these problems.

4.11 a. By “gigantic stimuli,” Nixon was referring to the expansionary monetary policy and wartime orders from Europe that greatly increased aggregate demand. b. Nixon’s position is more consistent with that of Robert Gordon who saw the problem of high unemployment as hysteresis brought on by insufficient aggregate demand.

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4.12 a. By a “low-employment trap,” Gordon means a situation where low employment will not be removed by the normal market forces of lower wages and prices causing a shift to right of the short-run aggregate supply curve and a movement down the aggregate demand curve, with output and employment increasing. b. With hysteresis, low employment may not represent an excess supply of labor. The unemployed workers have either: (1) lost their skills; (2) were viewed by employers as lacking current skills; or (3) dropped out of the labor force permanently. With low employment not representing an excess supply of labor, there would be no downward pressure on wages and prices.

Data Exercises D17.1 a. In 1960, real GDP equaled $3.126 trillion (chained 2012 dollars), and the GDP price deflator (2012 = 100) equaled 15.90.

In 2007, real GDP equaled $15.63 trillion and the GDP price deflator equaled 88.40.

Long-run aggregate supply increased substantially from $3.126 trillion in 1960 to $15.63 trillion in 2007. Because the GDP price deflator increased from 15.90 to 88.40, we know that aggregate demand must have grown more than long-run aggregate supply.

b. In 1973, real GDP equaled $5.69 trillion, and the GDP price deflator equaled 26.96 In 1975, real GDP equaled $5.64 trillion and the GDP price deflator equaled 28.53.

From these data, we know that from 1973 to 1975, short-run aggregate supply must have decreased.

In the following graph, to more clearly highlight the decrease in short-run aggregate supply, the long-run aggregate supply and aggregate demand for 1975 have been omitted.

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D17.2 a. Download the Personal Consumption Expenditure price index. Click “Edit Graph” and under “Units” choose “Percent Change from Year Ago” to get the inflation rate. b. The average inflation rate from 1982 through 1995 was 3.4%, and the average inflation rate from 1996 through 2007 was 2.0%. c. A positive supply shock decreases the inflation rate, so these calculations of the inflation rate are consistent with a positive supply shock after 1995.

D17.3 a. Generate the three data series for real GDP growth rate, the inflation rate using the percentage change in the GDP deflator, and the unemployment rate. The data series for the unemployment rate ends with February 2012 and the data series for the GDP deflator ends with the third quarter of 2014.

b. The data indicate that the experience of the United Kingdom during these years was quite similar to the experience of the United States. Both countries had: (1) significant declines in real GDP; (2) declines in the inflation rate; and (3) increases in the unemployment rate.

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Chapter 18 Monetary Theory II: The IS-MP Model 

Brief Chapter Summary and Chapter Objectives

18.1 The IS Curve (pages 634–644) Explain what the IS curve is and how it is derived.

• Aggregate expenditure is the sum of consumption, investment, government purchases, and net exports. Equilibrium occurs in the goods market when aggregate expenditure, or the value of goods and services demanded, equals the value of goods and services produced, or real GDP. • The Fed’s goal is to have equilibrium GDP close to potential GDP, which is the level of real GDP attained when all firms are producing at capacity.

• The series of induced changes in consumption spending that results from an initial change in autonomous expenditure is called the multiplier effect. The change in equilibrium GDP divided by a change in autonomous expenditures is called the multiplier.

• The IS curve shows the combination of real interest rates and GDP where the goods market is in equilibrium.

• The IS curve can be modified to reflect the relationship between real interest rates and the output gap.

• A demand shock is a change in one of the components of AE that causes the IS curve to shift.

18.2 The MP Curve and the Phillips Curve (pages 644–652) Explain the significance of the MP curve and the Phillips curve.

• According to the IS-MP model, when the Fed changes the real interest rate, the output gap changes.

• The Phillips curve represents the short-run trade-off between the inflation rate and the rate of unemployment. The Phillips curve will shift in response to supply shocks and changes in expectations of the inflation rate.

• Instead of considering the relationship between the inflation rate and the unemployment rate, we can use Okun’s Law to derive a Phillips curve that relates the inflation rate to the output gap.

18.3 Equilibrium in the IS-MP Model (pages 652–662) Use the IS-MP model to illustrate macroeconomic equilibrium.

• The Fed typically fights recessions by lowering the federal funds rate, which increases AE, causing the output gap to return to zero and the inflation rate to return to its previous rate.

• During the financial crisis of 2007-2009, long-term real interest rates did not respond as much as they usually do to the decline in the federal funds rate because of a rise in the risk premium.

18.4 Are Interest Rates All That Matter for Monetary Policy? (pages 662–667) Discuss alternative channels of monetary policy.

• In the bank lending channel, a monetary expansion increases banks’ ability to lend and increases in loans to bank-dependent borrowers increase their spending.

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• In the balance sheet channel, contractionary monetary policy reduces net worth, which raises the cost of external financing by more than the increase implied by higher interest rates. This, in turn, reduces firms’ ability to invest in plant and equipment.

18.A Appendix: The IS-LM Model (pages 675–678) Use the IS-LM model to illustrate macroeconomic equilibrium.

• The IS–LM model differs from the IS-MP model in that it assumes that the Fed is targeting the money supply rather than the federal funds rate.



Key Terms

Aggregate demand shock, p. 644. A change in one of the components of aggregate expenditure that causes the IS curve to shift.

Balance sheet channel, p. 664. A description of how interest rate changes resulting from monetary policy affect borrowers’ net worth and spending decisions.

Bank lending channel, p. 662. A description of how monetary policy influences the spending decisions of borrowers who depend on commercial bank loans or on selling securities to shadow banks.

Fiscal policy, p. 640. Changes in federal government purchases and taxes that are intended to achieve macroeconomic policy objectives.

IS curve, p. 633. A curve in the IS–MP model that shows the combinations of the real interest rate and aggregate output that represent equilibrium in the market for goods and services.

IS–MP model, p. 633. A macroeconomic model that consists of an IS curve, which represents equilibrium in the goods market; an MP curve, which represents monetary policy; and a Phillips curve, which represents the short-run relationship between the output gap (which is the percentage difference between actual and potential real GDP) and the inflation rate.



Appendix IS–LM model, p. 675. A macroeconomic model of aggregate demand that assumes that the central bank targets the money supply.

LM curve, p. 675. A curve that shows the combinations of the interest rate and the output gap that result in equilibrium in the money market.

MP curve, p. 633. A curve in the IS–MP model that represents Federal Reserve monetary policy.

Multiplier, p. 638. The change in equilibrium GDP divided by a change in autonomous expenditure.

Multiplier effect, p. 638. The process by which a change in autonomous expenditure leads to a larger change in equilibrium GDP. Okun’s law, p. 649. A statistical relationship discovered by Arthur Okun between the output gap and the cyclical rate of unemployment.

Output gap, p. 642. The percentage difference between real GDP and potential GDP. Phillips curve, p. 633. A curve that shows the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.

Potential GDP, p. 637. The level of real GDP attained when all firms are producing at normal capacity.

Chapter Outline

How Important Are Accurate Economic Forecasts to the Fed? At the end of 2010, the FOMC predicted that the unemployment rate at the end of 2012 would remain stubbornly high, at 8.0%, and the actual unemployment rate at the end of 2012 was only slightly lower than forecast, at 7.9%. The inflation rate at the end of 2012 remained low, at 1.7%, just somewhat above Copyright © 2022 Pearson Education, Inc.

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the 1.3% that the FOMC had expected. At both the end of 2015 and the end of 2017, the FOMC members forecast that the unemployment rate and the inflation rate would be higher than they turned out to be two years later. The FOMC also expected to vote to raise the target for the federal funds rate to a higher level than they actually did. Some critics of Fed policy argue that the Fed’s consistently missing its 2% inflation target indicates that Fed policy was insufficiently expansionary.

Increases in the federal funds rate usually are reflected in other short-run rates. Long-term interest rates are also affected by increases in the federal funds rate, although the relationship is less certain. A key reason some Fed officials were concerned about the Fed’s keeping interest rates so low for so long after the end of the 2007-2009 recession was the potential for low rates to cause a bubble in real estate and other asset markets. But members of the FOMC were also concerned that the inflation rate was consistently running below its target of 2%. A below-target inflation rate indicated that the Fed should pursue a more expansionary policy. But the unemployment rate was consistently below the FOMC’s forecast. The Fed did begin slowly increasing its target for the federal funds rate in December 2015, but by July 2019, slowing growth led the Fed to cut its target. In March 2020, the Fed cut the target back to a range of 0% to 0.25%, in response to the economic effects of the Covid-19 pandemic and announced that it would maintain that target through at least the end of 2022. In determining monetary policy, the Fed’s forecasts of future unemployment and inflation are crucial, and these forecasts typically rely on macroeconomic models, as this chapter explores.

Teaching Tips Instructors whose courses emphasize policy will want to devote significant class time to the material in this chapter because it extends the discussion of monetary theory in the previous chapter. This chapter introduces the IS-MP model, which shifts the focus from the central bank’s targeting the money supply to the central bank’s targeting the federal funds rate. This results in a more realistic and modern approach that allows students to tie what they learn in class to the policy discussions they encounter in the media. The chapter concludes with a discussion of monetary transmission mechanisms, including the economics of the bank lending and balance sheet channels. The chapter concludes with a succinct appendix on the IS-LM model for instructors who wish to cover it.

18.1 The IS Curve (pages 634–644) Learning Objective: Explain what the IS curve is and how it is derived.

A. Equilibrium in the Goods Market Equilibrium occurs in the goods market when the value of goods and services demanded— aggregate expenditure (AE)—equals the value of goods and services produced, or real GDP (Y).

If AE is less than Y, inventories will increase. Real GDP and employment will decline, and the economy will be in a recession (the opposite occurs when AE exceeds Y). Studies have shown that households spend more when their current income is rising and spend less when their current income is falling. Consumption is related to GDP using the marginal propensity to consumer (MPC) such that C = MPC × Y, where MPC is between 0 and 1. Holding the other components of AE fixed, the relationship between C and Y implies that the slope of the AE curve is equal to the MPC. The goods market equilibrium can be shown graphically using the AE curve and a 45o line as AE = Y. B. Potential GDP and the Multiplier Effect The Fed’s goal is to have equilibrium GDP close to potential GDP, which is the level of real GDP attained when all firms are producing at capacity. A decline in autonomous spending leads to a larger decline in equilibrium GDP due to an induced decrease in consumption as households reduce their spending as their incomes decline. The series of induced changes in consumption spending that result from an initial change in autonomous expenditure is called the multiplier Copyright © 2022 Pearson Education, Inc.

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effect. The change in equilibrium GDP resulting from a change in autonomous expenditure is called the multiplier.

C. Constructing the IS Curve Introducing the real interest rate into the AE model helps to derive the IS curve, which shows the combination of real interest rates and GDP where the goods market is in equilibrium. Higher real interest rates lead to a decline in AE, which in turn results in a decline in GDP. D. The Output Gap The output gap is the percentage difference between real GDP and potential GDP. The IS curve can be modified to reflect the relationship between real interest rates and the output gap.

E. Shifts of the IS Curve An aggregate demand shock is a change in one of the components of AE that causes the IS curve to shift. Positive demand shocks shift the IS curve to the right, while negative demand shocks shift the IS curve to the left.

18.2 The MP Curve and the Phillips Curve (pages 644–652) Learning Objective: Explain the significance of the MP curve and the Phillips curve.

A. The MP Curve The IS–MP model assumes that the Fed attempts to control the real interest rate by changing its target for the federal funds rate. The MP curve is a horizontal line at the real interest rate determined by the Fed because we assume that the Fed is able to keep the real interest rate constant. According to the IS-MP model, when the Fed changes the real interest rate, the output gap changes.

B. The Phillips Curve When real GDP is below potential GDP, firms operate below their capacity and the unemployment rate rises, which puts downward pressure on costs and prices, ultimately leading to a lower inflation rate. A graph showing the short-run relationship between the unemployment rate and the inflation rate is called a Phillips curve. Economists who have studied the Phillips curve relationship have concluded that rather than there being a single stable trade-off between inflation and unemployment, the position of the Phillips curve can shift over time in response to supply shocks and changes in expectations of the inflation rate. In addition, most economists believe that the best way to capture the effect of changes in the unemployment rate on the inflation rate is by looking at the natural rate of unemployment, which is the gap between the current unemployment rate and the unemployment rate when the economy is at full employment.

C. Okun’s Law and an Output Gap Phillips Curve Instead of considering the relationship between inflation and cyclical unemployment, we can use Okun’s Law to derive a Phillips curve that relates inflation to the output gap.

18.3 Equilibrium in the IS-MP Model (pages 652–662) Learning Objective: Use the IS-MP model to illustrate macroeconomic equilibrium.

A. Using Monetary Policy to Fight a Recession A negative demand shock results in a decline in AE causing a negative output gap, which puts downward pressure on inflation. The Fed fights recessions by lowering the federal funds rate so that AE increases, causing the output gap to return to zero and the inflation rate to return to its previous level.

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B. Complications in Fighting the Recessions of 2007–2009 and 2020 During the financial crisis of 2007–2009, long-term real interest rates did not respond as they typically do to the decline in the federal funds rate due to a rise in the risk premium. The economy began to recover in mid-2009 only after the risk premium began to decline to more normal levels. During the 2020 recession, the increase in the risk premium was much smaller.

C. The Fed’s New Monetary Policy Strategy In August 2020, the Fed announced that in attempting to reach its goal of high employment it would no longer rely on a particular estimate of the natural rate of unemployment in setting monetary policy.

Teaching Tips The discussion about the complications involved in fighting the recessions of 2007–2009 and 2020 helps to explain the difference between a typical recession and one caused by a financial crisis or by a pandemic.

Encourage students to discuss the role and effectiveness of monetary policy in response to a financial crisis such as that in 2007–2009 and in 2020. One point to note is that a rise in risk premiums can offset some of the effects of an expansionary monetary.

18.4 Are Interest Rates All That Matter for Monetary Policy? (pages 662–667) Learning Objective: Discuss alternative channels of monetary policy.

In the IS–MP model, monetary policy works through the channel of interest rates.

A. The Bank Lending Channel and the Shadow Bank Lending Channel In the bank lending channel, a change in banks’ ability or willingness to lend affects bankdependent borrowers’ ability to finance their spending plans. In this channel, a monetary expansion increases banks’ ability to lend, and increases in loans to bank-dependent borrowers increase their spending. Nonbank financial firms, or shadow banks, have increased their importance in the financial system. In response to low interest rates since 2008 many investors sold money market funds and bought bond mutual funds that had higher returns. The effect of the shadow bank lending channel is to make expansionary monetary policy less effective.

B. The Balance Sheet Channel: Monetary Policy and Net Worth The balance sheet channel describes ways in which, by changing interest rates, monetary policy affects borrowers’ net worth and spending decisions. Increases in interest rates in response to a contractionary monetary policy increase the amounts that borrowers with variable-rate loans pay on their debts and reduce the value of borrowers’ net worth by reducing the present value of their assets. This fall in net worth raises the cost of external financing by more than the increase that is implied by higher interest rates, and it reduces firms’ ability to invest in plant and equipment.

18.A Appendix: The IS–LM Model (pages 675–678) Learning Objective: Use the IS–LM model to illustrate macroeconomic equilibrium.

The IS–MP model in the chapter assumes that the Fed is targeting the federal funds rate. The IS–LM model in the appendix assumes that the Fed targets the money supply.

A. Deriving the LM curve The LM curve shows the combination of real interest rates and real GDP that result in equilibrium in the money market. Holding the supply of real money balances constant in the money market, higher levels of real GDP are associated with higher levels of the real interest rate.

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B. Shifting the LM Curve The LM curve will shift if factors, other than real GDP, that affect the demand or supply for real balances change.

C. Monetary Policy in the IS–LM Model Equilibrium in both the goods market and the money market occurs where the IS and LM curves cross. If the Fed increases real money balances, the LM curve shifts to the right, resulting in a decline in the real interest rate and an increase in real GDP relative to potential GDP.

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 18.1 The IS Curve Learning objective: Explain what the IS curve is and how it is derived.

Review Questions 1.1

The three parts of the IS–MP model are: 1. The IS curve, which shows the combinations of the real interest rate and aggregate output that represent equilibrium in the market for goods and services.

2. The MP curve, which represents Federal Reserve monetary policy.

3. The Phillips curve, which shows the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.

1.2

The goods market is the market for all goods and services in the economy. At Y2, aggregate expenditure is less than real GDP and there is an unintended increase in inventories, leading to a decline in real GDP. At Y3, aggregate expenditure is greater than real GDP and there is an unintended decrease in inventories, leading to an increase in real GDP.

1.3

The multiplier in the simple model equals 1/(1 – MPC). The larger the MPC, the larger the multiplier.

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1.4

Fiscal policy refers to changes in government spending and/or taxes intended to achieve macroeconomic policy objectives. If government spending increases by $50 billion, equilibrium GDP will increase by $50 billion times the spending multiplier.

1.5

The IS curve represents equilibrium in the goods market because it shows the combinations of the real interest rate and real GDP where planned aggregate expenditure equals real GDP. The IS curve is downward sloping because an increase in the real interest rate decreases consumption spending, investment spending, and net exports, which decreases the level of real GDP at which aggregate expenditure equals real GDP. Increases in consumption, investment, government spending, or net exports, or a decrease in taxes, will shift the IS curve to the right. Likewise, decreases in consumption, investment, government spending, or net exports, or an increase in taxes, will shift the IS curve to the left.

1.6

The output gap is the percentage difference between actual GDP and potential GDP. During a recession, actual GDP falls, so the output gap is negative.

Problems and Applications 1.7

We know that at equilibrium, Y = C + I + G + NX. Substituting in the given values, we have: Y = 0.75Y + $2.3 trillion + $1.7 trillion + (−$0.5 trillion) Y − 0.75Y = $3.5 trillion Y = $3.5 trillion/0.25 = $14 trillion The investment spending multiplier equals: 1/(1 × MPC) = 1/(1−0.75) = 4.

1.8

Disagree. The capacity of a firm is not the maximum output that the firm is capable of producing. The capacity of a firm is its production when operating on normal hours, using a workforce of normal size.

1.9

With a large value for the multiplier, any shock to the economy that changes autonomous expenditure causes a large change in real GDP, making the economy less stable.

1.10 a. b. c. d.

Consumption spending will increase, so the IS curve will shift to the right.

Planned investment spending will increase, so the IS curve will shift to the right.

The IS curve will not shift; instead there will be a movement up along the curve.

Planned investment spending will decrease, so the IS curve will shift to the left.

1.11

The larger the multiplier, the flatter (more elastic) the IS curve. With a larger multiplier, any given change in autonomous spending caused by a change in the real interest rate will lead to a larger change in equilibrium output in the market for goods and services.

1.12 a. An increase in Canadian interest rates would increase the demand for Canadian dollars, and so the Canadian dollar would appreciate. This appreciation would, in turn, reduce Canadian exports and increase Canadian imports. The multiplier effect of the increase in government spending would be less because of the reduction in net exports. b. Increases in interest rates will reduce investment and interest-sensitive consumption, further reducing the expansionary multiplier effect of an increase in government spending.

1.13

We could conclude that the IS curve was very inelastic, or close to vertical, during this period, as changes in the interest rate had little effect on investment.

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18.2 The MP Curve and the Phillips Curve Learning objective: Explain the significance of the MP curve and the Phillips curve.

Review Questions 2.1

Short-term interest rates and long-term interest rates tend to rise and fall together, so changes in the federal funds rate lead to changes in long-term interest rates. If expectations of future inflation rates remain stable, changes in nominal interest rates change real interest rates.

2.2

The Taylor rule is: Federal funds rate target = Current inflation rate + Equilibrium real federal funds rate + (1/2 × Inflation gap) + (1/2 × Output gap). The Taylor rule is linked to the MP curve because the MP curve is a horizontal line at the real interest rate, which the Fed keeps constant by changing the federal funds rate target. The MP curve is a horizontal line because the model assumes that the Fed is able to keep the real interest rate constant despite increases or decreases in the output gap.

The Fed changes the position of the MP curve by increasing or decreasing its target for the federal funds rate.

2.3

When the Fed raises the real interest rate, the economy moves up along the IS curve and the value of the output gap decreases.

2.4

Supply shocks and changes in the expected inflation rate shift the Phillips curve.

2.5

Okun’s law is a statistical relationship between the output gap and the cyclical rate of unemployment. The output gap Phillips curve can be derived from the unemployment Phillips curve by replacing the unemployment gap (cyclical unemployment) with the output gap equivalent from Okun’s law.

Problems and Applications 2.6

a. Being on automatic pilot, in this sense, means using a rules approach to monetary policy rather than using active policies in response to business cycle changes. b. The FOMC would be reluctant to put monetary policy on automatic pilot because it means that they would be unable to respond to shocks as they arise. c. The Taylor rule is: Federal funds rate target = Current inflation rate + Equilibrium real federal funds rate + (1/2 × Inflation gap) + (1/2 × Output gap). While the current inflation rate is known, the equilibrium real federal funds rate and the inflation and output gaps are based on forecasts. If the FOMC’s forecasts differ from those used by the Wall Street Journal columnist, this could explain the FOMC’s choice. However, it is also true that the FOMC does not follow this rule precisely and at various times may weigh either the output or inflation gap more heavily than the other gap.

2.7

If the FOMC had known that the inflation rate would stay below target, it might have chosen a more expansionary policy stance (and might not have started increasing rates in 2019).

2.8

a. If the Phillips curve has flattened, a decrease in the unemployment rate will have a smaller effect on the inflation rate than it would have otherwise. b. The equation of the Phillips curve is 𝜋𝜋 = 𝜋𝜋 𝑒𝑒 − 𝑎𝑎(𝑈𝑈 − 𝑈𝑈 ∗ ) − 𝑠𝑠 Therefore, changes in expected inflation shift the Phillips curve up or down. When the Phillips curve shifts up, the trade-off between unemployment and inflation worsens, all other things equal. If inflation expectations are stable, then the curve does not shift. Therefore, stable

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inflation expectations do not change the slope of the curve, but stable expectations do explain why the curve has not shifted upwards towards a worse trade-off between unemployment and inflation.

2.9

a. A decrease in expected inflation would shift the short-run Phillips curve downward. b. An increase in actual inflation would cause a movement upward along the short-run Phillips curve. c. A substantial decrease in the price of oil is a positive supply shock, which would cause the shortrun Phillips curve to shift downward. d. An increase in cyclical unemployment would cause a movement downward along the short-run Phillips curve. e. Favorable weather conditions resulting in bumper agricultural crops would cause a positive supply shock, which would shift the short-run Phillips curve downward.

2.10 a. According to Okun’s law, the output gap is equal to negative 2 times the cyclical unemployment ~ rate, Y = –2 × (U – U*). b. Okun’s law has been reasonably stable over time but did poorly predicting cyclical unemployment at the end of the 2007-2009 recession through mid-2013. c. A “rule of thumb” is a general principle that is roughly correct. Okun’s law has historically been a good rule of thumb.

2.11 a. It takes time for monetary policy to affect the economy. In general, if inflation is expected to rise to an unacceptable level in the future, it is best to implement policies that will head off that inflation rather than waiting until inflation rises and then trying to fix the problem. b. Because inflation was low in August 2020 and was expected to stay low for some time, the policy announcement meant that the FOMC would not be raising rates preemptively, suggesting to markets that rates would remain low for a long time. The long-term interest rate is the equal to the real rate of interest plus expected (long-run) inflation plus a term premium; if markets expect that long-run inflation will be lower than previously expected, long-term interest rates will fall. Likewise, investors might require a lower term premium if the chance of higher inflation is reduced.

2.12 a. The natural rate of unemployment depends on a variety of factors that can be difficult to observe. A lower natural rate of unemployment would imply more slack in the labor market and would explain a slower rate of wage growth. The FOMC would therefore be likely to prefer a more expansionary policy stance than it would have chosen if the natural rate of unemployment were higher. b. A lower natural rate of unemployment would shift the unemployment rate version of the shortturn Phillips curve down, because any given unemployment rate would be associated with more slack in the labor market and a lower inflation rate. The output gap version of the Phillips curve would not shift, because the output gap is not the level of real GDP but is, instead, the difference between real GDP and potential GDP, and is constructed to always have a value of 0.

18.3 Equilibrium in the IS–MP Model Learning objective: Use the IS–MP model to illustrate macroeconomic equilibrium.

Review Questions 3.1

The first graph that follows shows that in long-run equilibrium the IS and MP curves intersect where the output gap equals zero. The second graph shows that in long-run equilibrium the Copyright © 2022 Pearson Education, Inc.

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Phillips curve intersects the line representing an output gap of zero at the point where the expected and actual inflation rates are equal. In long-run equilibrium, the output gap equals zero and the actual and expected inflation rates are equal.

3.2

When the Fed lowers the real interest rate, the MP curve shifts down. The IS curve and the output gap Phillips curve do not shift. The lower real interest rate causes a movement down along the IS curve, and the increase in the output gap causes a movement up along the Phillips curve, resulting in a higher inflation rate.

3.3

The default risk premium is the additional yield that an investor requires for holding a bond with some default risk. The default risk premium dramatically increased during the 2007–2009 recession, particularly after the failure of Lehman Brothers in September 2008 because the perceived risk of borrowers defaulting had sharply increased. Likewise, the default risk premium increased during the 2020 recession but by significantly less, and it returned to more normal Copyright © 2022 Pearson Education, Inc.

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levels quickly due to the Fed’s rapid easing of credit conditions. An increase in the default risk premium shifts the MP curve up and decreases the output gap (makes the output gap more negative) as real GDP declines relative to potential GDP. Problems and Applications 3.4

In the first graph that follows, the large positive demand shock shifts the IS curve to the right, from IS1 to IS2, increasing the output gap as real GDP increases relative to potential GDP. The increase in the output gap results in a movement up the Phillips curve, increasing the inflation rate from π1 to π2, shown in the second graph that follows. To reduce inflation, the Fed can raise the federal funds rate, shifting the MP curve up from MP1 to MP2. The higher real interest rate reduces the output gap to zero, and the inflation rate falls from π2 back to π1.

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3.5

During the Great Depression, the economies of the United States and the United Kingdom were far below potential GDP and unemployment was very high. In those circumstances, even very large increases in aggregate expenditure—as a result of a substantial increase in government purchases, for example—were unlikely to lead to a significant increase in the inflation rate. In other words, Keynes and Hicks believed that under the circumstances, aggregate demand rather than aggregate supply should be the focus of macroeconomic analysis.

3.6

In conducting monetary policy, the Federal Reserve since the early 1980s has targeted the federal funds rate, not the money supply. Replacing the LM curve with the MP curve helps the short-run macroeconomic model do a better job of capturing the effects of Federal Reserve policy on the economy.

3.7

Having to rely on “real-time data” that is subject to revisions strengthens the argument against fine-tuning the economy with activist stabilization policy. With data inaccuracies, fine-tuning could lead to the wrong policies. For example, the Federal Reserve might begin an expansionary monetary policy on the basis of data showing that real GDP had declined below potential GDP. If later data revisions showed that the decline in real GDP had not actually taken place, the expansionary monetary policy could lead to an unnecessary increase in inflation. The policy of focusing on long-run objectives such as low inflation or steady economic growth depends less on policymakers having access to data that accurately reflect the current state of the economy.

3.8

a. “Private-label” mortgage-backed securities are securities issued by investment banks or other financial firms (rather than through Fannie Mae or Freddie Mac). b. During a severe recession, it is more likely that homeowners will default on mortgages, making them intrinsically more risky. Issuers of private-label MBS will therefore be less likely to purchase mortgages, and so the majority of mortgages will be purchased by Fannie Mae and Freddie Mac, organizations that are more able to bear the higher risk due to their government sponsorship.

3.9

a. The federal government effectively controls the residential mortgage market. With the federal government implicitly guaranteeing Fannie Mae and Freddie Mac mortgage-backed securities, the private securitization of mortgages has almost disappeared. Through its control of Fannie Mae and Freddie Mac and other federal agencies, the federal government holds the majority of residential mortgages. b. To reduce the government’s role in the mortgage market, Fannie Mae and Freddie Mac would have to return to being private corporations—they would have to be privatized by having the U.S. Treasury sell off its stock holdings in the firms. To level the playing field in the mortgage securitization market, Fannie Mae and Freddie Mac would need to be required to hold substantial amounts of capital and have their exemption from state and local taxes eliminated.

Additionally, given the implicit government guarantee of Fannie Mae and Freddie Mac, the two firms would need to pay fees to the federal government so that they would not have an advantage over other firms in the mortgage securitization market in raising funds from investors.

Reducing the government’s role in the mortgage market has proven difficult for two reasons.

First, reducing the government’s role in the mortgage market would increase mortgage interest rates which would reduce the accessibility of mortgages and home ownership. Second, the government would lose an important tool that allows it to intervene in the mortgage market during a financial crisis. c. Stricter lending requirements for mortgages, such as larger down payments, make mortgages safer and the bundling of mortgages into mortgage-backed securities by Fannie Mae and Freddie Mac safer. The stricter requirements, however, make mortgages to potential homebuyers less accessible. The government through effectively guaranteeing Fannie Mae and Freddie Mac Copyright © 2022 Pearson Education, Inc.

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mortgage-backed securities reduces risk to financial firms issuing mortgages and reduces mortgage interest rates, which increase the accessibility of mortgages to potential homeowners, but makes mortgage-backed securities less safe.

3.10 a. In the top graph that follows, equilibrium initially occurs where the MP1 curve intersects the IS curve. The real interest rate equals r1 and the output gap equals zero. In the bottom graph, equilibrium initially occurs where the PC1 curve intersects the line where the output gap equals zero. The inflation rate equals –2%.

These 2 graphs apply to answers for parts a., b., and c.

b. The Fed should reduce its target for the federal funds rate, lowering the real interest rate from r1 to r2. In the top graph (see above), the MP curve will shift down from MP1 to MP2. The lower real interest rate causes a movement along the IS curve. The output gap changes to 𝑌𝑌�2 . As a result of the change in the output gap, there is a movement along the PC1 curve and the inflation rate increases from –2% to 2%. c. As the inflation rate persists at 2%, the expected inflation rate will increase from –2% to 2%, shifting the output gap Phillips curve in the bottom graph up from PC1 to PC2. The Fed would then raise the real interest rate from r2 to r1, causing the MP curve to shift back up from MP2 to MP1, returning the output gap to zero. The economy has returned to long-run equilibrium at an inflation rate of 2%.

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3.11 a. Fiscal stimulus refers to increases in government spending or cuts in taxes. b. In mid-2020, the output gap was negative. Output was less than potential output. c. There are limits to the ability of monetary policy to induce increases in spending, especially when the fed funds rate is already zero or very low. To stimulate the economy, it was likely that increases in government spending or other fiscal policies would be more effective. d. The graph that follows shows an economy with a negative output gap at the current real interest rate, r1. An expansionary fiscal policy would shift the IS curve to the right to IS2, moving the economy to (or near) potential output.

18.4 Are Interest Rates All That Matter for Monetary Policy Learning Objective: Discuss alternative channels for monetary policy.

Review Questions 4.1

The channels of monetary policy refer to the ways in which monetary policy can affect output and prices. The four channels described in the chapter are: 1. The interest rate channel (how changes in interest rates affect aggregate expenditures) 2. The bank lending channel (how changes in bank willingness to lend affect spending patterns) 3. The shadow bank lending channel (how changes in the ability of shadow banks to buy commercial paper affects firm spending patterns) 4. The balance sheet channel (how changes in interest rates affect household net worth and spending decisions)

4.2

Yes, through the bank lending channel. In the bank lending channel, monetary policy affects the spending decisions of borrowers who depend on bank loans. This channel focuses on the economic fact that many households and firms depend on bank loans for credit because they have few or no alternative sources of credit.

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Problems and Applications 4.3

The bank lending channel (as it operates through commercial banks) and the balance sheet channel reinforce the interest rate channel. For example, consider an expansionary monetary policy that increases bank reserves and lowers interest rates. The increase in bank reserves increases banks’ ability to lend to bank-dependent borrowers (the bank lending channel) and the lower interest rate increases the net worth of borrowers, increasing their ability to borrow (the balance sheet channel). The bank lending channel (as it operates through shadow banks) partially offsets the effect of the interest rate channel, at least when expansionary monetary policy takes the form of very low interest rates. Because very low interest rates result in a contraction of commercial paper purchases by money market mutual funds, they may have a negative effect on firms that rely on issuing commercial paper to fund their short-term operations.

4.4

A monetary expansion increases banks’ ability to lend, and increases in loans to bank-dependent borrowers increase their spending. A monetary contraction decreases banks’ ability to lend, and decreases in loans to bank-dependent borrowers reduce their spending.

4.5

You would expect the bank lending channel to have a larger effect in emerging economies.

Financial markets are considerably less developed in emerging economies, so firms are more dependent on banks and similar financial intermediaries.

4.6

If the program by the U.S. Treasury of guaranteeing investors against losses on their holdings of money market mutual fund shares had become permanent, the bank lending channel as it operates through shadow banks would be diminished. With the guarantee against losses, fewer investors would move funds out of money market mutual funds when interest rates fell to low levels. Therefore, the contraction of commercial paper purchases by money market mutual funds would not be as great.

4.7

a. In terms of the output gap, “slack” means that actual output is below potential output (and so the output gap is negative). b. In the IS–MP model, it is certainly possible for the economy to experience inflation and slack at the same time. For example, in the case of an oil price shock, the increase in oil prices drives up inflation, shifting the Phillips curve up. At the same time, at least for countries that are oil importers, the increase in the price of oil increases the price of imports, and with inelastic demand for oil in the short run, raises the total value of imports. The oil price increase may also may reduce spending in other categories, which would shift the IS curve to the left , creating an output gap. The economy now has a higher rate of inflation at the same time that there is an output gap, the situation that existed in the 1970s.

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Data Exercises D18.1

a. The relationship between the federal funds rate and long-term nominal interest rates is not as strong as the relationship between the federal funds rate and other short-term nominal interest rates because long-term interest rates include the term-structure effect of expected future short-term interest rates and the term premium attached to longer-term securities. b. Although all three rates tend to move together, the relationship between the federal funds rate and the 30-year fixed mortgage rate is weaker than the relationship between the federal funds rate and the 10-year Treasury note rate. Compared with the 10-year Treasury rate, the 30year mortgage rate fluctuates more because of the effect of changes over time in the default risk premium. During the first part of the 2007–2009 recession as the federal funds rate fell sharply, mortgage interest rates rose, partly due to a higher risk of default caused by falling house prices.

D18.2

a.

The default-risk premium in AAA rated corporate bonds equals the interest rate on AAA rated corporate bonds minus the interest rate on 10-year U.S. Treasury notes.

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Business Cycle Trough April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 November 2001 June 2009 In early 2021, the National Bureau of Economic Research had not yet determined the month of the business cycle trough.

b. The default-risk premium rises during recessions, which would, holding everything else constant, raise the MP curve. c. To offset the effect of a rise in the default-risk premium during recessions, the Fed could lower the federal funds rate and could also signal that it intended to keep short-term interest rates low several years into the future, which would lower future expected short-term rates and, thereby, lower current long-term interest rates.

D18.3

a. Calculate the expected inflation rate by subtracting the interest rate on 10-year U.S. Treasury inflation-protected securities from the interest rate on 10-year U.S. Treasury notes and use it to calculate the real interest rate on Aaa corporate bonds in part (b) below.

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b.

c. The real interest rate on Aaa corporate bonds went from 3.18% in December 2007 to 3.43% in August 2008. Because the real interest rate increased by a relatively small amount, it seems likely that a shift to the left of the IS curve was responsible for the start of the recession. d. The real interest rate on Aaa corporate bonds went from 4.80% in September 2008 to 5.48% in November 2008. The rise in the real interest rate suggests that a shift upward of the MP curve was responsible for the worsening of the recession during the fall of 2008.

D18.4

a. For the 1966–1969 period, the economy moved up the short-run Phillips curve with the inflation rate rising and the unemployment rate declining. b. For the 1973–1975 period, both the inflation rate and the unemployment rate rose, implying that the short-run Phillips curve shifted up. c. For the 1992–1994 period, both the inflation rate and the unemployment rate fell, implying that the short-run Phillips curve shifted down. d. For the 2000–2002 period, the economy moved out the short-run Phillips curve with the inflation rate falling and the unemployment rate rising.

Year 1966 1967

Unemployment Rate 3.8% 3.8

Inflation Rate 3.0% 2.8

1968

3.6

4.2

1969

3.5

5.4

1973

4.9

6.3

1974

5.6

11.0

1975

8.5

9.1

1992

7.5

3.0

1993

6.9

3.0

1994

6.1

2.6

2000

4.0

3.4

2001

4.7

2.8

2002

5.8

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